XNYS:NCTPRD Newcastle Investment Corporation Pref Share Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10-Q

 

S   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2012

 

or

 

£   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

 

For the transition period from _____________________ to ___________________

 

Commission File Number: 001-31458

 

Newcastle Investment Corp.


(Exact name of registrant as specified in its charter)

 

Maryland   81-0559116
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)
     
1345 Avenue of the Americas, New York, NY   10105
(Address of principal executive offices)   (Zip Code)

 

(212) 798-6100


(Registrant’s telephone number, including area code)

 


(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes S No £

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

S Yes No £

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer £   Accelerated filer S   Non-accelerated filer £ (Do not check if a smaller reporting company)

Smaller reporting company £

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes £ No S

 

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the last practicable date.

 

Common stock, $0.01 par value per share: 172,487,757 shares outstanding as of August 7, 2012.

 



 
 

 

CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS

 

This report contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements relate to, among other things, the operating performance of our investments, the stability of our earnings, and our financing needs. Forward-looking statements are generally identifiable by use of forward-looking terminology such as “may,” “will,” “should,” “potential,” “intend,” “expect,” “endeavor,” “seek,” “anticipate,” “estimate,” “overestimate,” “underestimate,” “believe,” “could,” “project,” “predict,” “continue” or other similar words or expressions. Forward-looking statements are based on certain assumptions, discuss future expectations, describe future plans and strategies, contain projections of results of operations or of financial condition or state other forward-looking information. Our ability to predict results or the actual outcome of future plans or strategies is inherently uncertain. Although we believe that the expectations reflected in such forward-looking statements are based on reasonable assumptions, our actual results and performance could differ materially from those set forth in the forward-looking statements. These forward-looking statements involve risks, uncertainties and other factors that may cause our actual results in future periods to differ materially from forecasted results. Factors which could have a material adverse effect on our operations and future prospects include, but are not limited to:

 

reductions in cash flows received from our investments;
our ability to take advantage of opportunities in additional asset classes or types of assets, including, without limitation, senior living facilities, at attractive risk-adjusted prices or at all;
our ability to take advantage of investment opportunities in interests in excess mortgage servicing rights (“Excess MSRs”);
our ability to deploy capital accretively;
the risks that default and recovery rates on our real estate securities and loan portfolios deteriorate compared to our underwriting estimates;
changes in prepayment rates on the loans underlying certain of our assets, including, but not limited to, our Excess MSRs;
the risk that projected recapture rates on the portfolios underlying our Excess MSRs are not achieved;
the relationship between yields on assets which are paid off and yields on assets in which such monies can be reinvested;
the relative spreads between the yield on the assets we invest in and the cost of financing;
changes in economic conditions generally and the real estate and bond markets specifically;
adverse changes in the financing markets we access affecting our ability to finance our investments, or in a manner that maintains our historic net spreads;
changing risk assessments by lenders that potentially lead to increased margin calls, not extending our repurchase agreements or other financings in accordance with their current terms or entering into new financings with us;
changes in interest rates and/or credit spreads, as well as the success of any hedging strategy we may undertake in relation to such changes;
the quality and size of the investment pipeline and the rate at which we can invest our cash, including cash inside our collateralized debt obligations (“CDOs”);
impairments in the value of the collateral underlying our investments and the relation of any such impairments to our judgments as to whether changes in the market value of our securities, loans or real estate are temporary or not and whether circumstances bearing on the value of such assets warrant changes in carrying values;
legislative/regulatory changes, including but not limited to, any modification of the terms of loans;
the availability and cost of capital for future investments;
competition within the finance and real estate industries; and
other risks detailed from time to time below, particularly under the heading “Risk Factors,” and in our other SEC reports.

 

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. The factors noted above could cause our actual results to differ significantly from those contained in any forward-looking statement.

 

Readers are cautioned not to place undue reliance on any of these forward-looking statements, which reflect our management’s views only as of the date of this report. We are under no duty to update any of the forward-looking statements after the date of this report to conform these statements to actual results.

 

 
 

 

SPECIAL NOTE REGARDING EXHIBITS

 

In reviewing the agreements included as exhibits to this Quarterly Report on Form 10-Q, please remember they are included to provide you with information regarding their terms and are not intended to provide any other factual or disclosure information about the Company or the other parties to the agreements.  The agreements contain representations and warranties by each of the parties to the applicable agreement.  These representations and warranties have been made solely for the benefit of the other parties to the applicable agreement and:

 

should not in all instances be treated as categorical statements of fact, but rather as a way of allocating the risk to one of the parties if those statements provide to be inaccurate;
   
have been qualified by disclosures that were made to the other party in connection with the negotiation of the applicable agreement, which disclosures are not necessarily reflected in the agreement;
   
may apply standards of materiality in a way that is different from what may be viewed as material to you or other investors; and
   
were made only as of the date of the applicable agreement or such other date or dates as may be specified in the agreement and are subject to more recent developments.

 

Accordingly, these representations and warranties may not describe the actual state of affairs as of the date they were made or at any other time.  Additional information about the Company may be found elsewhere in this Quarterly Report on Form 10-Q and the Company’s other public filings, which are available without charge through the SEC’s website at http://www.sec.gov.

 

The Company acknowledges that, notwithstanding the inclusion of the foregoing cautionary statements, it is responsible for considering whether additional specific disclosures of material information regarding material contractual provisions are required to make the statements in this report not misleading.

 

 
 

 

NEWCASTLE INVESTMENT CORP.

FORM 10-Q

 

INDEX

 

      PAGE
       
PART I. FINANCIAL INFORMATION    
       
Item 1.   Financial Statements    
       
  Consolidated Balance Sheets as of June 30, 2012 (unaudited) and December 31, 2011     1
       
  Consolidated Statements of Income (unaudited) for the three and six months ended June 30, 2012 and 2011     2
       
  Consolidated Statements of Comprehensive Income (unaudited) for the three and six months ended June 30, 2012 and 2011     3
       
  Consolidated Statement of Stockholders’ Equity (unaudited) for the six months ended June 30, 2012     4
       
  Consolidated Statements of Cash Flows (unaudited) for the six months ended June 30, 2012 and 2011     5
       
  Notes to Consolidated Financial Statements (unaudited)     7
       
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations   36
       
Item 3. Quantitative and Qualitative Disclosures About Market Risk   64
       
Item 4.   Controls and Procedures   66
       
PART II.  OTHER INFORMATION    
       
Item 1. Legal Proceedings   67
       
Item 1A. Risk Factors   67
       
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds   91
       
Item 3. Defaults upon Senior Securities   91
       
Item 4. Mine Safety Disclosures   91
       
Item 5. Other Information   91
       
Item 6. Exhibits   92
       
SIGNATURES   95

 

 

 

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS 

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except share data)


 

   June 30, 2012     
   (Unaudited)   December 31, 2011 
Assets          
Non-Recourse VIE Financing Structures          
Real estate securities, available-for-sale  $1,505,791   $1,479,214 
Real estate related loans, held-for-sale, net   891,953    807,214 
Residential mortgage loans, held-for-investment, net   311,097    331,236 
Subprime mortgage loans subject to call option   405,247    404,723 
Operating real estate, held-for-sale   7,737    7,741 
Other investments   18,883    18,883 
Restricted cash   62,692    105,040 
Derivative assets   966    1,954 
Receivables from brokers, dealers and clearing organizations   30,632     
Receivables and other assets   21,021    23,319 
    3,256,019    3,179,324 
Recourse Financing Structures and Unlevered Assets          
Real estate securities, available-for-sale   532,609    252,530 
Real estate related loans, held-for-sale, net       6,366 
Residential mortgage loans, held-for-sale, net   2,946    2,687 
Investments in excess mortgage servicing rights at fair value   265,132    43,971 
Other investments   6,024    6,024 
Cash and cash equivalents   102,647    157,356 
Receivables and other assets   28,313    3,541 
    937,671    472,475 
   $4,193,690   $3,651,799 
Liabilities and Stockholders’ Equity          
Liabilities          
Non-Recourse VIE Financing Structures          
CDO bonds payable  $2,350,648   $2,403,605 
Other bonds and notes payable   179,001    200,377 
Repurchase agreements   5,538    6,546 
Financing of subprime mortgage loans subject to call option   405,247    404,723 
Derivative liabilities   101,809    119,320 
Payables to brokers, dealers and clearing organizations   20,560     
Accrued expenses and other liabilities   14,228    16,112 
    3,077,031    3,150,683 
Recourse Financing Structures and Other Liabilities          
Repurchase agreements   317,972    233,194 
Junior subordinated notes payable   51,246    51,248 
Dividends payable   30,366    16,707 
Due to affiliates   8,448    1,659 
Purchase price payable on investments in excess mortgage servicing rights   31,382    3,250 
Payables to brokers, dealers and clearing organizations   68,296     
Accrued expenses and other liabilities   6,219    2,969 
    513,929    309,027 
    3,590,960    3,459,710 
Stockholders' Equity          
Preferred stock, $0.01 par value, 100,000,000 shares authorized, 1,347,321 shares of 9.75% Series B Cumulative Redeemable Preferred Stock, 496,000 shares of 8.05% Series C Cumulative Redeemable Preferred Stock, and 620,000 shares of 8.375% Series D Cumulative Redeemable Preferred Stock, liquidation preference $25.00 per share, issued and outstanding as of June 30, 2012 and December 31, 2011   61,583    61,583 
Common stock, $0.01 par value, 500,000,000 shares authorized, 147,187,757 and 105,181,009 shares issued and outstanding at June 30, 2012 and December 31, 2011, respectively   1,472    1,052 
Additional paid-in capital   1,542,806    1,275,792 
Accumulated deficit   (1,022,604)   (1,073,252)
Accumulated other comprehensive income (loss)   19,473    (73,086)
    602,730    192,089 
   $4,193,690   $3,651,799 

 

See notes to consolidated financial statements

 

1

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(dollars in thousands, except share data)


 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
   2012   2011   2012   2011 
                 
Interest income  $82,438   $74,143   $157,337   $146,346 
Interest expense   29,462    35,750    59,627    73,915 
Net interest income   52,976    38,393    97,710    72,431 
Impairment (Reversal)                    
Valuation allowance (reversal) on loans   (3,223)   (14,555)   (12,254)   (55,862)
Other-than-temporary impairment on securities   10,859    5,784    16,742    8,896 
Portion of other-than-temporary impairment on securities recognized in other comprehensive income (loss), net of the reversal of other comprehensive loss into net income (loss)   863    (296)   (3,069)   693 
    8,499    (9,067)   1,419    (46,273)
                     
Net interest income after impairment/reversal   44,477    47,460    96,291    118,704 
                     
Other Income (Loss)                    
Gain (loss) on settlement of investments, net   (1,177)   35,606    3,646    69,698 
Gain on extinguishment of debt   39    33,443    20,782    44,485 
Change in fair value of investments in excess mortgage servicing rights   3,523        4,739     
Other income (loss), net   (3,744)   (10,160)   (774)   (9,825)
    (1,359)   58,889    28,393    104,358 
Expenses                    
Loan and security servicing expense   1,104    1,200    2,202    2,260 
General and administrative expense   6,205    1,649    8,490    3,250 
Management fee to affiliate   5,631    4,555    10,607    8,744 
    12,940    7,404    21,299    14,254 
Income from continuing operations   30,178    98,945    103,385    208,808 
Income (loss) from discontinued operations   261    190    525     
Net Income   30,439    99,135    103,910    208,808 
Preferred dividends   (1,395)   (1,395)   (2,790)   (2,790)
Income Available for Common Stockholders  $29,044   $97,740   $101,120   $206,018 
Income Per Share of Common Stock                    
Basic  $0.21   $1.23   $0.84   $2.90 
Diluted  $0.21   $1.23   $0.84   $2.90 
Income from continuing operations per share of common stock, after preferred dividends                    
Basic  $0.21   $1.23   $0.84   $2.90 
Diluted  $0.21   $1.23   $0.84   $2.90 
Income (loss) from discontinued operations per share of common stock                    
Basic  $   $   $   $ 
Diluted  $   $   $   $ 
Weighted Average Number of Shares of Common Stock Outstanding                    
Basic   134,115,335    79,282,480    119,648,172    70,988,410 
Diluted   135,172,953    79,282,480    120,421,528    70,992,828 
Dividends Declared per Share of Common Stock  $0.20   $0.10   $0.40   $0.10 

 

 

See notes to consolidated financial statements

 

2

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

(dollars in thousands)


 

   Three Months Ended
 June 30,
   Six Months Ended
 June 30,
 
   2012   2011   2012   2011 
Net income  $30,439   $99,135   $103,910   $208,808 
Other comprehensive income (loss):                    
Net unrealized gain (loss) on securities   (10,128)   (24,396)   66,289    101,747 
Reclassification of net realized (gain) loss on securities into earnings   12,900    (30,052)   8,413    (58,323)
Net unrealized gain (loss) on derivatives designated as cash flow hedges   4,058    (5,336)   12,232    13,075 
Reclassification of net realized (gain) loss on derivatives designated as cash flow hedges into earnings   5,836    7,867    5,625    12,465 
Other comprehensive income (loss)   12,666    (51,917)   92,559    68,964 
Total comprehensive income  $43,105   $47,218   $196,469   $277,772 

 

3

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (Unaudited)

FOR THE SIX MONTHS ENDED JUNE 30, 2012

(dollars in thousands)


 

   Preferred Stock    Common Stock    Additional Paid-in    Accumulated   Accum. Other Comp. Income    Total Stock- holders’ 
   Shares   Amount   Shares   Amount   Capital   Deficit   (Loss)   Equity 
Stockholders’ equity - December 31, 2011   2,463,321   $61,583    105,181,009   $1,052   $1,275,792   $(1,073,252)  $(73,086)  $192,089 
Dividends declared                       (53,262)       (53,262)
Issuance of common stock           42,006,748    420    267,014            267,434 
Net income                       103,910        103,910 
Other comprehensive income (loss)                           92,559    92,559 
Stockholders’ equity - June 30, 2012   2,463,321   $61,583    147,187,757   $1,472   $1,542,806   $(1,022,604)  $19,473   $602,730 

 

 

See notes to consolidated financial statements

 

4

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) 

(dollars in thousands)


 

   Six Months Ended June 30, 
   2012   2011 
Cash Flows From Operating Activities          
Net income  $103,910   $208,808 
Adjustments to reconcile net income to net cash provided by (used in) operating activities (inclusive of amounts related to discontinued operations):          
Depreciation and amortization   174    137 
Accretion of discount and other amortization   (25,860)   (21,807)
Interest income in CDOs redirected for reinvestment or CDO bond paydown   (2,445)   (6,579)
Interest income on investments accrued to principal balance   (10,914)   (9,298)
Interest expense on debt accrued to principal balance   218    514 
Deferred interest received       1,027 
Non-cash directors' compensation   220    122 
Reversal of valuation allowance on loans   (12,254)   (55,862)
Other-than-temporary impairment on securities   13,673    9,589 
Impairment on real estate held-for-sale       433 
Change in fair value of investments in excess mortgage servicing rights   (4,739)    
Gain on settlement of investments (net) and real estate held-for-sale   (3,646)   (68,766)
Unrealized loss on non-hedge derivatives and hedge ineffectiveness   2,476    11,194 
Gain on extinguishment of debt   (20,782)   (44,485)
Change in:          
Restricted cash   364    245 
Receivables and other assets   (4,371)   1,076 
Due to affiliates   334    99 
Accrued expenses and other liabilities   2,977    (73)
Net cash provided by (used in) operating activities   39,335    26,374 
Cash Flows From Investing Activities          
Principal repayments from repurchased CDO debt   12,567    48,881 
Principal repayments from CDO securities   527    8,865 
Principal repayments from non-Agency RMBS   4,173    70 
Return of investments in excess mortgage servicing rights   4,820     
Principal repayments from loans and non-CDO securities (excluding non-Agency RMBS)   38,115    51,863 
Purchase of real estate securities   (227,670)   (180,245)
Proceeds from sale of real estate securities       3,885 
Acquisition of investments in excess mortgage servicing rights   (190,510)    
Acquisition of servicing rights       (2,268)
Deposit paid on investment in excess mortgage servicing rights   (16,801)    
Payments on settlement of derivative instruments       (14,322)
Net cash provided by (used in) investing activities   (374,779)   (83,271)

 

Continued on page 6

 

See notes to consolidated financial statements

 

5

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) 

JUNE 30, 2012 

(dollars in thousands)


 

   Six Months Ended June 30, 
   2012   2011 
Cash Flows From Financing Activities          
Repurchases of CDO bonds payable   (9,177)   (87,064)
Issuance of other bonds payable       142,736 
Repayments of other bonds payable   (21,684)   (184,242)
Borrowings under repurchase agreements   102,194    108,576 
Repayments of repurchase agreements   (18,424)   (9,263)
Issuance of common stock   268,050    98,843 
Costs related to issuance of common stock   (621)   (468)
Common stock dividends paid   (36,813)    
Preferred stock dividends paid   (2,790)   (5,581)
Payment of deferred financing costs       (1,546)
Restricted cash returned from refinancing activities       62,220 
Net cash provided by (used in) financing activities   280,735    124,211 
Net Increase (Decrease) in Cash and Cash Equivalents   (54,709)   67,314 
Cash and Cash Equivalents, Beginning of Period   157,356    33,524 
Cash and Cash Equivalents, End of Period  $102,647   $100,838 
Supplemental Disclosure of Cash Flow Information          
Cash paid during the period for interest expense  $40,390   $53,169 
Supplemental Schedule of Non-Cash Investing and Financing Activities          
Preferred stock dividends declared but not paid  $930   $930 
Common stock dividends declared but not paid  $29,436   $7,930 
Securities purchased not yet settled  $68,296   $85,278 
Purchase price payable on investments in excess mortgage servicing rights  $31,382   $ 
Deposit on senior housing assets due to affiliates  $5,930   $ 

 

See notes to consolidated financial statements

 

6

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

 1. GENERAL

 

Newcastle Investment Corp. (and its subsidiaries, “Newcastle”) is a Maryland corporation that was formed in 2002. Newcastle conducts its business through the following segments:(i) investments financed with non-recourse collateralized debt obligations (“non-recourse CDOs”), (ii) unlevered investments in deconsolidated Newcastle CDO debt (“unlevered CDOs”), (iii) unlevered investments in excess mortgage servicing rights (“unlevered Excess MSRs”), (iv) investments financed with other non-recourse debt (“non-recourse other”), (v) investments and debt repurchases financed with recourse debt (“recourse”), (vi) other unlevered investments (“unlevered other”) and (vii) corporate. With respect to the non-recourse CDOs and non-recourse other segments, subject to the passing of certain periodic coverage tests, Newcastle is generally entitled to receive the net cash flows from these structures on a periodic basis.

 

Newcastle is organized and conducts its operations to qualify as a real estate investment trust (“REIT”) for U.S. federal income tax purposes. As such, Newcastle will generally not be subject to U.S. federal corporate income tax on that portion of its net income that is distributed to stockholders if it distributes at least 90% of its REIT taxable income to its stockholders by prescribed dates and complies with various other requirements.

 

Newcastle is party to a management agreement (the "Management Agreement") with FIG LLC (the "Manager"), a subsidiary of Fortress Investment Group LLC (“Fortress”), under which the Manager advises Newcastle on various aspects of its business and manages its day-to-day operations, subject to the supervision of Newcastle's board of directors. For its services, the Manager is entitled to an annual management fee and incentive compensation, both as defined in, and in accordance with the terms of, the Management Agreement.

 

In April 2012, Newcastle issued 18,975,000 shares of its common stock in a public offering at a price to the public of $6.22 per share for net proceeds of approximately $115.2 million. For the purpose of compensating the Manager for its successful efforts in raising capital for Newcastle, in connection with this offering, Newcastle granted options to the Manager to purchase 1,897,500 shares of Newcastle’s common stock at the public offering price, which had a fair value of approximately $5.6 million as of the grant date.

 

In May 2012, Newcastle issued 23,000,000 shares of its common stock in a public offering at a price to the public of $6.71 per share for net proceeds of approximately $152.0 million. For the purpose of compensating the Manager for its successful efforts in raising capital for Newcastle, in connection with this offering, Newcastle granted options to the Manager to purchase 2,300,000 shares of Newcastle’s common stock at the public offering price, which had a fair value of approximately $7.6 million as of the grant date.

 

In July 2012, Newcastle issued 25,300,000 shares of its common stock in a public offering at a price, net of underwriting discounts and commissions, to the underwriters of $6.63 per share for net proceeds of approximately $167.4 million, after deducting the expenses for this offering. Certain officers and directors of Newcastle participated in this offering and purchased an aggregate of 450,000 shares at $6.70 per share. For the purpose of compensating the Manager for its successful efforts in raising capital for Newcastle, in connection with this offering, Newcastle granted options to the Manager to purchase 2,530,000 shares of Newcastle’s common stock at $6.70, which had a fair value of approximately $8.3 million as of the grant date.

 

Approximately 4.4 million shares of Newcastle’s common stock were held by Fortress, through its affiliates, and its principals at June 30, 2012. In addition, Fortress, through its affiliates, held options to purchase approximately 8.5 million shares of Newcastle’s common stock at June 30, 2012.

 

The accompanying consolidated financial statements and related notes of Newcastle have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared under U.S. generally accepted accounting principles have been condensed or omitted. In the opinion of management, all adjustments considered necessary for a fair presentation of Newcastle's financial position, results of operations and cash flows have been included and are of a normal and recurring nature. The operating results presented for interim periods are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. These financial statements should be read in conjunction with Newcastle's consolidated financial statements for the year ended December 31, 2011 and notes thereto included in Newcastle’s Annual Report on Form 10-K filed with the Securities and Exchange Commission. Capitalized terms used herein, and not otherwise defined, are defined in Newcastle’s consolidated financial statements for the year ended December 31, 2011.

 

Certain prior period amounts have been reclassified to conform to the current period’s presentation.

 

7

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

In May 2011, the FASB issued new guidance regarding the measurement and disclosure of fair value, which became effective for Newcastle on January 1, 2012. The adoption of this guidance did not have a material impact on Newcastle’s financial position, liquidity or results of operations.

 

In June 2011, the FASB issued a new accounting standard that eliminates the current option to report other comprehensive income and its components in the statement of stockholders’ equity. Instead, an entity will be required to present items of net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements. Newcastle early-adopted this accounting standard in 2011 and opted to present two separate statements.

 

The FASB has recently issued or discussed a number of proposed standards on such topics as consolidation, the definition of an investment company, financial statement presentation, revenue recognition, leases, financial instruments, hedging and contingencies. Some of the proposed changes are significant and could have a material impact on Newcastle’s reporting. Newcastle has not yet fully evaluated the potential impact of these proposals, but will make such an evaluation as the standards are finalized.

 

2. SEGMENT REPORTING AND VARIABLE INTEREST ENTITIES

 

Newcastle conducts its business through the following segments: (i) investments financed with non-recourse collateralized debt obligations (“non-recourse CDOs”), (ii) unlevered investments in deconsolidated Newcastle CDO debt (“unlevered CDOs”), (iii) unlevered investments in excess mortgage servicing rights (“unlevered Excess MSRs”), (iv) investments financed with other non-recourse debt (“non-recourse other”), (v) investments and debt repurchases financed with recourse debt (“recourse”), (vi) other unlevered investments (“unlevered other”) and (vii) corporate. With respect to the non-recourse CDOs and non-recourse other segments, subject to the passing of certain periodic coverage tests, Newcastle is generally entitled to receive the net cash flows from these structures on a periodic basis.

 

In the fourth quarter of 2011, Newcastle changed the composition of its reportable segments such that the unlevered segment is further broken down into (i) unlevered CDOs, (ii) unlevered Excess MSRs and (iii) unlevered other. Management believes the additional segments better reflect its investments in deconsolidated CDOs and its new investment in Excess MSRs. Segment information for previously reported periods in the accompanying financial statements has been restated to reflect this change to the composition of its segments.

 

The corporate segment consists primarily of interest income on short term investments, general and administrative expenses, interest expense on the junior subordinated notes payable and management fees pursuant to the Management Agreement.

 

8

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

 

Summary financial data on Newcastle's segments is given below, together with a reconciliation to the same data for Newcastle as a whole:

 

   Non- Recourse CDOs (A)   Unlevered CDOs (B)   Unlevered Excess MSRs   Non- Recourse Other (A) (C)   Recourse (D)   Unlevered Other (E)   Corporate   Inter- segment Elimination (F)   Total 
Six Months Ended June 30, 2012                                             
Interest income  $110,440   $230   $6,519   $36,463   $1,768   $4,851   $103   $(3,037)  $157,337 
Interest expense   34,640            25,334    561        1,903    (2,811)   59,627 
Net interest income (expense)   75,800    230    6,519    11,129    1,207    4,851    (1,800)   (226)   97,710 
Impairment (reversal)   (789)           2,703        (495)           1,419 
Other income (loss)   24,533    176    4,739            (1,055)           28,393 
Expenses   483    1    1,494    1,693        25    17,603        21,299 
Income (loss) from continuing operations   100,639    405    9,764    6,733    1,207    4,266    (19,403)   (226)   103,385 
Income (loss) from discontinued operations               330        (31)       226    525 
Net income (loss)   100,639    405    9,764    7,063    1,207    4,235    (19,403)       103,910 
Preferred dividends                           (2,790)       (2,790)
Income (loss) applicable to common stockholders  $100,639   $405   $9,764   $7,063   $1,207   $4,235   $(22,193)  $   $101,120 
                                              
Three Months Ended June 30, 2012                                             
Interest income  $56,038   $115   $4,482   $18,037   $954   $4,328   $52   $(1,568)  $82,438 
Interest expense   17,004            12,671    293        949    (1,455)   29,462 
Net interest income (expense)   39,034    115    4,482    5,366    661    4,328    (897)   (113)   52,976 
Impairment (reversal)   7,742            1,055        (298)           8,499 
Other income (loss)   (5,380)   84    3,523            414            (1,359)
Expenses   242        1,371    850        12    10,465        12,940 
Income (loss) from continuing operations   25,670    199    6,634    3,461    661    5,028    (11,362)   (113)   30,178 
Income (loss) from discontinued operations               162        (14)       113    261 
Net income (loss)   25,670    199    6,634    3,623    661    5,014    (11,362)       30,439 
Preferred dividends                           (1,395)       (1,395)
Income (loss) applicable to common stockholders  $25,670   $199   $6,634   $3,623   $661   $5,014   $(12,757)  $   $29,044 
                                              
June 30, 2012                                             
Investments  $2,509,771   $3,957   $265,132   $772,025   $403,392   $134,230   $   $(141,088)  $3,947,419 
Cash and restricted cash   62,692        9,278                93,369        165,339 
Derivative assets   966                                966 
Other assets   51,457    6    16,815    196    958    4,344    6,543    (353)   79,966 
Total assets   2,624,886    3,963    291,225    772,221    404,350    138,574    99,912    (141,441)   4,193,690 
Debt   (2,356,186)           (725,336)   (317,972)       (51,246)   141,088    (3,309,652)
Derivative liabilities   (101,809)                               (101,809)
Other liabilities   (31,861)       (33,031)   (2,927)   (65,777)   (2,601)   (43,655)   353    (179,499)
Total liabilities   (2,489,856)       (33,031)   (728,263)   (383,749)   (2,601)   (94,901)   141,441    (3,590,960)
Preferred stock                           (61,583)       (61,583)
GAAP book value  $135,030   $3,963   $258,194   $43,958   $20,601   $135,973   $(56,572)  $   $541,147 

 

9

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

 

   Non- Recourse CDOs (A)   Unlevered CDOs (B)   Unlevered Excess MSRs   Non- Recourse Other (A)   Recourse   Unlevered Other   Corporate   Inter- segment Elimination (F)   Total 
                                              
Six Months Ended June 30, 2011                                             
Interest income  $111,399   $23   $   $35,006   $597   $992   $63   $(1,734)  $146,346 
Interest expense   47,285            25,990    242        1,906    (1,508)   73,915 
Net interest income (expense)   64,114    23        9,016    355    992    (1,843)   (226)   72,431 
Impairment (reversal)   (44,158)           1,797        (3,912)           (46,273)
Other income (loss)   98,234    3,527        1,490        1,107            104,358 
Expenses   639            1,636        115    11,864        14,254 
Income (loss) from continuing operations   205,867    3,550        7,073    355    5,896    (13,707)   (226)   208,808 
Income (loss) from discontinued operations               (185)       (41)       226     
Net income (loss)   205,867    3,550        6,888    355    5,855    (13,707)       208,808 
Preferred dividends                           (2,790)       (2,790)
Income (loss) applicable to common stockholders  $205,867   $3,550   $   $6,888   $355   $5,855   $(16,497)  $   $206,018 
                                              
Three Months Ended June 30, 2011                                             
Interest income  $56,571   $12   $   $17,525   $450   $510   $43   $(968)  $74,143 
Interest expense   22,672            12,835    144        954    (855)   35,750 
Net interest income (expense)   33,899    12        4,690    306    510    (911)   (113)   38,393 
Impairment (reversal)   (5,913)           643        (3,797)           (9,067)
Other income (loss)   55,127    3,452        (337)       647            58,889 
Expenses   326            892        70    6,116        7,404 
Income (loss) from continuing operations   94,613    3,464        2,818    306    4,884    (7,027)   (113)   98,945 
Income (loss) from discontinued operations               97        (20)       113    190 
Net income (loss)   94,613    3,464        2,915    306    4,864    (7,027)       99,135 
Preferred dividends                           (1,395)       (1,395)
Income (loss) applicable to common stockholders  $94,613   $3,464   $   $2,915   $306   $4,864   $(8,422)  $   $97,740 

 

(A)Assets held within CDOs and other non-recourse structures are not available to satisfy obligations outside of such financings, except to the extent Newcastle receives net cash flow distributions from such structures. Furthermore, creditors or beneficial interest holders of these structures have no recourse to the general credit of Newcastle. Therefore, Newcastle’s exposure to the economic losses from such structures is limited to its invested equity in them and economically their book value cannot be less than zero. Therefore, impairment recorded in excess of Newcastle’s investment, which results in negative GAAP book value for a given non-recourse financing structure, cannot economically be incurred and will eventually be reversed through amortization, sales at gains, or as gains at the deconsolidation or termination of such non-recourse financing structure.
   
(B)Represents unlevered investments in CDO securities issued by Newcastle. These CDOs have been deconsolidated as Newcastle does not have the power to direct the relevant activities of the CDOs.

 

10

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

(C)The following table summarizes the investments and debt in the other non-recourse segment:

 

   June 30, 2012 
   Investments    Debt 
   Outstanding Face   Carrying   Outstanding Face   Carrying 
   Amount   Value   Amount*   Value* 
Manufactured housing loan portfolio I  $125,948   $105,225   $98,268   $89,282 
Manufactured housing loan portfolio II   165,494    162,402    130,949    129,968 
Residential mortgage loans   54,744    40,007    53,266    52,195 
Subprime mortgage loans subject to call options   406,217    405,247    406,217    405,247 
Real estate securities   66,762    51,407    46,862    42,644 
Operating real estate    N/A    7,737    6,000    6,000 
   $819,165   $772,025   $741,562   $725,336 

  

  * An aggregate face amount of $154.8 million (carrying value of $141.1 million) of debt represents financing provided by the CDO segment (and included as investments in the CDO segment), which is eliminated upon consolidation.
  (D)  The $318.0 million of recourse debt is comprised of (i) a $316.1 million repurchase agreement secured by $337.6 million carrying value of FNMA/FHLMC securities and (ii) a $1.9 million repurchase agreement secured by $27.3 million face amount of senior notes issued by Newcastle CDO VI, which was repurchased by Newcastle and is eliminated in consolidation.
  (E) The following table summarizes the investments in the unlevered other segment:

 

   June 30, 2012 
   Outstanding
Face Amount
   Carrying
Value
   Number of
Investments
 
Real estate securities*  $318,909   $125,260    30 
Residential mortgage loans   4,322    2,946    144 
Other investments    N/A    6,024    1 
   $323,231   $134,230    175 

  

  * During the three months ended June 30, 2012, Newcastle purchased 10 non-agency residential mortgage backed (“RMBS”) securities with an aggregate face amount of $181.6 million for an aggregate purchase price of approximately $122.4 million, or an average price of 67.4% of par. As of June 30, 2012, these securities had an aggregate face amount of $177.4 million and a carrying value of $119.5 million.
  (F) Represents the elimination of investments and financings and their related income and expenses between the CDO segment and other non-recourse segment as the corresponding inter-segment investments and financings are presented on a gross basis within each of these segments.

 

Variable Interest Entities (“VIEs”)

 

The VIEs in which Newcastle has a significant interest include (i) Newcastle’s CDOs, in which Newcastle has been determined to be the primary beneficiary and therefore consolidates them (with the exception of CDOs V and VII), since it has the power to direct the activities that most significantly impact the CDOs’ economic performance and would absorb a significant portion of their expected losses and receive a significant portion of their expected residual returns, and (ii) the manufactured housing loan financing structures, which are similar to the CDOs in analysis. Newcastle’s CDOs and manufactured housing loan financings are held in special purpose entities whose debt is treated as non-recourse secured borrowings of Newcastle. Newcastle’s subprime securitizations are also considered VIEs, but Newcastle does not control their activities and no longer receives a significant portion of their returns. These subprime securitizations are not consolidated.

 

In addition, Newcastle’s investments in CMBS, CDO securities and loans may be deemed to be variable interests in VIEs, depending on their structure. Newcastle is not obligated to provide, nor has it provided, any financial support to these VIEs. Newcastle monitors these investments and, to the extent Newcastle determines that it potentially owns a majority of the currently controlling class, it analyzes them for potential consolidation. As of June 30, 2012, Newcastle has not consolidated these potential VIEs due to the determination that, based on the nature of Newcastle’s investments and the provisions governing these structures, Newcastle does not have the power to direct the activities that most significantly impact their economic performance.

 

Newcastle had variable interests in the following unconsolidated VIE at June 30, 2012, in addition to the subprime securitizations which are described in Note 4:

 

Entity  Gross Assets (A)   Debt (B)   Carrying Value of Newcastle’s Investment (C) 
Newcastle CDO V  $298,549   $298,995   $3,957 

 

(A) Face amount.
(B) Includes $42.3 million face amount of debt owned by Newcastle with a carrying value of $4.0 million at June 30, 2012.
(C) This amount represents Newcastle’s maximum exposure to loss from this entity, which was the fair value at June 30, 2012, related to $5.3 million face amount of CDO V Class I notes.

 

11

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

 3. REAL ESTATE SECURITIES

 

The following is a summary of Newcastle’s real estate securities at June 30, 2012, all of which are classified as available-for-sale and are, therefore, reported at fair value with changes in fair value recorded in other comprehensive income, except for securities that are other-than-temporarily impaired.

 

       Amortized Cost Basis               Weighted Average 
   Outstanding        Other- Than- Temporary             Number             Maturity   Principal 
   Face   Before   Impairment   After   Gross Unrealized    Carrying   of    Rating          (Years)   Subordination 
Asset Type  Amount   Impairment   (A)   Impairment   Gains   Losses   Value (B)   Securities   (C)  Coupon   Yield   (D)   (E) 
CMBS-Conduit  $1,279,728   $1,098,922   $(168,256)  $930,666   $112,293   $(46,483)  $996,476    159   BB+   5.55%   10.71%   3.9    11.7%
CMBS- Single Borrower   175,346    170,879    (12,364)   158,515    3,869    (10,426)   151,958    31   BB   5.24%   6.54%   3.2    6.8%
CMBS-Large Loan   14,938    14,404        14,404    434    (50)   14,788    2   BBB+   5.06%   8.89%   0.7    10.1%
REIT Debt   120,288    119,542        119,542    5,685    (2,130)   123,097    18   BB+   5.72%   5.72%   2.2    N/A 
ABS-Subprime (F)   421,669    321,385    (76,547)   244,838    13,935    (6,033)   252,740    70   CCC   0.89%   8.91%   5.5    24.7%
ABS-Manufactured Housing   27,722    26,890        26,890    2,138    (74)   28,954    7   BBB+   6.59%   7.38%   3.7    42.9%
ABS-Franchise   11,121    10,835    (8,451)   2,384    34    (391)   2,027    4   CCC-   5.56%   5.45%   4.9    3.2%
FNMA/FHLMC   377,220    400,531        400,531    3,127    (266)   403,392    37   AAA   2.48%   1.39%   4.7    N/A 
CDO (G)   206,124    83,374    (14,861)   68,513    25    (3,570)   64,968    13   CCC+   3.03%   7.76%   1.2    21.0%
Total / Average (H)  $2,634,156    2,246,762   $(280,479)  $1,966,283   $141,540   $(69,423)  $2,038,400    341    BB+   4.16%   7.79%   3.9      

  

(A) Represents the cumulative impairment against amortized cost basis recorded through earnings, net of the effect of the cumulative adjustment as a result of the adoption of new accounting guidance on impairment in 2009.
(B) See Note 6 regarding the estimation of fair value, which is equal to carrying value for all securities.
(C) Represents the weighted average of the ratings of all securities in each asset type, expressed as an S&P equivalent rating. For each security rated by multiple rating agencies, the lowest rating is used. Newcastle used an implied AAA rating for the FNMA/FHLMC securities. Ratings provided were determined by third party rating agencies as of a particular date, may not be current and are subject to change at any time.
(D) The weighted average maturity is based on the timing of expected principal reduction on the assets.
(E) Percentage of the outstanding face amount of securities and residual interests that is subordinate to Newcastle’s investments.
(F) Includes (i) the retained bonds with a face amount of $4.0 million and a carrying value of $1.1 million from Securitization Trust 2006 (Note 4) and (ii) 10 non-agency RMBS purchased during the three months ended June 30, 2012 with an aggregate face amount of $177.4 million and a carrying value of $119.5 million as of June 30, 2012.
(G) Includes two CDO bonds issued by a third party with a carrying value of $58.3 million, four CDO bonds issued by CDO V (which has been deconsolidated) and held as investments by Newcastle with a carrying value of $4.0 million and seven CDO bonds issued by C-BASS with a carrying value of $2.8 million.
(H) The total outstanding face amount of fixed rate securities was $1.6 billion, and of floating rate securities was $1.0 billion.

 

12

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

Unrealized losses that are considered other-than-temporary are recognized currently in earnings. During the six months ended June 30, 2012, Newcastle recorded other-than-temporary impairment charges (“OTTI”) of $16.7 million (gross of $3.1 million of other-than-temporary impairment recognized in other comprehensive income) with respect to real estate securities. Based on management’s analysis of these securities, the performance of the underlying loans and changes in market factors, Newcastle noted adverse changes in the expected cash flows on certain of these securities and concluded that they were other-than-temporarily impaired. Any remaining unrealized losses on Newcastle’s securities were primarily the result of changes in market factors, rather than issue-specific credit impairment. Newcastle performed analyses in relation to such securities, using management’s best estimate of their cash flows, which support its belief that the carrying values of such securities were fully recoverable over their expected holding period. The following table summarizes Newcastle’s securities in an unrealized loss position as of June 30, 2012.

  

       Amortized Cost Basis              Weighted Average 
Securities in an Unrealized   Outstanding       Other- than-       Gross       Number                 
Loss  Face   Before   Temporary   After   Unrealized   Carrying   of               Maturity 
Position  Amount   Impairment   Impairment   Impairment   Gains   Losses   Value   Securities   Rating   Coupon   Yield   (Years) 
Less Than Twelve Months  $283,224   $274,738   $(11,209)  $263,529   $   $(4,980)   258,549    27     A    3.14%   3.66%   5.1 
Twelve or More Months   704,267    644,904    (16,707)   628,197        (64,443)   563,754    96     BB    4.43%   6.90%   3.1 
Total  $987,491   $919,642   $(27,916)  $891,726   $   $(69,423)  $822,303    123     BBB-    4.06%   5.94%   3.7 

 

Newcastle performed an assessment of all of its debt securities that are in an unrealized loss position (unrealized loss position exists when a security’s amortized cost basis, excluding the effect of OTTI, exceeds its fair value) and determined the following:

 

   June 30, 2012 
       Amortized Cost Basis    Unrealized Losses 
   Fair Value   After Impairment   Credit (B)   Non-Credit (C) 
Securities Newcastle intends to sell  $4,456   $4,456   $(11,502)   N/A 
Securities Newcastle is more likely than not to be required to sell (A)               N/A 
Securities Newcastle has no intent to sell and is not more likely than not to be required to sell:                    
Credit impaired securities   48,274    52,063    (26,752)   (3,789)
Non credit impaired securities   774,029    839,663        (65,634)
Total debt securities in an unrealized loss position  $826,759   $896,182   $(38,254)  $(69,423)

 

(A) Newcastle may, at times, be more likely than not to be required to sell certain securities for liquidity purposes. While the amount of the securities to be sold may be an estimate, and the securities to be sold have not yet been identified, Newcastle must make its best estimate, which is subject to significant judgment regarding future events, and may differ materially from actual future sales.
   
(B) This amount is required to be recorded as other-than-temporary impairment through earnings. In measuring the portion of credit losses, Newcastle’s management estimates the expected cash flow for each of the securities. This evaluation includes a review of the credit status and the performance of the collateral supporting those securities, including the credit of the issuer, key terms of the securities and the effect of local, industry and broader economic trends. Significant inputs in estimating the cash flows include management’s expectations of prepayment speeds, default rates and loss severities. Credit losses are measured as the decline in the present value of the expected future cash flows discounted at the investment’s effective interest rate.
   
(C) This amount represents unrealized losses on securities that are due to non-credit factors and is required to be recorded through other comprehensive income.

 

13

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

The following table summarizes the activity related to credit losses on debt securities for the six months ended June 30, 2012:

 

Beginning balance of credit losses on debt securities for which a portion of an OTTI was recognized in other comprehensive income  $(20,207)
      
Additions for credit losses on securities for which an OTTI was not previously recognized   (6,800)
      
Increases to credit losses on securities for which an OTTI was previously recognized and a portion of an OTTI was recognized in other comprehensive income   (242)
      
Additions for credit losses on securities for which an OTTI was previously recognized without any portion of OTTI recognized in other comprehensive income   (8,669)
      
Reduction for credit losses on securities for which no OTTI was recognized in other comprehensive income at the current measurement date   7,188 
      
Reduction for securities sold during the period   1,498 
      
Reduction for increases in cash flows expected to be collected that are recognized over the remaining life of the security   480 
      
Ending balance of credit losses on debt securities for which a portion of an OTTI was recognized in other comprehensive income  $(26,752)

 

As of June 30, 2012, Newcastle had $63.4 million of restricted cash and net receivables from brokers, dealers and clearing organizations held in CDO financing structures pending its reinvestment in real estate securities and loans.

 

The table below summarizes the geographic distribution of the collateral securing Newcastle’s CMBS and ABS at June 30, 2012 (in thousands):

 

   CMBS   ABS 
Geographic Location  Outstanding Face Amount   Percentage   Outstanding Face Amount   Percentage 
Western U.S.  $574,813    39.1%  $125,608    27.3%
Northeastern U.S.   253,261    17.2%   94,256    20.4%
Southeastern U.S.   293,247    20.0%   116,819    25.4%
Midwestern U.S.   156,504    10.7%   61,673    13.4%
Southwestern U.S.   122,175    8.3%   53,022    11.5%
Other   16,823    1.1%   9,134    2.0%
Foreign   53,189    3.6%       0.0%
   $1,470,012    100.0%  $460,512    100.0%

 

Geographic concentrations of investments expose Newcastle to the risk of economic downturns within the relevant regions, particularly given the current unfavorable market conditions. These market conditions may make regions more vulnerable to downturns in certain market factors. Any such downturn in a region where Newcastle holds significant investments could have a material, negative impact on Newcastle.

 

14

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

4. REAL ESTATE RELATED LOANS, RESIDENTIAL MORTGAGE LOANS, SUBPRIME MORTGAGE LOANS, CDO SERVICING RIGHTS AND INVESTMENTS IN EXCESS MORTGAGE SERVICING RIGHTS

 

The following is a summary of real estate related loans, residential mortgage loans and subprime mortgage loans at June 30, 2012. The loans contain various terms, including fixed and floating rates, self-amortizing and interest only. They are generally subject to prepayment. 

 

Loan Type  Outstanding Face Amount   Carrying Value (A)   Loan Count   Wtd. Avg. Yield   Weighted Average Coupon   Weighted Average Maturity (Years) (B)   Floating Rate Loans as a % of Face Amount   Delinquent Face Amount (C) 
Mezzanine Loans  $608,953   $486,572    17    10.20%   7.90%   2.1    71.2%  $12,000 
Corporate Bank Loans   300,663    189,328    6    19.62%   9.70%   2.3    51.1%   1,397 
B-Notes   207,981    185,701    7    11.32%   5.51%   2.5    71.4%    
Whole Loans   30,352    30,352    3    5.17%   3.87%   1.5    95.9%    
Total Real Estate Related Loans Held-for-Sale, Net  $1,147,949   $891,953    33    12.26%   7.83%   2.2    66.6%  $13,397 
Non-Securitized Manufactured Housing Loan Portfolio I  $640   $169    18    39.15%   8.01%   0.7    0.0%  $45 
Non-Securitized Manufactured Housing Loan Portfolio II   3,682    2,777    126    15.48%   10.10%   5.7    8.0%   524 
Total Residential Mortgage Loans Held-for-Sale, Net (D)  $4,322   $2,946    144    16.84%   9.79%   5.0    6.8%  $569 
                                         
Securitized Manufactured Housing Loan Portfolio I  $125,948   $105,225    3,352    9.48%   8.67%   6.9    0.9%  $978 
Securitized Manufactured Housing Loan Portfolio II   165,494    162,402    5,733    7.54%   9.64%   5.8    17.0%   3,370 
Residential Loans   58,523    43,470    207    7.67%   2.56%   6.5    100.0%   7,914 
Total Residential Mortgage Loans Held- for-Investment, Net (D) (E)  $349,965   $311,097    9,292    8.21%   8.10%   6.3    25.1%  $12,262 
Subprime Mortgage Loans Subject to Call Option  $406,217   $405,247                               

  

(A) Carrying value includes interest receivable of $0.1 million for the residential housing loans and principal and interest receivable of $5.4 million for the manufactured housing loans.
(B) The weighted average maturity is based on the timing of expected principal reduction on the assets.
(C) Includes loans that are 60 or more days past due (including loans that are in foreclosure, or borrower’s in bankruptcy) or considered real estate owned (“REO”). As of June 30, 2012, $71.6 million face amount of real estate related loans was on non-accrual status.
(D) Loans acquired at a discount for credit quality.
(E) The following is an aging analysis of past due residential loans held-for-investment as of June 30, 2012:

 

   30-59 Days Past Due   60-89 Days Past Due   Over 90 Days Past Due   REO   Total Past Due   Current   Total Outstanding Face Amount 
Securitized Manufactured Housing Loan Portoflio I  $467   $344   $401   $233   $1,445   $124,503   $125,948 
Securitized Manufactured Housing Loan Portoflio II  $1,399   $838   $1,370   $1,162   $4,769   $160,725   $165,494 
Residential Loans  $400   $267   $6,831   $816   $8,314   $50,209   $58,523 

 

Newcastle’s management monitors the credit qualities of the Manufactured Housing Loan Portfolios I and II primarily by using aging analyses, current trends in delinquencies and actual loss incurrence rates.

 

15

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

The following is a summary of real estate related loans by maturities at June 30, 2012:

 

Year of Maturity (1)   Outstanding Face Amount   Carrying Value   Number of Loans 
Delinquent (2)   $13,397   $611    2 
Period from July 1, 2012 to December 31, 2012    63, 454        2 
2013    36,068    27,246    3 
2014    406,229    283,207    10 
2015    242,801    202,585    6 
2016    274,102    272,306    5 
2017    95,602    91,536    4 
Thereafter    16,296    14,462    1 
Total   $1,147,949   $891,953    33 

  

(1) Based on the final extended maturity date of each loan investment as of June 30, 2012.
(2) Includes loans that are non-performing, in foreclosure, or under bankruptcy.

 

Activities relating to the carrying value of our real estate loans and residential mortgage loans are as follows:

 

   Held-for-Sale    Held-for-Investment 
   Real Estate Related Loans   Residential Mortgage Loans   Residential Mortgage Loans 
Balance at December 31, 2011  $813,580   $2,687   $331,236 
Purchases / additional fundings   91,481         
Interest accrued to principal balance   10,914         
Principal paydowns   (36,922)   (302)   (19,708)
Sales            
Valuation (allowance) reversal on loans   14,398    559    (2,703)
Loss on repayment of loans held-for-sale   (1,614)        
Accretion of loan discount and other amortization           2,165 
Other   116    2    107 
Balance at June 30, 2012  $891,953    2,946   $311,097 

 

The following is a rollforward of the related loss allowance.

  

   Held-For-Sale   Held-For-Investment 
   Real Estate Related Loans   Residential Mortgage Loans   Residential Mortgage Loans (B) 
Balance at December 31, 2011  $(228,017)  $(2,461)  $(26,075)
Charge-offs (A)   17,648    602    4,295 
Valuation (allowance) reversal on loans   14,398    559    (2,703)
Balance at June 30, 2012  $(195,971)  $(1,300)  $(24,483)

 

(A) The charge-offs for real estate related loans represent a loan which was paid off at a discounted price during the period.
(B) The allowance for credit losses was determined based on the guidance for loans acquired with deteriorated credit quality.

 

16

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

Investments in Excess Mortgage Servicing Rights

 

The following is a summary of Newcastle’s Excess MSRs:

  

      June 30, 2012  Six Months Ended June 30, 2012
   Unpaid Principal Balance  Amortized Cost Basis  Carrying Value (A)  Weighted Average Yield  Average Maturity (Years) (B)  Changes in Fair Value Recorded in Other Income (Loss) (C)
MSR Pool 1  $9,120,148   $32,465   $37,613    18.0%   4.7   $4,151 
MSR Pool 1 - Recapture Agreement       6,111    6,067    18.0%   10.5    588
MSR Pool 2   9,942,371    36,934    36,934    17.3%   4.7     
MSR Pool 2 - Recapture Agreement       5,904    5,904    17.3%   11.9     
MSR Pool 3   9,739,715    31,421    31,421    17.6%   4.7     
MSR Pool 3 - Recapture Agreement       5,221    5,221    17.6%   11.3     
MSR Pool 4   6,210,442    12,638    12,638    17.9%   4.6     
MSR Pool 4 - Recapture Agreement       2,969    2,969    17.9%   11.1     
MSR Pool 5   46,945,452    117,844    117,844    17.5%   4.8     
MSR Pool 5 - Recapture Agreement       8,521    8,521    17.5%   12.3     
   $81,958,128   $260,028   $265,132    17.6%   5.5   $4,739 

  

(A) Fair value.

(B) The weighted average maturity is based on the timing of expected return of investments.

(C) The portion of change in fair value of the recapture agreement relating to loans recaptured to date is reflected in the respective pool.

 

In December 2011, Newcastle entered into an agreement (“MSR Agreement I”) with Nationstar Mortgage LLC (“Nationstar”), a leading residential mortgage servicer majority-owned by funds managed by Newcastle’s manager, to purchase Excess MSRs from Nationstar. Nationstar acquired the mortgage servicing rights on a pool of government-sponsored enterprise (“GSE”) residential mortgage loans with an outstanding principal balance of approximately $9.9 billion (“MSR Pool 1”) on September 30, 2011. Nationstar is entitled to receive an initial weighted average total mortgage servicing amount of 35 basis points (bps) on the performing unpaid principal balance, as well as any ancillary income from MSR Pool 1. Pursuant to MSR Agreement I, Nationstar performs all servicing functions and advancing functions related to MSR Pool 1 for a base servicing fee of 6 bps. Therefore, the remainder, or “excess mortgage servicing amount” is initially equal to a weighted average of 29 bps. Newcastle acquired the right to receive 65% of the excess mortgage servicing amount on MSR Pool 1 and, subject to certain limitations and pursuant to a loan replacement agreement (the “Recapture Agreement”), 65% of the Excess MSRs on certain future mortgage loans originated by Nationstar, that represent refinancings of loans in MSR Pool 1 (which loans then become part of MSR Pool 1) for $43.7 million. Nationstar has co-invested, pari passu with Newcastle, in 35% of the Excess MSRs. Nationstar, as servicer, also retains the ancillary income, the servicing obligations and liabilities as the servicer. If Nationstar is terminated as the servicer, Newcastle’s right to receive its portion of the excess mortgage servicing amount is also terminated. To the extent that Nationstar is terminated as the servicer and receives a termination payment, Newcastle is entitled to a pro rata share, or 65%, of such termination payment.

 

On June 5, 2012, Newcastle announced the completion of a co-investment with Nationstar related to their acquisition of mortgage servicing assets from Bank of America, National Association. Newcastle has invested approximately $44 million to acquire a 65% interest in the Excess MSRs on a portfolio of residential mortgage loans with an outstanding principal balance of approximately $10.4 billion (“MSR Pool 2”), comprised of conforming loans in GSE pools. Nationstar has co-invested pari passu with Newcastle in 35% of the Excess MSRs and will be the servicer of the loans performing all servicing and advancing functions, and retaining the ancillary income, servicing obligations and liabilities as the servicer. Under the terms of this investment, to the extent that any loans in the portfolio are refinanced by Nationstar, the resulting Excess MSRs will be shared pro rata by Newcastle and Nationstar, subject to certain limitations. As of June 30, 2012, Newcastle funded $11.0 million of the purchase price and expected the remainder of the purchase price payable to Nationstar to be funded in the third quarter of 2012 pursuant to the payment terms of the agreement.

 

On June 29, 2012, Newcastle announced the completion of a co-investment in Excess MSRs in connection with Nationstar’s acquisition of mortgage servicing assets from Aurora Bank FSB, a subsidiary of Lehman Brothers Bancorp Inc. Newcastle invested approximately $176.5 million to acquire a 65% interest in the Excess MSRs on a portfolio of residential mortgage loans with an outstanding principal balance of approximately $63.7 billion, comprised of approximately 75% non-conforming loans in private label securitizations and approximately 25% conforming loans in GSE pools. The portfolio is comprised of three pools: a pool of non-conforming loans in private label securities with an

 

17

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

outstanding principal balance of approximately $47.6 billion (“MSR Pool 5”), and two GSE loan pools with outstanding principal balances of approximately $6.3 billion (“MSR Pool 4”) and $9.8 billion (“MSR Pool 3”), respectively. Nationstar has co-invested pari passu with Newcastle in 35% of the Excess MSRs and will be the servicer of the loans performing all servicing and advancing functions, and retaining the ancillary income, servicing obligations and liabilities as the servicer. Under the terms of this investment, to the extent that any loans in the portfolio are refinanced by Nationstar, the resulting Excess MSRs will be shared pro rata by Newcastle and Nationstar, subject to certain limitations.

 

The table below summarizes the geographic distribution of the underlying residential mortgage loans of the Excess MSRs at June 30, 2012:

  

State Concentration  Percentage of Total Outstanding
California   32.5%
Florida   10.0%
Washington   4.3%
New York   4.1%
Arizona   4.0%
Texas   3.5%
Colorado   3.5%
Maryland   3.3%
New Jersey   3.2%
Virginia   3.0%
Other U.S.   28.6%
    100.0%

 

  (A)Based on the information provided by the loan servicer as of the most recent remittance.

 

Geographic concentrations of investments expose Newcastle to the risk of economic downturns within the relevant states. Any such downturn in a state where Newcastle holds significant investments could affect the underlying borrower’s ability to make the mortgage payment and therefore could have a meaningful, negative impact on Newcastle’s Excess MSRs.

 

See note 11 regarding the agreements to acquire an additional portfolio of Excess MSRs.

 

CDO Servicing Rights

 

In February 2011, Newcastle, through one of its subsidiaries, purchased the management rights with respect to certain CBASS Investment Management LLC (“C-BASS”) CDOs pursuant to a bankruptcy proceeding for $2.2 million. Newcastle initially recorded the cost of acquiring the collateral management rights as a servicing asset and subsequently amortizes this asset in proportion to, and over the period of, estimated net servicing income. Servicing assets are assessed for impairment on a quarterly basis, with impairment recognized as a valuation allowance. Key economic assumptions used in measuring any potential impairment of the servicing assets include the prepayment speeds of the underlying loans, default rates, loss severities and discount rates. During the six months ended June 30, 2012 and 2011, respectively, Newcastle recorded $0.2 million and $0.1 million of servicing rights amortization and no servicing rights impairment. As of June 30, 2012, Newcastle’s servicing asset had a carrying value of $1.9 million recorded in Receivables and Other Assets.

 

18

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

Securitization of Subprime Mortgage Loans

 

The following table presents information on the retained interests in Newcastle’s securitizations of subprime mortgage loans at June 30, 2012:

 

   Subprime Portfolio      
   I   II   Total 
Total securitized loans (unpaid principal balance) (A)  $447,144   $585,022   $1,032,166 
Loans subject to call option (carrying value)  $299,176   $106,071   $405,247 
Retained interests (fair value) (B)  $1,117   $   $1,117 

  

(A)Average loan seasoning of 83 months and 65 months for Subprime Portfolios I and II, respectively, at June 30, 2012.
(B)The retained interests include retained bonds of the securitizations. The fair value of which is estimated based on pricing models. Newcastle’s residual interests were written off in 2010. The weighted average yield of the retained bonds was 8.40% as of June 30, 2012.

 

Newcastle has no obligation to repurchase any loans from either of its subprime securitizations. Therefore, it is expected that its exposure to loss is limited to the carrying amount of its retained interests in the securitization entities, as described above.  A subsidiary of Newcastle gave limited representations and warranties with respect to Subprime Portfolio II and is required to pay the difference, if any, between the repurchase price of any loan in such portfolio and the price required to be paid by a third party originator for such loan. Such subsidiary, however, has no assets and does not have recourse to the general credit of Newcastle.

 

The following table summarizes certain characteristics of the underlying subprime mortgage loans, and related financing, in the securitizations as of June 30, 2012:

 

   Subprime Portfolio
   I  II
Loan unpaid principal balance (UPB)  $447,144   $585,022 
Weighted average coupon rate of loans   5.24%   4.61%
Delinquencies of 60 or more days (UPB) (A)  $98,807   $153,706 
Net credit losses for the six months ended June 30, 2012  $17,963   $22,916 
Cumulative net credit losses  $210,832   $244,769 
Cumulative net credit losses as a % of original UPB   14.0%   22.5%
Percentage of ARM loans (B)   51.5%   64.7%
Percentage of loans with original loan-to-value ratio >90%   10.8%   17.2%
Percentage of interest-only loans   21.3%   4.3%
Face amount of debt (C)  $443,144   $585,022 
Weighted average funding cost of debt (D)   0.61%   1.22%

 

(A)Delinquencies include loans 60 or more days past due, in foreclosure, under bankruptcy filing or real estate owned.
(B)ARM loans are adjustable-rate mortgage loans. An option ARM is an adjustable-rate mortgage that provides the borrower with an option to choose from several payment amounts each month for a specified period of the loan term. None of the loans in the subprime portfolios are option ARMs.
(C)Excludes face amount of $4 million of retained notes for Subprime Portfolio I at June 30, 2012.
(D)Includes the effect of applicable hedges.

 

Newcastle received negligible cash inflows from the retained interests of Subprime Portfolios I and II during the six months ended June 30, 2012 and 2011.

 

The loans subject to call option and the corresponding financing recognize interest income and expense based on the expected weighted average coupons of the loans subject to call option at the call date of 9.24% and 8.68% for Subprime Portfolio’s I and II, respectively.

 

19

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

5. DEBT OBLIGATIONS

 

The following table presents certain information regarding Newcastle’s debt obligations and related hedges at June 30, 2012:

 

                                        Collateral        
Debt Obligation/Collateral  

Month

Issued

 

Outstanding

Face

Amount

   

Carrying

Value

  Final Stated Maturity  

Unhedged Weighted

Average

Funding Cost (A)

   

Weighted Average

Funding

Cost (B)

 

Weighted Average Maturity

(Years)

 

Face

Amount

of Floating Rate

Debt

    Outstanding Face Amount (C)    

Amortized

Cost Basis (C)

   

Carrying

Value (C)

 

Weighted Average Maturity

(Years)

   

Floating Rate Face

Amount

(C)

   

Aggregate

Notional

Amount of Current Hedges (D)

 
                                                                         
CDO Bonds Payable                                                                        
CDO IV (E)   Mar 2004   $ 94,912     $ 94,774   Mar 2039     1.85%       4.96 %   1.7   $ 83,617     $ 188,784     $ 178,159     $ 167,159     2.2     $ 51,438     $ 83,617  
CDO VI (E)   Apr 2005     91,359       91,359   Apr 2040     0.90%       5.35 %   5.1     88,376       213,627       123,951       142,506     3.0       54,968       88,376  
CDO VIII   Nov 2006     567,613       566,434   Nov 2052     0.79%       2.10 %   2.8     560,013       729,131       538,300       551,905     2.8       438,747       155,132  
CDO IX   May 2007     478,905       480,426   May 2052     0.61       0.61 %   2.6     478,905       695,919       569,341       572,351     2.8       373,904       -  
CDO X   Jul 2007     1,120,000       1,117,655   Jul 2052     0.59%       3.38 %   4.0     1,120,000       1,235,436       951,744       998,116     4.5       214,451       811,054  
          2,352,789       2,350,648                 2.65 %   3.4     2,330,911       3,062,897       2,361,495       2,432,037     3.4       1,133,508       1,138,179  
Other Bonds and Notes Payable                                                                                            
MH loans Portfolio I (F)   Apr 2010     61,345       60,685   Jul 2035     5.44%       5.44 %   2.9     -       125,948       105,225       105,225     6.9       1,095       -  
MH loans Portfolio II (F)   May 2011     113,936       113,007   Dec 2033     3.90%       3.90 %   3.4     -       165,494       162,402       162,402     5.8       28,121       -  
Residential Mortgage Loans (G)   Aug 2006     5,309       5,309   Dec 2034   LIBOR+ 0.90%       1.15 %   6.6     5,309       54,744       40,007       40,007     6.7       54,744       -  
          180,590       179,001                 4.34 %   3.3     5,309       346,186       307,634       307,634     6.3       83,960       -  
Repurchase Agreements                                                                                                
Real estate securities, loans and properties (H)   Dec 2011     7,384       7,384   Oct 2012   LIBOR+ 2.00%       2.25 %   0.3     7,384       -       -       -     -       -       -  
FNMA/FHLMC securities (I)   Various     316,126       316,126   Aug 2012     0.42%       0.42 %   0.1     316,126       315,646       337,810       337,610     4.7       315,646       -  
          323,510       323,510                 0.46 %   0.1     323,510       315,646       337,810       337,810     4.7       315,646       -  
Corporate                                                                                                
Junior subordinated notes payable   Mar 2006     51,004       51,246   Apr 2035     7.57%(K)       7.41 %   22.8     -       -       -       -     -       -       -  
          51,004       51,246                 7.41 %   22.8     -       -       -       -     -       -       -  
Subtotal debt obligations         2,907,893       2,904,405                 2.59 %   3.3   $ 2,659,730     $ 3,724,729     $ 3,006,771     $ 3,077,313     3.8     $ 1,533,114     $ 1,138,179  
Financing on subprime mortgage loans subject to call option   (J)     406,217       405,247                                                                              
Total debt obligations       $ 3,314,110     $ 3,309,652                                                                              

 

(A)Weighted average, including floating and fixed rate classes and including the amortization of deferred financing costs.
(B)Including the effect of applicable hedges.
(C)Including restricted cash available for reinvestment in CDOs.
(D) Including a $42.4 million notional amount of interest rate cap agreements in CDO X and a $83.6 million and $88.4 million notional amount of interest rate swap agreements in CDO IV and CDO VI, respectively, which were economic hedges not designated as hedges for accounting purposes.
(E)These CDOs were not in compliance with their applicable over collateralization tests as of June 30, 2012. Newcastle is not receiving cash flows from these CDOs (other than senior management fees and cash flows on senior classes of bonds that were repurchased), since net interest is being used to repay debt, and expects these CDOs to remain out of compliance for the foreseeable future.
(F)Excluding $36.9 million and $17.0 million face amount of other bonds payable relating to MH loans Portfolio I and Portfolio II, respectively, and $48.0 million face amount of notes payable relating to residential mortgage loans sold to certain Newcastle CDOs, which were eliminated in consolidation.
(G)Notes payable issued to CDO V, that are no longer eliminated since the deconsolidation of CDO V.
(H)The counterparty of this repurchase agreement is Bank of America. It is secured by $27.3 million face amount of senior notes issued by Newcastle CDO VI, which is eliminated in consolidation. The maximum recourse to Newcastle is $1.9 million.
(I)The counterparties on these repurchase agreements are Bank of America and Goldman Sachs. Interest rates on these repurchase agreements are fixed, but will be reset on a short-term basis.
(J)Issued in April 2006 and July 2007. See Note 4 regarding the securitizations of Subprime Portfolios I and II.
(K)LIBOR + 2.25% after April 2016.

 

20

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data) 

Each CDO financing is subject to tests that measure the amount of over collateralization and excess interest in the transaction.  Failure to satisfy these tests would cause the principal and/or interest cashflow that would otherwise be distributed to more junior classes of securities (including those held by Newcastle) to be redirected to pay down the most senior class of securities outstanding until the tests are satisfied. As a result, our cash flow and liquidity are negatively impacted upon such a failure. As of June 30, 2012, CDOs IV and VI were not in compliance with their applicable over collateralization tests.

 

In the first six months of 2012, Newcastle repurchased $30.1 million face amount of CDO bonds payable for $9.2 million. As a result, Newcastle extinguished $30.1 million face amount of CDO bonds payable and recorded a gain on extinguishment of debt of $20.8 million.

 

Newcastle’s non-CDO financings contain various customary loan covenants. Newcastle was in compliance with all of the covenants in its non-CDO financings as of June 30, 2012.

 

21

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

6. FAIR VALUE OF FINANCIAL INSTRUMENTS

 

Fair Value Summary Table

 

The carrying values and fair values of Newcastle’s financial instruments at June 30, 2012 were as follows:

 

   Principal              Weighted   Weighted 
   Balance or              Average   Average 
   Notional   Carrying   Estimated   Fair Value  Yield/Funding   Maturity 
   Amount   Value   Fair Value   Method (A)  Cost   (Years) 
Assets                       
Non-Recourse VIE Financing Structures (F)                       
Financial instruments:                       
Real estate securities, available-for-sale*  $1,895,695   $1,505,791   $1,505,791   Broker quotations, counterparty quotations, pricing services, pricing models   9.47%   4.1 
Real estate related loans, held-for-sale, net   1,147,949    891,953    898,618   Broker quotations, counterparty quotations, pricing services, pricing models   12.26%   2.2 
Residential mortgage loans, held-for-investment, net   349,965    311,097    308,810   Pricing models   8.21%   6.3 
Subprime mortgage loans subject to call option (B)   406,217    405,247    405,247  (B)    9.09%   (B) 
Restricted cash*   62,692    62,692    62,692              
Derivative assets, treated as hedges (C)(E)*   122,665    504    504   Counterparty quotations   N/A    (C) 
Non-hedge derivative assets (D)(E)*   42,428    462    462   Counterparty quotations   N/A    (D) 
Operating real estate, held-for-sale        7,737    7,737              
Other investments        18,883    18,883              
Receivables and other assets        51,653    51,653              
        $3,256,019   $3,260,397              
Recourse Financing Structures and Unlevered Assets                            
Financial instruments:                            
Real estate securities, available-for-sale*  $738,461   $532,609   $532,609   Broker quotations, counterparty quotations, pricing services, pricing models   3.20%   3.5 
Residential mortgage loans, held-for-sale, net   4,322    2,946    2,946   Pricing models   16.84%   5.0 
Investments in excess mortgage servicing rights at fair value *(H)   81,958,128    265,132    265,132   Pricing models   17.6%   5.5 
Cash and cash equivalents*   102,647    102,647    102,647              
Other investments        6,024    6,024              
Receivables and other assets        28,313    28,313              
        $937,671   $937,671             

 

22

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

 

  Principal              Weighted   Weighted 
   Balance or              Average   Average 
   Notional   Carrying   Estimated   Fair Value  Yield/Funding   Maturity 
   Amount   Value   Fair Value   Method (A)  Cost   (Years) 
Liabilities                       
Non-Recourse VIE Financing Structures (F) (G)                       
Financial instruments:                       
CDO bonds payable  $2,352,789   $2,350,648   $1,539,213   Pricing models   2.65%   3.4 
Other bonds and notes payable   180,590    179,001    181,773   Broker quotations, pricing models   4.34%   3.3 
Repurchase agreements   5,538    5,538    5,538   Market comparables   2.25%   0.3 
Financing of subprime mortgage loans subject to call option (B)   406,217    405,247    405,247  (B)   9.09%   (B) 
Interest rate swaps, treated as hedges (C)(E)*   766,859    70,226    70,226   Counterparty quotations   N/A    (C) 
Non-hedge derivatives (D)(E)*   339,990    31,583    31,583   Counterparty quotations   N/A    (D) 
Accrued expenses and other liabilities        34,788    34,788              
        $3,077,031   $2,268,368              
Recourse Financing Structures and Other Liabilities (G)                            
Financial instruments:                            
Repurchase agreements  $317,972   $317,972   $317,972   Market comparables   0.43%   0.1 
Junior subordinated notes payable   51,004    51,246    31,594   Pricing models   7.41%   22.8 
Due to affiliates        8,448    8,448              
Dividends payable, accrued expenses and other liabilities        136,263    136,263              
        $513,929   $494,277             

 

 

*Measured at fair value on a recurring basis.

 

23

 

  

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

 

(A)Methods are listed in order of priority. In the case of real estate securities and real estate related loans, broker quotations are obtained if available and practicable, otherwise counterparty quotations or pricing service valuations are obtained or, finally, internal pricing models are used. Internal pricing models are only used for (i) securities and loans that are not traded in an active market, and, therefore, have little or no price transparency, and for which significant unobservable inputs must be used in estimating fair value, or (ii) loans or debt obligations which are private and untraded.
  
(B)These two items result from an option, not an obligation, to repurchase loans from Newcastle’s subprime mortgage loan securitizations (Note 4), are noneconomic until such option is exercised, and are equal and offsetting.
  
(C)Represents derivative agreements as follows:

 

Year of Maturity   Weighted Average Month of Maturity   Aggregate Notional Amount   Weighted Average Fixed Pay Rate / Cap Rate   Aggregate Fair Value
 Asset / (Liability)
 
                  
Interest rate cap agreements which receive 1-Month LIBOR:       
 2015    Nov   $39,460    2.10%  $115 
 2016    Jul    77,905    2.66%   354 
 2017    Jan    5,300    1.86%   35 
          $122,665        $504 
Interest rate swap agreements which receive 1-Month LIBOR:
 2014    Nov   $14,898    5.08%  $(1,603)
 2015    May    438,529    5.42%   (18,719)
 2016    May    165,132    5.04%   (17,121)
 2017    Aug    148,300    5.28%   (32,783)
          $766,859        $(70,226)

 

(D)This represents five interest rate swap agreements with a total notional balance of $340.0 million, maturing between March 2014 and November 2017, respectively, and four interest rate cap agreements with a total notional balance of $42.4 million, maturing in March 2013, August 2017 and January 2019. Newcastle entered, respectively, into these hedge agreements to reduce its exposure to interest rate changes on the floating rate financings of CDO IV, CDO VI and CDO X. These derivative agreements were not designated as hedges for accounting purposes as of June 30, 2012.
  
(E)Newcastle’s derivatives fall into two categories. As of June 30, 2012, all derivatives were held within Newcastle’s nonrecourse CDO structures. An aggregate notional balance of $1.3 billion, which were liabilities at period end, are only subject to the credit risks of the respective CDO structures. As they are senior to all the debt obligations of the respective CDOs and the fair value of each of the CDOs’ total investments exceeded the fair value of each of the CDOs’ derivative liabilities, no credit valuation adjustments were recorded. An aggregate notional balance of $165.1 million were assets at period end and therefore are subject to the counterparty’s credit risk. No adjustments have been made to the fair value quotations received related to credit risk as a result of the counterparty’s “AA” credit rating. Newcastle’s significant derivative counterparties include Bank of America, Credit Suisse and Wells Fargo.
  
(F)Assets held within CDOs and other non-recourse structures are not available to satisfy obligations outside of such financings, except to the extent Newcastle receives net cash flow distributions from such structures. Furthermore, creditors or beneficial interest holders of these structures have no recourse to the general credit of Newcastle. Therefore, Newcastle’s exposure to the economic losses from such structures is limited to its invested equity in them and economically their book value cannot be less than zero. As a result, the fair value of Newcastle’s net investments in these non-recourse financing structures is equal to the present value of their expected future net cash flows.
  
(G)Newcastle notes that the unrealized gain on the liabilities within such structures cannot be fully realized.
  
(H)The notional amount represents the total unpaid principal balance of the mortgage loans. Generally, Newcastle does not receive an excess mortgage servicing amount on nonperforming loans.

 

24

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

Valuation Hierarchy

 

The methodologies used for valuing such instruments have been categorized into three broad levels, which form a hierarchy.

 

Level 1 - Quoted prices in active markets for identical instruments.

 

Level 2 - Valuations based principally on other observable market parameters, including 

Quoted prices in active markets for similar instruments,
Quoted prices in less active or inactive markets for identical or similar instruments,
Other observable inputs (such as interest rates, yield curves, volatilities, prepayment speeds, loss severities, credit risks and default rates), and
Market corroborated inputs (derived principally from or corroborated by observable market data).

 

Level 3 - Valuations based significantly on unobservable inputs.

Level 3A - Valuations based on third party indications (broker quotes, counterparty quotes or pricing services) which were, in turn, based significantly on unobservable inputs or were otherwise not supportable as Level 2 valuations.
Level 3B - Valuations based on internal models with significant unobservable inputs.

 

Newcastle follows this hierarchy for its financial instruments measured at fair value on a recurring basis. The classifications are based on the lowest level of input that is significant to the fair value measurement.

 

The following table summarizes such financial assets and liabilities measured at fair value on a recurring basis at June 30, 2012:

  

          Fair Value 
   Principal Balance or Notional Amount   Carrying Value   Level 2   Level 3A   Level 3B   Total 
Assets:                        
Real estate securities, available-for-sale:                        
CMBS  $1,470,012   $1,163,222   $   $929,807   $233,415   $1,163,222 
REIT debt   120,288    123,097    123,097            123,097 
ABS - subprime   421,669    252,740        183,947    68,793    252,740 
ABS - other real estate   38,843    30,981        29,875    1,106    30,981 
FNMA / FHLMC   377,220    403,392    403,392            403,392 
CDO   206,124    64,968        61,011    3,957    64,968 
Real estate securities total  $2,634,156   $2,038,400   $526,489   $1,204,640   $307,271   $2,038,400 
Investments in Excess MSRs (1)  $81,958,128   $265,132   $   $   $265,132   $265,132 
                               
Derivative assets:                              
Interest rate caps, treated as hedges  $122,665   $504   $504   $   $   $504 
Interest rate caps, not treated as hedges   42,428    462    462            462 
Derivative assets total  $165,093   $966   $966   $   $   $966 
                               
Liabilities:                              
Derivative Liabilities:                              
Interest rate swaps, treated as hedges  $766,859   $70,226   $70,226   $   $   $70,226 
Interest rate swaps, not treated as hedges   339,990    31,583    31,583            31,583 
Derivative liabilities total  $1,106,849   $101,809   $101,809   $   $   $101,809 

 

(1)The notional amount represents the total unpaid principal balance of the mortgage loans. Generally, Newcastle does not receive an excess mortgage servicing amount on nonperforming loans.

 

25

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

Newcastle’s investments in instruments (excluding the Excess MSRs, see below) measured at fair value on a recurring basis using Level 3 inputs changed during the six months ended June 30, 2012 as follows:

 

   Level 3A 
   CMBS   ABS   Equity/Other     
   Conduit   Other   Subprime   Other   Securities   Total 
Balance at December 31, 2011  $816,283   $132,435   $66,141   $31,188   $52,047   $1,098,094 
Transfers (A)                              
Transfers from Level 3B   6,056    4,057                10,113 
Transfers into Level 3B   (35,796)   (14,105)   (11,057)   (5)       (60,963)
Total gains (losses) (B)                              
Included in net income (C)   1,202                    1,202 
Included in other comprehensive income (loss)   47,119    3,564    2,632    1,354    8,111    62,780 
Amortization included in interest income   15,639    740    3,174    (43)   2,216    21,726 
Purchases, sales and repayments                              
Purchases   6,007        134,829            140,836 
Proceeds from sales   (24,551)                   (24,551)
Proceeds from repayments   (27,591)   (1,252)   (11,772)   (2,619)   (1,363)   (44,597)
Balance at June 30, 2012  $804,368   $125,439   $183,947   $29,875   $61,011   $1,204,640 

 

   Level 3B 
   CMBS   ABS   Equity/Other     
   Conduit   Other   Subprime   Other   Securities   Total 
Balance at December 31, 2011  $140,622   $39,478   $62,481   $6,919   $3,939   $253,439 
Transfers (A)                              
Transfers from Level 3A   35,796    14,105    11,057    5        60,963 
Transfers into Level 3A   (6,056)   (4,057)               (10,113)
Total gains (losses) (B)                              
Included in net income (C)   (6,663)   (396)   1,536    (4,092)       (9,615)
Included in other comprehensive income (loss)   3,533    1,049    (329)   2,165    (18)   6,400 
Amortization included in interest income   5,966    261    3,946    139    207    10,519 
Purchases, sales and repayments                              
Purchases   39,757                    39,757 
Proceeds from sales   (6,677)       (3,295)   (3,743)       (13,715)
Proceeds from repayments   (14,170)   (9,133)   (6,603)   (287)   (171)   (30,364)
Balance at June 30, 2012  $192,108   $41,307   $68,793   $1,106   $3,957   $307,271

 

(A)Transfers are assumed to occur at the beginning of the quarter.
(B)None of the gains (losses) recorded in earnings during the period is attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date.
(C)These gains (losses) are recorded in the following line items in the consolidated statements of income:

 

   Six Months Ended June 30, 2012 
   Level 3A   Level 3B 
Gain (loss) on settlement of investments, net  $1,204   $4,056 
Other income (loss), net        
OTTI   (2)   (13,671)
Total  $1,202   $(9,615)
           
Gain (loss) on settlement of investments, net, from investments transferred into Level 3  during the period  $   $

 

26

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

Securities Valuation

 

As of June 30, 2012, Newcastle’s securities valuation methodology and results are further detailed as follows:

 

          Fair Value 
   Outstanding   Amortized           Internal     
   Face   Cost   Multiple   Single   Pricing     
Asset Type  Amount (A)   Basis (B)   Quotes (C)   Quote (D)   Models (E)   Total 
                         
CMBS  $1,470,012   $1,103,585   $825,826   $103,981   $233,415   $1,163,222 
REIT debt   120,288    119,542    38,131    84,966        123,097 
ABS - subprime   421,669    244,838    150,321    33,626    68,793    252,740 
ABS - other real estate   38,843    29,274    28,954    921    1,106    30,981 
FNMA / FHLMC   377,220    400,531    242,144    161,248        403,392 
CDO   206,124    68,513    2,750    58,261    3,957    64,968 
Total  $2,634,156   $1,966,283   $1,288,126   $443,003   $307,271   $2,038,400 

 

(A)Net of incurred losses.
(B)Net of discounts (or gross of premiums) and after OTTI, including impairment taken during the period ended June 30, 2012.
(C)Management generally obtained pricing service quotations or broker quotations from two sources, one of which was generally the seller (the party that sold us the security). Management selected one of the quotes received as being most representative of fair value and did not use an average of the quotes. Even if Newcastle receives two or more quotes on a particular security that come from non-selling brokers or pricing services, it does not use an average because management believes using an actual quote more closely represents a transactable price for the security than an average level. Furthermore, in some cases there is a wide disparity between the quotes Newcastle receives. Management believes using an average of the quotes in these cases would generally not represent the fair value of the asset. Based on Newcastle’s own fair value analysis using internal models, management selects one of the quotes which is believed to more accurately reflect fair value. Newcastle never adjusts quotes received. These quotations are generally received via email and contain disclaimers which state that they are “indicative” and not “actionable” – meaning that the party giving the quotation is not bound to actually purchase the security at the quoted price.
(D)Management was unable to obtain quotations from more than one source on these securities. The one source was generally the seller (the party that sold us the security) or a pricing service.
(E)Securities whose fair value was estimated based on internal pricing models are further detailed as follows:

 

          Impairment   Unrealized Gains   Assumption Ranges
   Amortized       Recorded   (Losses) in         Cumulative   
   Cost       In Current   Accumulated   Discount  Prepayment  Default  Loss
   Basis (B)   Fair Value   Period   OCI   Rate  Speed (F)  Rate  Severity
CMBS - Conduit  $165,184   $192,108   $12,802   $26,924    10%   N/A   0% - 100%   0% - 100%
CMBS - Large loan / single borrower   42,490    41,307        (1,183)   5% - 10%   N/A   0% - 100%   0% - 100%
ABS - subprime   59,062    68,793    804    9,731    8%   0% - 10%   24% - 88%   60% - 100%
ABS - other RE   1,086    1,106    64    20    8%   1% - 4%   30% - 46%   90% - 100%
CDO   4,259    3,957        (302)   14%   4%   14%   80%
Total  $272,081   $307,271   $13,670   $35,190                 

 

All of the assumptions listed have some degree of market observability, based on Newcastle’s knowledge of the market, relationships with market participants, and use of common market data sources. Collateral prepayment, default and loss severity projections are in the form of “curves” or “vectors” that vary for each monthly collateral cash flow projection. Methods used to develop these projections vary by asset class (e.g., CMBS projections are developed differently than home equity ABS projections) but conform to industry conventions.  Newcastle uses assumptions that generate its best estimate of future cash flows of each respective security.

 

The prepayment vector specifies the percentage of the collateral balance that is expected to voluntarily pay off at each point in the future. The prepayment vector is based on projections from a widely published investment bank model which considers factors such as collateral FICO score, loan-to-value ratio, debt-to-income ratio, and vintage on a loan level basis. This vector is scaled up or down to match recent collateral-specific prepayment experience, as obtained from remittance reports and market data services.

 

Loss severities are based on recent collateral-specific experience with additional consideration given to collateral characteristics. Collateral age is taken into consideration because severities tend to initially increase with collateral age before eventually stabilizing. Newcastle typically uses projected severities that are higher than the historic experience for collateral that is relatively new to account for this effect. Collateral characteristics such as loan size, lien position, and location (state) also effect loss severity. Newcastle considers whether a collateral pool has experienced a significant change in its composition with respect to these factors when assigning severity projections.

 

Default rates are determined from the current “pipeline” of loans that are more than 90 days delinquent, in foreclosure, or are real estate owned (REO). These significantly delinquent loans determine the first 24 months of the default vector. Beyond month 24, the default vector transitions to a steady-state value that is generally equal to or greater than that given by the widely published investment bank model.

 

The discount rates Newcastle uses are derived from a range of observable pricing on securities backed by similar collateral and offered in a live market. As the markets in which Newcastle transacts have become less liquid, Newcastle has had to rely on fewer data points in this analysis.

 

(F)Projected annualized average prepayment rate.

 

27

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

Loan Valuation

 

Loans which Newcastle does not have the ability or intent to hold into the foreseeable future are classified as held-for-sale. As a result, these held-for-sale loans are carried at the lower of amortized cost or fair value and are therefore recorded at fair value on a non-recurring basis. These loans were written down to fair value at the time of the impairment, based on broker quotations, pricing service quotations or internal pricing models. All the loans were within Level 3 of the fair value hierarchy. For real estate related loans, the most significant inputs used in the valuations are the amount and timing of expected future cash flows, market yields and the estimated collateral value of such loan investments.  For residential mortgage loans, significant inputs include management’s expectations of prepayment speeds, default rates, loss severities and discount rates that market participants would use in determining the fair values of similar pools of residential mortgage loans.

 

The following tables summarize certain information for real estate related loans and residential mortgage loans held-for-sale as of June 30, 2012:

 

               Valuation        
   Outstanding           Allowance/   Significant Input Ranges
   Face   Carrying   Fair   (Reversal) In   Discount  Loss 
Loan Type  Amount   Value   Value   Current Year   Rate  Severity 
Mezzanine  $608,953   $486,572   $493,221   $(1,788)  8.0% - 15.0%   0.0% - 100.0% 
Bank Loan   300,663    189,328    189,328    (12,064)  7.7% - 29.0%   0.0% - 68.0% 
B-Note   207,981    185,701    185,701    (546)  6.2% - 15.0%   0.0%
Whole Loan   30,352    30,352    30,368       5.1% - 7.1%   0.0%
Total Real Estate Related Loans Held-for-Sale, Net  $1,147,949   $891,953   $898,618   $(14,398)        

 

               Valuation    
               Allowance/                 
   Outstanding           (Reversal)    Significant Input Ranges 
   Face   Carrying   Fair   In   Discount   Prepayment   Constant   Loss 
Loan Type  Amount   Value   Value   Current Year   Rate   Speed   Default Rate  Severity 
Non-securitized Manufactured Housing Loans Portfolio I  $640   $169   $169   $14    39.2%   0.0%   52.9%   75.0%
Non-securitized Manufactured Housing Loans Portfolio II   3,682    2,777    2,777    (573)   15.5%   5.0%   3.5%   80.0%
Total Residential Mortgage Loans Held-for-Sale, Net  $4,322   $2,946   $2,946   $(559)                   

 

Loans which Newcastle has the intent and ability to hold into the foreseeable future are classified as held-for-investment. Loans held-for-investment are carried at the aggregate unpaid principal balance adjusted for any unamortized premium or discount, deferred fees or expenses, an allowance for loan losses, charge-offs and write-downs for impaired loans.

 

The following table summarizes certain information for residential mortgage loans held-for-investment as of June 30, 2012:

 

                   Significant Input Ranges
Loan Type  Outstanding Face Amount   Carrying Value   Fair Value   Valuation Allowance/
(Reversal) In Current Year
   Discount Rate  Prepayment Speed  Constant Default Rate  Loss Severity
Securitized Manufactured Housing Loans Portoflio I  $125,948   $105,225   $105,441   $810    9.5%   4.0%   4.0%   75.0%
Securitized Manufactured Housing Loans Portfolio II   165,494    162,402    159,737    2,074    7.5%   5.0%   3.5%   80.0%
Residential Loans   58,523    43,470    43,632    (181)   4.7% - 7.9%   0.0% - 5.0%   0.0% - 3.0%   0.0% - 50.0%
Total Residential Mortgage Loans, Held-for-Investment, Net  $349,965   $311,097   $308,810   $2,703                 

 

28

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

Excess MSRs Valuation

 

Fair value estimates of Newcastle’s Excess MSRs were based on internal pricing models. Significant inputs used in the valuations included expectations of prepayment rates, delinquency rates, recapture rates, the excess mortgage servicing amount of the underlying mortgage loans, and discount rates that market participants would use in determining the fair values of mortgage servicing rights on similar pools of residential mortgage loans. In addition, in valuing the Excess MSRs, management considered the likelihood of Nationstar being removed as servicer, which likelihood is considered to be remote.

 

The following table summarizes certain information regarding the inputs used in valuing the Excess MSRs as of June 30, 2012:

  

  Significant Input Ranges 
   Prepayment Speed (A)   Delinquency (B)   Recapture Rate (C)   Excess Mortgage Servicing Amount (D)  Discount Rate 
MSR Pool 1   20.0%   10.0%   35.0%  29 bps   18.0%
MSR Pool 1 - Recapture Agreement   8.0%   10.0%   35.0%   21 bps   18.0%
MSR Pool 2   18.0%   11.0%   35.0%   23 bps   17.3%
MSR Pool 2 - Recapture Agreement   8.0%   10.0%   35.0%   21 bps   17.3%
MSR Pool 3   18.0%   12.0%   35.0%  23 bps   17.6%
MSR Pool 3 - Recapture Agreement   8.0%   10.0%   35.0%   21 bps   17.6%
MSR Pool 4   19.0%   16.0%   35.0%   17 bps   17.9%
MSR Pool 4 - Recapture Agreement   8.0%   10.0%   35.0%   21 bps   17.9%
MSR Pool 5   15.0%   N/A (E)   35.0%   13 bps   17.5%
MSR Pool 5 - Recapture Agreement   8.0%   N/A (E)   35.0%  21 bps   17.5%

 

 (A) Projected annualized weighted average lifetime voluntary and involuntary prepayment rate using a prepayment vector.
  (B) Projected percentage of mortgage loans in the pool that are expected to miss their mortgage payments.
  (C) Percentage of voluntarily prepaid loans that are expected to be refinanced by Nationstar.
  (D) Weighted average total mortgage servicing amount in excess of the base servicing fee.
  (E) The Excess MSR will be paid on the total UPB of the mortgage portfolio (including both performing and delinquent loans until REO)

 

All of the assumptions listed have some degree of market observability, based on Newcastle’s knowledge of the market, relationships with market participants, and use of common market data sources. Prepayment rates are in the form of “curves” or “vectors” that vary over the expected life of the pool. Newcastle uses assumptions that generate its best estimate of future cash flows for each investment in Excess MSRs.

 

The prepayment vector specifies the percentage of the collateral balance that is expected to prepay voluntarily (i.e. pay off) and involuntarily (i.e. default) at each point in the future. The prepayment vector is based on projections that consider factors such as the underlying borrower’s FICO score, loan-to-value ratio, debt-to-income ratio, vintage on a loan level basis, as well as the potential effect on loans eligible for the Home Affordable Refinance Program 2.0 (“HARP 2.0”). This vector is scaled up or down to match recent collateral-specific prepayment experience, as obtained from remittance reports, market data services and other market factors.

 

Delinquency rates are based on the recent pool-specific experience of loans that missed their most recent mortgage payments, with additional consideration given to loans that are expected to become 30 or more days delinquent.

 

Recapture rates are based on recent actual average recapture rates experienced by Nationstar on similar GSE mortgage loan pools.

 

For existing mortgage pools, excess mortgage servicing amount projections are based on the actual total mortgage servicing amount in excess of a base servicing fee. For loans that are yet to be refinanced by Nationstar, Newcastle considers the excess mortgage servicing amount on loans recently originated by Nationstar and generally assumes lower excess mortgage servicing amount than the historic experience.

 

The discount rates Newcastle uses are derived from a range of observable pricing on mortgage servicing rights backed by similar collateral.

 

29

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

Newcastle’s MSRs investments measured at fair value on a recurring basis using Level 3B inputs changed during the period ended June 30, 2012 as follows:

 

   Level 3B (A) 
   MSR Pool 1   MSR Pool 2   MSR Pool 3   MSR Pool 4   MSR Pool 5   Total 
Balance at December 31, 2011  $43,971   $   $   $   $   $43,971 
Transfers (B)                              
Transfers from Level 3A                        
Transfers into Level 3A                        
Gains (losses) included in net income (C)   4,739                    4,739 
Interest income   3,884    488    424    168    1,552    6,516 
Purchases, sales and repayments                              
Purchases       43,872    36,218    15,439    124,813    220,342 
Purchase adjustments   (178)   (1,522)               (1,700)
Proceeds from sales                        
Proceeds from repayments   (8,736)                   (8,736)
Balance at June 30, 2012  $43,680   $42,838   $36,642   $15,607   $126,365   $265,132 

 

(A)Includes the recapture agreement for each respective pool.
(B)Transfers are assumed to occur at the beginning of the quarter.
(C)The gains (losses) recorded in earnings during the period are attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates. These gains(losses) are recorded in “Other Income (Loss)” in the consolidated statement of income.

 

Newcastle has various processes and controls in place to ensure that fair value is reasonably estimated. With respect to the broker and pricing service quotations, to ensure these quotes represent a reasonable estimate of fair value, Newcastle’s quarterly procedures include a comparison to the outputs generated from its internal pricing models and transactions Newcastle has completed with respect to these or similar securities, as well as on its knowledge and experience of these markets. With respect to fair value estimates generated based on Newcastle’s internal pricing models, Newcastle’s management validates the inputs and outputs of the internal pricing models by comparing them to available independent third party market parameters and models for reasonableness. Newcastle believes its valuation methods and the assumptions used are appropriate and consistent with other market participants.

 

Fair value measurements categorized within Level 3 are sensitive to changes in the assumptions or methodology used to determine fair value and such changes could result in a significant increase or decrease in the fair value. For Newcastle’s investments in real estate securities, real estate related loans and residential mortgage loans categorized within Level 3 of the fair value hierarchy, the significant unobservable inputs include the discount rates, assumptions relating to prepayments, default rates and loss severities. Significant increases (decreases) in any of the discount rates, default rates or loss severities in isolation would result in a significantly lower (higher) fair value measurement. The impact of changes in prepayment speeds would have differing impacts on fair value, depending on the seniority of the investment. Generally, a change in the default assumption is generally accompanied by directionally similar changes in the assumptions used for the loss severity and the prepayment speed. For Newcastle’s investments in Excess MSRs, significant unobservable inputs include the discount rate, assumptions relating to prepayments, delinquency rates, recapture rates and excess mortgage servicing amount. Significant increases (decreases) in the discount rates, prepayments or delinquency rates in isolation would result in a significantly lower (higher) fair value measurement, whereas significant increases (decreases) in the recapture rates or excess mortgage servicing amount in isolation would result in a significantly higher (lower) fair value measurement. Generally, a change in the delinquency rate assumption is accompanied by directionally similar changes in the assumptions used for the prepayment speed.

 

30

 

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2012

(dollars in tables in thousands, except share data)

Derivatives

 

Newcastle’s derivative instruments are valued using counterparty quotations. These quotations are generally based on valuation models with model inputs that can generally be verified and which do not involve significant judgment. The significant observable inputs used in determining the fair value of our Level 2 derivative contracts are contractual cash flows and market based interest rate curves. Newcastle’s derivatives are recorded on its balance sheet as follows:

  

      Fair Value  
        June 30,     December 31,  
    Balance sheet location   2012     2011  
                 
Derivative Assets                
Interest rate caps, designated as hedges   Derivative Assets   $ 504     $ 1,092  
Interest rate caps, not designated as hedges   Derivative Assets     462       862  
        $ 966     $ 1,954  
Derivative Liabilities                    
Interest rate swaps, designated as hedges   Derivative Liabilities   $ 70,226     $ 90,025  
Interest rate swaps, not designated as hedges   Derivative Liabilities     31,583       29,295  
        $ 101,809     $ 119,320  

 

The following table summarizes information related to derivatives:

 

   June 30, 2012   December 31, 2011 
Cash flow hedges        
Notional amount of interest rate swap agreements  $766,859   $848,434 
Notional amount of interest rate cap agreements   122,665    104,205 
Amount of (loss) recognized in OCI on effective portion   (51,397)   (69,908)
Deferred hedge gain (loss) related to anticipated financings,  which have subsequently occurred, net of amortization   269    299 
Deferred hedge gain (loss) related to dedesignation,  net of amortization   (1,515)   (893)
Expected reclassification of deferred hedges from AOCI into earnings over the next 12 months   799    1,688 
           
Expected reclassification of current hedges from AOCI into  earnings over the next 12 months   (28,666)   (35,348)
           
Non-hedge Derivatives          
Notional amount of interest rate swap agreements   339,990    316,600 
Notional amount of interest rate cap agreements   42,428    36,428 

 

The following table summarizes gains (losses) recorded in relation to derivatives:

 

     

Three Months Ended

June 30,

   

Six Months Ended

June 30,

 
    Income statement location   2012     2011     2012     2011  
Cash flow hedges                            
Gain (loss) on the ineffective portion   Other income (loss)   $ 453     $ 17     $ 483     $ 300  
Gain (loss) immediately recognized at dedesignation   Gain (loss) on sale of investments; Other income (loss)     (6,760 )     (8,481 )     (7,036 )     (13,796 )
Amount of gain (loss) reclassified from AOCI into income, related to effective portion   Interest expense     (10,290 )     (17,517 )     (20,936 )     (38,708 )
Deferred hedge gain reclassified from AOCI into income, related to anticipated financings   Interest expense     15       14       30       28  
Deferred hedge gain (loss) reclassified from AOCI into income, related to effective portion of dedesignated hedges   Interest expense     456       583       898       1,302  
Non-hedge derivatives gain (loss)   Other income (loss)     2,021