UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549
FORM 10-Q

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

For the quarterly period ended March 31, 2006

or

o 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 x No o     

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x Accelerated filer o Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No x

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: 43,997,409 shares outstanding as of May 8, 2006.
 

 
NEWCASTLE INVESTMENT CORP.
FORM 10-Q

INDEX
 
     
PAGE
       
PART I
FINANCIAL INFORMATION
   
       
Item 1
Financial Statements
   
       
 
Consolidated Balance Sheets as of March 31, 2006 (unaudited) and December 31, 2005
 
1
       
 
Consolidated Statements of Income (unaudited) for the three ended March 31, 2006 and 2005
 
2
       
 
Consolidated Statements of Stockholders' Equity (unaudited) for the three months ended March 31, 2006 and 2005
 
3
       
 
Consolidated Statements of Cash Flows (unaudited) for the three months ended March 31, 2006 and 2005
 
4
       
 
Notes to Consolidated Financial Statements (unaudited)
 
6
       
Item 2
Management's Discussion and Analysis of Financial Condition and Results of Operations
 
14
       
Item 3
Quantitative and Qualitative Disclosures About Market Risk
 
31
       
Item 4
Controls and Procedures
 
36
       
PART II.
OTHER INFORMATION
   
       
Item 1
Legal Proceedings
 
37
       
Item 1A
Risk Factors
 
37
       
Item 2
Unregistered Sales of Equity Securities and Use of Proceeds
 
38
       
Item 3
Defaults upon Senior Securities
 
38
       
Item 4
Submission of Matters to a Vote of Security Holders
 
38
       
Item 5
Other Information
 
38
       
Item 6
Exhibits
 
39
       
SIGNATURES
 
 
40
 


PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)


   
March 31, 2006 (Unaudited)
 
December 31, 2005
 
Assets
         
Real estate securities, available for sale
 
$
4,732,563
 
$
4,554,519
 
Real estate related loans, net
   
670,938
   
615,551
 
Residential mortgage loans, net
   
540,231
   
600,682
 
Subprime mortgage loans, held for sale - Note 5
   
1,510,022
   
-
 
Investments in unconsolidated subsidiaries
   
28,946
   
29,953
 
Operating real estate, net
   
28,821
   
16,673
 
Cash and cash equivalents
   
38,475
   
21,275
 
Restricted cash
   
190,259
   
268,910
 
Derivative assets
   
109,944
   
63,834
 
Receivables and other assets
   
35,575
   
38,302
 
   
$
7,885,774
 
$
6,209,699
 
Liabilities and Stockholders' Equity
             
               
Liabilities
             
CBO bonds payable
 
$
3,521,395
 
$
3,530,384
 
Other bonds payable
   
352,050
   
353,330
 
Notes payable
   
220,825
   
260,441
 
Repurchase agreements
   
2,674,127
   
1,048,203
 
Credit facility
   
-
   
20,000
 
Junior subordinated notes payable (security for trust preferred)
   
100,100
   
-
 
Derivative liabilities
   
9,108
   
18,392
 
Dividends payable
   
29,032
   
29,052
 
Due to affiliates
   
4,011
   
8,783
 
Accrued expenses and other liabilities
   
35,849
   
23,111
 
     
6,946,497
   
5,291,696
 
Stockholders' Equity
             
Preferred stock, $0.01 par value, 100,000,000 shares authorized, 2,500,000 shares of 9.75% Series B Cumulative Redeemable Preferred Stock and 1,600,000 shares of 8.05% Series C Cumulative Redeemable Preferred Stock, liquidation preference $25.00 per share, issued and outstanding
   
102,500
   
102,500
 
Common stock, $0.01 par value, 500,000,000 shares authorized, 43,967,409 and 43,913,409 shares issued and outstanding at March 31, 2006 and December 31, 2005, respectively
   
440
   
439
 
               
Additional paid-in capital
   
783,784
   
782,735
 
               
Dividends in excess of earnings
   
(12,124
)
 
(13,235
)
               
Accumulated other comprehensive income
   
64,677
   
45,564
 
     
939,277
   
918,003
 
   
$
7,885,774
 
$
6,209,699
 
 
1


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(dollars in thousands, except share data)


   
Three Months Ended
March 31,
 
   
2006
 
2005
 
Revenues
         
Interest income
 
$
113,907
 
$
79,036
 
Rental and escalation income
   
2,008
   
1,264
 
Gain on sale of investments, net
   
1,928
   
1,714
 
Other income
   
5,705
   
1,649
 
     
123,548
   
83,663
 
Expenses
             
Interest expense
   
76,965
   
48,766
 
Property operating expense
   
818
   
693
 
Loan and security servicing expense
   
2,006
   
1,583
 
Provision for credit losses
   
2,007
   
712
 
Provision for losses, loans held for sale - Note 5
   
4,127
   
-
 
General and administrative expense
   
1,630
   
891
 
Management fee to affiliate
   
3,471
   
3,263
 
Incentive compensation to affiliate
   
2,852
   
1,972
 
Depreciation and amortization
   
199
   
136
 
 
   
94,075
   
58,016
 
Income before equity in earnings of unconsolidated subsidiaries
   
29,473
   
25,647
 
Equity in earnings of unconsolidated subsidiaries
   
1,195
   
2,086
 
Income taxes on related taxable subsidiaries
   
-
   
(233
)
Income from continuing operations
   
30,668
   
27,500
 
Income from discontinued operations
   
251
   
1,184
 
Net Income
   
30,919
   
28,684
 
Preferred dividends
   
(2,328
)
 
(1,523
)
Income Available For Common Stockholders
 
$
28,591
 
$
27,161
 
Net Income Per Share of Common Stock
             
Basic
 
$
0.65
 
$
0.63
 
Diluted
 
$
0.65
 
$
0.62
 
Income from continuing operations per share of common stock, after preferred dividends
             
Basic
 
$
0.64
 
$
0.60
 
Diluted
 
$
0.64
 
$
0.59
 
Income from discontinued operations per share of common stock
             
Basic
 
$
0.01
 
$
0.03
 
Diluted
 
$
0.01
 
$
0.03
 
Weighted Average Number of Shares of Common Stock Outstanding
             
Basic
   
43,944,820
   
43,221,792
 
Diluted
   
44,063,940
   
43,629,078
 
Dividends Declared per Share of Common Stock
 
$
0.625
 
$
0.625
 
 
2


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Unaudited)
FOR THE THREE MONTHS ENDED MARCH 31, 2006 AND 2005
(dollars in thousands)


 
 
Preferred Stock
 
Common Stock
 
Additional Paid-in
Capital
 
Dividends in Excess of 
Earnings
 
Accum. Other Comp.
Income
 
Total Stock-holders'
Equity
 
 
 
Shares
 
Amount
 
Shares
 
Amount
         
Stockholders' equity - December 31, 2005
   
4,100,000
 
$
102,500
   
43,913,409
 
$
439
 
$
782,735
 
$
(13,235
)
$
45,564
 
$
918,003
 
Dividends declared
   
-
   
-
   
-
   
-
   
-
   
(29,808
)
 
-
   
(29,808
)
Exercise of common stock options
   
-
   
-
   
54,000
   
1
   
1,049
   
-
   
-
   
1,050
 
Comprehensive income:
                                                 
Net income
   
-
   
-
   
-
   
-
   
-
   
30,919
   
-
   
30,919
 
Net unrealized (loss) on securities
   
-
   
-
   
-
   
-
   
-
   
-
   
(36,554
)
 
(36,554
)
Reclassification of net realized (gain) on securities into earnings
   
-
   
-
   
-
   
-
   
-
   
-
   
(29
)
 
(29
)
Foreign currency translation
   
-
   
-
   
-
   
-
   
-
   
-
   
(34
)
 
(34
)
Net unrealized gain on derivatives designated as cash flow hedges
   
-
   
-
   
-
   
-
   
-
   
-
   
56,145
   
56,145
 
Reclassification of net realized (gain) on derivatives designated as cash flow hedges into earnings
   
-
   
-
   
-
   
-
   
-
   
-
   
(415
)
 
(415
)
Total comprehensive income
                                             
50,032
 
Stockholders' equity - March 31, 2006
   
4,100,000
 
$
102,500
   
43,967,409
 
$
440
 
$
783,784
 
$
(12,124
)
$
64,677
 
$
939,277
 
Stockholders' equity - December 31, 2004
   
2,500,000
 
$
62,500
   
39,859,481
 
$
399
 
$
676,015
 
$
(13,969
)
$
71,770
 
$
796,715
 
Dividends declared
   
-
   
-
   
-
   
-
   
-
   
(28,873
)
 
-
   
(28,873
)
Issuance of common stock
   
-
   
-
   
3,300,000
   
33
   
96,567
   
-
   
-
   
96,600
 
Exercise of common stock options
   
-
   
-
   
599,430
   
6
   
9,077
   
-
   
-
   
9,083
 
Comprehensive income:
                                                 
Net income
   
-
   
-
   
-
   
-
   
-
   
28,684
   
-
   
28,684
 
Net unrealized (loss) on securities
   
-
   
-
   
-
   
-
   
-
   
-
   
(42,353
)
 
(42,353
)
Reclassification of net realized (gain) on securities into earnings
   
-
   
-
   
-
   
-
   
-
   
-
   
(1,409
)
 
(1,409
)
Foreign currency translation
   
-
   
-
   
-
   
-
   
-
   
-
   
(719
)
 
(719
)
Reclassification of net realized foreign currency translation into earnings
   
-
   
-
   
-
   
-
   
-
   
-
   
(542
)
 
(542
)
Net unrealized gain on derivatives designated as cash flow hedges
   
-
   
-
   
-
   
-
   
-
   
-
   
44,637
   
44,637
 
Reclassification of net realized (gain) on derivatives designated as cash flow hedges into earnings
   
-
   
-
   
-
   
-
   
-
   
-
   
(342
)
 
(342
)
Total comprehensive income
                                             
27,956
 
Stockholders' equity - March 31, 2005
   
2,500,000
 
$
62,500
   
43,758,911
 
$
438
 
$
781,659
 
$
(14,158
)
$
71,042
 
$
901,481
 
 
3


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOW (Unaudited)
(dollars in thousands)


   
Three Months Ended March 31,
 
   
2006
 
2005
 
Cash Flows From Operating Activities
         
Net income
 
$
30,919
 
$
28,684
 
Adjustments to reconcile net income to net cash provided by (used in) operating activities
             
(inclusive of amounts related to discontinued operations):
             
Depreciation and amortization
   
199
   
312
 
Accretion of discount and other amortization
   
(9,732
)
 
386
 
Equity in earnings of unconsolidated subsidiaries
   
(1,195
)
 
(2,086
)
Distributions of earnings from unconsolidated subsidiaries
   
1,195
   
2,086
 
Deferred rent
   
(837
)
 
(258
)
Gain on sale of investments
   
(2,291
)
 
(2,456
)
Unrealized gain on non-hedge derivatives and hedge ineffectiveness
   
(5,673
)
 
(2,687
)
Provision for credit losses
   
2,007
   
-
 
Provision for losses, loans held for sale
   
4,127
   
-
 
Purchase of loans held for sale - Note 5
   
(1,511,086
)
 
-
 
Change in:
             
Restricted cash
   
8,570
   
(696
)
Receivables and other assets
   
5,929
   
(1,539
)
Due to affiliates
   
(4,772
)
 
(5,883
)
Accrued expenses and other liabilities
   
12,239
   
327
 
Net cash provided by (used in) operating activities
   
(1,470,401
)
 
16,190
 
Cash Flows From Investing Activities
             
Purchase of real estate securities
   
(168,480
)
 
(122,254
)
Proceeds from sale of real estate securities
   
54,225
   
6,574
 
Deposit on real estate securities (treated as a derivative)
   
-
   
(15,539
)
Purchase of and advances on loans
   
(221,173
)
 
(342,878
)
Repayments of loan and security principal
   
187,188
   
120,136
 
Margin deposit on derivative instruments
   
(15,517
)
 
(20,000
)
Return of margin deposit on derivative instruments
   
19,866
   
-
 
Proceeds from sale of derivative instruments
   
7,356
   
342
 
Purchase and improvement of operating real estate
   
(179
)
 
(199
)
Proceeds from sale of operating real estate
   
-
   
10,693
 
Contributions to unconsolidated subsidiaries
   
(100
)
 
-
 
Distributions of capital from unconsolidated subsidiaries
   
1,107
   
3,966
 
Payment of deferred transaction costs
   
-
   
(24
)
Net cash used in investing activities
   
(135,707
)
 
(359,183
)

Continued on Page 5
 
4


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOW (Unaudited)
(dollars in thousands)


   
Three Months Ended March 31,
 
   
2006
 
2005
 
Cash Flows From Financing Activities
         
Repayments of CBO bonds payable
   
(10,129
)
 
(891
)
Issuance of other bonds payable
   
237,111
   
246,547
 
Repayments of other bonds payable
   
(236,372
)
 
(31,473
)
Repayments of notes payable
   
(39,616
)
 
(65,320
)
Borrowings under repurchase agreements
   
1,817,109
   
129,430
 
Repayments of repurchase agreements
   
(191,185
)
 
(22,780
)
Draws under credit facility
   
90,000
   
-
 
Repayments of credit facility
   
(110,000
)
 
-
 
Issuance of junior subordinated notes payable
   
100,100
   
-
 
Issuance of common stock
   
-
   
97,680
 
Costs related to issuance of common stock
   
-
   
(1,036
)
Exercise of common stock options
   
1,050
   
9,083
 
Dividends paid
   
(29,828
)
 
(26,436
)
Payment of deferred financing costs
   
(4,932
)
 
(933
)
               
Net cash provided by financing activities
   
1,623,308
   
333,871
 
               
Net Increase (Decrease) in Cash and Cash Equivalents
   
17,200
   
(9,122
)
               
Cash and Cash Equivalents, Beginning of Period
   
21,275
   
37,911
 
               
Cash and Cash Equivalents, End of Period
 
$
38,475
 
$
28,789
 
               
Supplemental Disclosure of Cash Flow Information
             
Cash paid during the period for interest expense
 
$
67,648
 
$
46,232
 
Cash paid during the period for income taxes
 
$
244
 
$
355
 
               
Supplemental Schedule of Non-Cash Investing and Financing Activities
             
Common stock dividends declared but not paid
 
$
27,480
 
$
27,349
 
Preferred stock dividends declared but not paid
 
$
1,552
 
$
1,016
 
Foreclosure of loans
 
$
12,200
 
$
-
 
 
5

 
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2006
(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 three primary segments: (i) real estate securities and real estate related loans, (ii) residential mortgage loans, and (iii) operating real estate.

The following table presents information on shares of Newcastle’s common stock issued subsequent to its formation:

Year
 
Shares Issued
 
Range of Issue Prices (1)
 
Net Proceeds (millions)
 
Formation
   
16,488,517
   
N/A
   
N/A
 
2002
   
7,000,000
 
 
$13.00
 
$
80.0
 
2003
   
7,886,316
 
 
$20.35-$22.85
 
$
163.4
 
2004
   
8,484,648
 
 
$26.30-$31.40
 
$
224.3
 
2005
   
4,053,928
 
 
$29.60
 
$
108.2
 
Three Months 2006
   
54,000
   
N/A
 
$
1.1
 
March 31, 2006
   
43,967,409
             
 
(1) Excludes prices of shares issued pursuant to the exercise of options and shares issued to Newcastle's independent directors.
 
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 Fortress Investment Group LLC (the "Manager"), an affiliate, 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 receives an annual management fee and incentive compensation, both as defined in the Management Agreement.

Approximately 2.9 million shares of Newcastle’s common stock were held by an affiliate of the Manager and its principals at March 31, 2006. In addition, an affiliate of the Manager held options to purchase approximately 1.2 million shares of Newcastle’s common stock at March 31, 2006.

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 accounting principles generally accepted in the United States 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, 2005 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, 2005.

6


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2006
(dollars in tables in thousands, except share data)

 
2. INFORMATION REGARDING BUSINESS SEGMENTS

Newcastle conducts its business through three primary segments: real estate securities and real estate related loans, residential mortgage loans, and operating real estate.
 
Summary financial data on Newcastle's segments is given below, together with a reconciliation to the same data for Newcastle as a whole:
 
   
Real Estate Securities
and Real Estate Related Loans
 
Residential Mortgage Loans
 
Operating Real Estate
 
Unallocated
 
Total
 
March 31, 2006 and the Three Months then Ended
                     
Gross revenues
 
$
95,193
 
$
26,029
 
$
2,184
 
$
142
 
$
123,548
 
Operating expenses
   
(817
)
 
(7,463
)
 
(877
)
 
(7,754
)
 
(16,911
)
Operating income (loss)
   
94,376
   
18,566
   
1,307
   
(7,612
)
 
106,637
 
Interest expense
   
(62,198
)
 
(13,928
)
 
-
   
(839
)
 
(76,965
)
Depreciation and amortization
   
-
   
-
   
(131
)
 
(68
)
 
(199
)
Equity in earnings of unconsolidated subsidiaries (A)
   
701
   
-
   
494
   
-
   
1,195
 
Income (loss) from continuing operations
   
32,879
   
4,638
   
1,670
   
(8,519
)
 
30,668
 
Income from discontinued operations
   
-
   
-
   
251
   
-
   
251
 
Net Income (loss)
 
$
32,879
 
$
4,638
 
$
1,921
 
$
(8,519
)
$
30,919
 
Revenue derived from non-U.S. sources:
                               
Canada
 
$
-
 
$
-
 
$
2,380
 
$
-
 
$
2,380
 
Total assets
 
$
5,739,539
 
$
2,060,487
 
$
44,059
 
$
41,689
 
$
7,885,774
 
Long-lived assets outside the U.S.:
                               
Canada
 
$
-
 
$
-
 
$
16,632
 
$
-
 
$
16,632
 
December 31, 2005
                               
Total assets
 
$
5,544,818
 
$
606,320
 
$
36,306
 
$
22,255
 
$
6,209,699
 
Long-lived assets outside the U.S.:
                               
Canada
 
$
-
 
$
-
 
$
16,673
 
$
-
 
$
16,673
 
Three Months Ended March 31, 2005
                               
Gross revenues
 
$
69,546
 
$
12,694
 
$
1,276
 
$
147
 
$
83,663
 
Operating expenses
   
(323
)
 
(2,003
)
 
(701
)
 
(6,087
)
 
(9,114
)
Operating income (loss)
   
69,223
   
10,691
   
575
   
(5,940
)
 
74,549
 
Interest expense
   
(41,330
)
 
(7,278
)
 
(158
)
 
-
   
(48,766
)
Depreciation and amortization
   
-
   
-
   
(116
)
 
(20
)
 
(136
)
Equity in earnings of unconsolidated subsidiaries (A)
   
846
   
-
   
1,007
   
-
   
1,853
 
Income (loss) from continuing operations
   
28,739
   
3,413
   
1,308
   
(5,960
)
 
27,500
 
Income from discontinued operations
   
-
   
-
   
1,184
   
-
   
1,184
 
Net Income (loss)
 
$
28,739
 
$
3,413
 
$
2,492
 
$
(5,960
)
$
28,684
 
Revenue derived from non-U.S. sources:
                               
Canada
 
$
-
 
$
-
 
$
4,071
 
$
-
 
$
4,071
 
Belgium
 
$
-
 
$
-
 
$
532
 
$
-
 
$
532
 
 
(A) Net of income taxes on related taxable subsidiaries.
 
Continued on Page 8
 
7


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2006
(dollars in tables in thousands, except share data)


Unconsolidated Subsidiaries

The following table summarizes the activity affecting the equity held by Newcastle in unconsolidated subsidiaries:

   
Operating Real Estate Subsidiary
 
Real Estate Loan Subsidiary
 
Trust Preferred Subsidiary
 
Balance at December 31, 2005
 
$
12,151
 
$
17,802
 
$
-
 
Contributions to unconsolidated subsidiaries
   
-
   
-
   
100
 
Distributions from unconsolidated subsidiaries
   
(456
)
 
(1,846
)
 
-
 
Equity in earnings of unconsolidated subsidiaries
   
494
   
701
   
-
 
Balance at March 31, 2006
 
$
12,189
 
$
16,657
 
$
100
 

Summarized financial information related to Newcastle’s unconsolidated subsidiaries was as follows:

   
Operating
Real Estate
Subsidiary (A) (B)
 
Real Estate Loan Subsidiary (A) (C)
 
   
March 31,
 
December 31,
 
March 31,
 
December 31,
 
   
2006
 
2005
 
2006
 
2005
 
Assets
 
$
77,835
 
$
77,758
 
$
33,503
 
$
35,806
 
Liabilities
   
(53,000
)
 
(53,000
)
 
-
   
-
 
Minority interest
   
(457
)
 
(455
)
 
(189
)
 
(202
)
                           
Equity
 
$
24,378
 
$
24,303
 
$
33,314
 
$
35,604
 
                           
Equity held by Newcastle
 
$
12,189
 
$
12,151
 
$
16,657
 
$
17,802
 
             
 
   
Three Months Ended March 31,  
 
 Three Months Ended March 31,
 
     
2006
   
2005
   
2006
   
2005
 
Revenues
 
$
1,835
 
$
4,347
 
$
1,418
 
$
1,713
 
Expenses
   
(828
)
 
(1,822
)
 
(8
)
 
(12
)
Minority interest
   
(19
)
 
(47
)
 
(8
)
 
(9
)
Net income
 
$
988
 
$
2,478
 
$
1,402
 
$
1,692
 
                           
Newcastle's equity in net income
 
$
494
 
$
1,240
 
$
701
 
$
846
 
 
(A)  
The unconsolidated subsidiaries’ summary financial information is presented on a fair value basis, consistent with their internal basis of accounting.

(B)  
Included in the operating real estate segment.

(C)  
Included in the real estate securities and real estate related loans segment.

For information regarding the trust preferred subsidiary, which is a financing subsidiary with no material net income or cash flow, see Note 5.
8


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2006
(dollars in tables in thousands, except share data)


3. REAL ESTATE SECURITIES

The following is a summary of Newcastle’s real estate securities at March 31, 2006, all of which are classified as available for sale and are therefore marked to market through other comprehensive income.

 
 
 
 
 
 
Gross Unrealized
 
 
 
 
 
Weighted Average
 
Asset Type
 
Current Face Amount
 
Amortized Cost Basis
 
Gains
 
Losses
 
Carrying Value
 
Number of
Securities
 
S&P
Equivalent
Rating
 
Coupon
 
Yield
 
Maturity (Years)
 
CMBS-Conduit
 
$
1,439,923
 
$
1,386,083
 
$
22,437
 
$
(33,864
)
$
1,374,656
   
197
   
BBB-
   
5.84
%
 
6.55
%
 
7.61
 
CMBS-Large Loan
   
651,043
   
647,783
   
7,707
   
(712
)
 
654,778
   
61
   
BBB-
   
6.77
%
 
6.99
%
 
2.39
 
CMBS- B-Note
   
219,200
   
213,295
   
3,340
   
(1,286
)
 
215,349
   
33
   
BBB-
   
6.55
%
 
7.15
%
 
6.34
 
Unsecured REIT Debt
   
931,208
   
946,833
   
14,286
   
(19,877
)
 
941,242
   
99
   
BBB-
   
6.35
%
 
5.98
%
 
6.70
 
ABS-Manufactured Housing
   
175,912
   
159,727
   
1,503
   
(3,744
)
 
157,486
   
10
   
B
   
7.12
%
 
8.64
%
 
6.13
 
ABS-Home Equity
   
549,937
   
547,563
   
5,873
   
(210
)
 
553,226
   
97
   
A-
   
6.47
%
 
6.65
%
 
3.00
 
ABS-Franchise
   
70,523
   
69,666
   
1,081
   
(1,557
)
 
69,190
   
20
   
BBB+
   
6.86
%
 
8.09
%
 
5.17
 
Agency RMBS
   
776,725
   
781,505
   
-
   
(14,869
)
 
766,636
   
23
   
AAA
   
4.84
%
 
4.79
%
 
4.74
 
Total/Average (A)
 
$
4,814,471
 
$
4,752,455
 
$
56,227
 
$
(76,119
)
$
4,732,563
   
540
   
BBB+
   
6.07
%
 
6.34
%
 
5.59
 
 
(A) The total current face amount of fixed rate securities was $3,754.2 million, and of floating rate securities was $1,060.3 million.
 
Unrealized losses that are considered other than temporary are recognized currently in income. There were no such losses incurred during the three months ended March 31, 2006. The unrealized losses on Newcastle’s securities are primarily the result of market factors, rather than credit impairment, and Newcastle believes their carrying values are fully recoverable over their expected holding period. None of the securities were in default as of March 31, 2006. Newcastle has performed credit analyses in relation to such securities which support its belief that the carrying values of such securities are fully recoverable over their expected holding period. Although management expects to hold these securities until their recovery, there is no assurance that such securities will not be sold or at what price they may be sold.
 
 
 
 
 
 
 
Gross Unrealized
 
 
 
 
 
Weighted Average
 
Securities in an Unrealized Loss Position
 
Current Face Amount
 
Amortized Cost Basis
 
Gains
 
Losses
 
Carrying Value
 
Number of
Securities
 
S&P
Equivalent
Rating
 
Coupon
 
Yield
 
Maturity (Years)
 
Less Than Twelve Months
 
$
2,157,334
 
$
2,131,028
 
$
-
 
$
(41,780
)
$
2,089,248
   
249
   
A-
   
5.80
%
 
5.96
%
 
6.63
 
Twelve or More Months
   
851,130
   
861,347
   
-
   
(34,339
)
 
827,008
   
91
   
A
   
5.58
%
 
5.37
%
 
5.64
 
Total
 
$
3,008,464
 
$
2,992,375
 
$
-
 
$
(76,119
)
$
2,916,256
   
340
   
A-
   
5.74
%
 
5.79
%
 
6.35
 

As of March 31, 2006, Newcastle had $106.7 million of restricted cash held in CBO financing structures pending its investment in real estate securities and loans.

9

 
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2006
(dollars in tables in thousands, except share data)


4. REAL ESTATE RELATED LOANS, RESIDENTIAL MORTGAGE LOANS AND SUBPRIME MORTGAGE LOANS

The following is a summary of real estate related loans, residential mortgage loans and subprime mortgage loans at March 31, 2006. The loans contain various terms, including fixed and floating rates, self-amortizing and interest only. They are generally subject to prepayment.
 
Loan Type
 
Current
Face Amount
 
Carrying
Value
 
Loan
Count
 
Wtd. Avg. Yield
 
Weighted Average Maturity
(Years) (D)
 
Delinquent Carrying Amount (E)
 
B-Notes
 
$
38,568
 
$
38,964
   
6
   
7.84
%
 
3.14
 
$
-
 
Mezzanine Loans (A)
   
445,200
   
444,904
   
7
   
8.79
%
 
2.30
   
-
 
Bank Loans
   
21,977
   
21,993
   
2
   
7.13
%
 
1.86
   
-
 
Real Estate Loans
   
20,917
   
20,140
   
1
   
20.02
%
 
1.75
   
-
 
ICH Loans (B)
   
145,360
   
144,937
   
85
   
8.64
%
 
1.54
   
6,104
 
Total Real Estate Related Loans
 
$
672,022
 
$
670,938
   
101
   
8.99
%
 
2.15
 
$
6,104
 
                                       
Residential Loans
 
$
276,381
 
$
282,755
   
785
   
5.40
%
 
2.80
 
$
3,192
 
Manufactured Housing Loans
   
271,420
   
257,476
   
6,752
   
7.84
%
 
5.77
   
1,512
 
Total Residential Mortgage Loans
   
547,801
   
540,231
   
7,537
   
6.56
%
 
4.27
   
4,704
 
Subprime Mortgage Loans (C)
   
1,502,181
   
1,510,022
   
11,272
   
7.18
%
 
2.49
   
-
 
Total Residential Mortgage and Subprime Mortgage Loan
 
$
2,049,982
 
$
2,050,253
   
18,809
   
7.02
%
 
2.97
 
$
4,704
 

(A)  
One of these loans has a contractual exit fee which Newcastle will begin to accrue if and when management believes
it is probable that such exit fee will be received.

(B)  
In October 2003, pursuant to FIN No. 46, Newcastle consolidated an entity which holds a portfolio of commercial mortgage loans which has been securitized. This investment, which is referred to as the ICH CMO, was previously treated as a non-consolidated residual interest in such securitization. The primary effect of the consolidation is the requirement that Newcastle reflect the gross loan assets and gross bonds payable of this entity in its financial statements.

(C)  
See Note 5 regarding the securitization of this portfolio in April 2006.

(D)  
The weighted average maturities for the residential loan portfolio, the manufactured housing loan portfolio and the subprime mortgage loan portfolio were calculated based on constant prepayment rates (CPR) of approximately 30%, 10% and 28%, respectively.

(E)  
This face amount of loans is 60 or more days delinquent.

The following is a reconciliation of loss allowance.

   
Real Estate Related Loans
 
Residential Mortgage Loans
 
Balance at December 31, 2005
 
$
4,226
 
$
3,207
 
Provision for credit losses
   
291
   
1,716
 
Realized losses
   
(2,930
)
 
(1,514
)
Balance at March 31, 2006
 
$
1,587
 
$
3,409
 
 
10


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2006
(dollars in tables in thousands, except share data)


Newcastle has entered into arrangements with a major investment bank to finance certain loans whereby Newcastle receives the sum of all interest, fees and any positive change in value amounts (the total return cash flows) from a reference asset with a specified notional amount, and pays interest on such notional plus any negative change in value amounts from such asset. These agreements are recorded in Derivative Assets and treated as non-hedge derivatives for accounting purposes and are therefore marked to market through income. Net interest received is recorded to Interest Income and the mark to market is recorded to Other Income. If Newcastle owned the reference assets directly, they would not be marked to market. Under the agreements, Newcastle is required to post an initial margin deposit to an interest bearing account and additional margin may be payable in the event of a decline in value of the reference asset. Any margin on deposit (recorded in Restricted Cash), less any negative change in value amounts, will be returned to Newcastle upon termination of the contract.

The following table presents information on these instruments as of March 31, 2006.

 
Reference Asset
 
Notional
Amount
 
Margin
Amount
 
Receive
Interest Rate
 
Pay
Interest Rate
 
Maturity Date
 
Fair
Value
 
Term loan to a diversified real estate and
   finance company
 
$
90,544
 
$
18,109
   
LIBOR + 3.000%
 
 
LIBOR + 0.625%
 
 
Feb 2008
 
$
1,092
 
Mezzanine loan to a real estate company
   
15,000
   
5,224
   
LIBOR + 4.985%
 
 
LIBOR + 1.350%
 
 
Jun 2007
   
101
 
Term loan to a diversified real estate
   company
   
92,847
   
9,270
   
LIBOR + 1.750%
 
 
LIBOR + 0.500%
 
 
Aug 2007
   
970
 
Term loan to a retail company
   
100,000
   
19,960
   
LIBOR + 3.000%
 
 
LIBOR + 0.500%
 
 
Dec 2008
   
416
 
Term loan and revolver to an appliance
   manufacturer (A)
   
37,168
   
15,517
   
LIBOR + 6.000% (B)
 
 
LIBOR + 1.000%
 
 
Feb 2007
   
(809
)
   
$
335,559
 
$
68,080
                   
$
1,770
 
 
(A) A portion of the yield on this investment was received as an upfront fee, which was recorded as a reduction to its fair value.
(B) The revolver, which represents $1.2 million of the notional amount, receives PRIME + 1.500%.

5. RECENT ACTIVITIES

In January 2006, Newcastle closed on a three year term financing of its manufactured housing loan portfolio which provided for an initial financing amount of approximately $237.1 million. The financing bears interest at LIBOR + 1.25%. The lender received an upfront structuring fee equal to 0.75% of the initial financing amount. Newcastle entered into an interest rate swap in order to hedge its exposure to the risk of changes in market interest rates with respect to this debt. In connection with this term financing, Newcastle renewed its servicing agreement on these loans, with a portfolio company of a private equity fund advised by an affiliate of its manager, at the same terms.

In February 2006, employees of the Manager exercised options to acquire 54,000 shares of Newcastle’s common stock for net proceeds of $1.1 million.

In March 2006, Newcastle, through a consolidated subsidiary, acquired a portfolio of approximately 11,300 residential mortgage loans to subprime borrowers (the “Subprime Portfolio”) for $1.50 billion. The loans are being serviced by Centex Home Equity Company, LLC for a servicing fee equal to 0.50% per annum on the unpaid principal balance of the Subprime Portfolio. At March 31, 2006, these loans were considered “held for sale” and carried at the lower of cost or fair value. A write down of $4.1 million was recorded to Provision for Losses, Loans Held for Sale in March 2006 related to these loans, related to market factors. Furthermore, the acquisition of loans held for sale is considered an operating activity for statement of cash flow purposes. An offsetting cash inflow from the sale of such loans (as described below) will be recorded as an operating cash flow in April 2006. This acquisition was initially funded with an approximately $1.47 billion repurchase agreement which bore interest at LIBOR + 0.50%. Newcastle entered into an interest rate swap in order to hedge its exposure to the risk of changes in market interest rates with respect to the financing of the Subprime Portfolio. This swap does not qualify as a hedge for accounting purposes and is therefore marked to market through income. An unrealized mark to market gain of $5.5 million was recorded to Other Income in connection with this swap in March 2006.

In April 2006, Newcastle, through Newcastle Mortgage Securities Trust 2006-1 (the “Securitization Trust”), closed on a securitization of the Subprime Portfolio. The Securitization Trust is not consolidated by Newcastle. Newcastle sold the Subprime Portfolio and the related interest rate swap to the Securitization Trust. The Securitization Trust issued $1.45 billion of debt (the “Notes”). Newcastle retained $37.6 million face amount of the low investment grade Notes and all of the equity issued by the Securitization Trust. The Notes have a stated maturity of March 25, 2036. Newcastle, as holder of the equity of the Securitization Trust, has the option to redeem the Notes once the aggregate principal balance of the Subprime Portfolio is equal to or less than 20% of such balance at the date of the transfer. The proceeds from the securitization were used to repay the repurchase agreement described above.
 
11

 
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2006
(dollars in tables in thousands, except share data)


The transaction between Newcastle and the Securitization Trust qualified as a sale for accounting purposes, resulting in a net gain of less than $0.1 million being recorded in April 2006. However, 20% of the loans which are subject to future repurchase by Newcastle were not treated as being sold and are classified as “held for investment” subsequent to the completion of the securitization. Following the securitization, Newcastle held the following interests in the Subprime Portfolio, all valued at the date of securitization: (i) the $62.4 million equity of the Securitization Trust, (ii) the $33.7 million of retained bonds ($37.6 million face amount), which have been financed with a $28.0 million repurchase agreement, and (iii) subprime mortgage loans subject to future repurchase of $286.3 million and related financing in the amount of 100% of such loans.

The key assumptions utilized in measuring the $62.4 million fair value of the equity, or residual interest, in the Securitization Trust were as follows:
 
Weighted average life (years)
   
2.5
 
         
Expected credit losses
   
5.3
%
         
Weighted average constant prepayment rate
   
28.0
%
         
Discount rate
   
18.7
%

The weighted average yield of the retained bonds was 11.4% and the weighted average funding cost of the related repurchase agreement was 5.3% as of the date of securitization. The loans subject to future repurchase and the corresponding financing will recognize interest income and expense based on the expected weighted average coupon of the loans subject to future repurchase at the call date.

The residual equity interest and the retained bonds will be reported as real estate securities, available for sale. The retained loans and corresponding financing will be reported as new line items on our balance sheet.

In March 2006, Newcastle foreclosed on $12.2 million of loans formerly in the ICH portfolio. The related real estate is considered held for investment.

In March 2006, Newcastle completed the placement of $100 million of trust preferred securities through its wholly owned subsidiary, Newcastle Trust I (the “Preferred Trust”). Newcastle owns all of the common stock of the Preferred Trust. The Preferred Trust used the proceeds to purchase $100.1 million of Newcastle’s junior subordinated notes. These notes represent all of the Preferred Trust’s assets. The terms of the junior subordinated notes are substantially the same as the terms of the trust preferred securities. The trust preferred securities require quarterly distributions at a fixed rate of 7.574% through April 2016 and at a floating rate of 3-month LIBOR plus 2.25% thereafter. The trust preferred securities mature in April 2036, but may be redeemed at par beginning in April 2011. Under the provisions of FIN 46R, Newcastle determined that the holders of the trust preferred securities were the primary beneficiaries of the Preferred Trust. As a result, Newcastle did not consolidate the Preferred Trust and has reflected the obligation to the Preferred Trust under the caption Junior Subordinated Notes Payable in its consolidated balance sheet and will account for its investment in the common stock of the Preferred Trust, which is reflected in Investments in Unconsolidated Subsidiaries in the consolidated balance sheet, under the equity method of accounting.

In May 2006, Newcastle entered into a new $200.0 million revolving credit facility, secured by substantially all of its unencumbered assets and its equity interests in its subsidiaries. Newcastle paid an upfront fee of 0.25% of the total commitment. The credit facility bears interest at one month LIBOR + 1.75% and matures in November 2007. It does not contain any unused fees. Newcastle simultaneously terminated its prior credit facility and recorded an expense of $0.7 million related to deferred financing costs.

12


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2006
(dollars in tables in thousands, except share data)


6. DERIVATIVE INSTRUMENTS

The following table summarizes the notional amounts and fair (carrying) values of Newcastle's derivative financial instruments, excluding the credit derivative arrangements described in Note 4, as of March 31, 2006.
 
   
Notional Amount
 
Fair Value
 
Longest Maturity
 
Interest rate swaps, treated as hedges (A)
 
$
3,077,308
 
$
91,123
   
November 2018
 
Interest rate caps, treated as hedges (A)
   
342,351
   
2,127
   
October 2015
 
Non-hedge derivative obligations (A) (B)
   
1,573,061
   
5,932
   
July 2038
 
 
(A)  
Included in Derivative Assets or Derivative Liabilities, as applicable. Derivative Liabilities also include accrued interest.
(B)  
Represents two essentially offsetting interest rate caps and two essentially offsetting interest rate swaps, each with notional amounts of $32.5 million, an interest rate cap with a notional amount of $17.5 million, four interest rate swaps with an aggregate notional amount of $24.8 million, and the swap related to the financing of our Subprime Portfolio (Note 5) with a notional of $1,400.8 million.


7. EARNINGS PER SHARE

Newcastle is required to present both basic and diluted earnings per share (“EPS”). Basic EPS is calculated by dividing net income available for common stockholders by the weighted average number of shares of common stock outstanding during each period. Diluted EPS is calculated by dividing net income available for common stockholders by the weighted average number of shares of common stock outstanding plus the additional dilutive effect of common stock equivalents during each period. Newcastle’s common stock equivalents are its outstanding stock options. Net income available for common stockholders is equal to net income less preferred dividends.

The following is a reconciliation of the weighted average number of shares of common stock outstanding on a diluted basis.

   
Three Months Ended March 31,
 
   
2006
 
2005
 
 
         
Weighted average number of shares of common stock outstanding, basic
   
43,944,820
   
43,221,792
 
Dilutive effect of stock options, based on the treasury stock method
   
119,120
   
407,286
 
Weighted average number of shares of common stock outstanding, diluted
   
44,063,940
   
43,629,078
 

As of March 31, 2006, Newcastle’s outstanding options were summarized as follows:

Held by the Manager
 
1,193,439
 
Issued to the Manager and subsequently transferred to certain of the Manager's Employees
 
550,368
 
Held by the directors
 
14,000
 
Total
 
1,757,807
 
 
13


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following should be read in conjunction with the unaudited consolidated financial statements and notes included herein.

GENERAL

Newcastle Investment Corp. is a real estate investment and finance company. We invest in real estate securities, loans and other real estate related assets. In addition, we consider other opportunistic investments which capitalize on our manager’s expertise and which we believe present attractive risk/return profiles and are consistent with our investment guidelines. We seek to deliver stable dividends and attractive risk-adjusted returns to our stockholders through prudent asset selection, active management and the use of match funded financing structures, which reduce our interest rate and financing risks. Our objective is to maximize the difference between the yield on our investments and the cost of financing these investments while hedging our interest rate risk. We emphasize asset quality, diversification, match funded financing and credit risk management.

We currently own a diversified portfolio of moderately credit sensitive real estate debt investments including securities and loans. Our portfolio of real estate securities includes commercial mortgage backed securities (CMBS), senior unsecured debt issued by property REITs, real estate related asset backed securities (ABS), and agency residential mortgage backed securities (RMBS). Mortgage backed securities are interests in or obligations secured by pools of mortgage loans. We generally target investments rated A through BB, except for our agency RMBS which are generally considered AAA rated. We also own, directly and indirectly, interest in loans and pools of loans, including real estate related loans, commercial mortgage loans, residential mortgage loans, manufactured housing loans, and subprime mortgage loans. We also own, directly and indirectly, interests in operating real estate. Our investment in subprime mortgage loans, further described in “Liquidity and Capital Resources” below, was structured as a direct investment in loans held for sale at March 31, 2006. In April 2006, the loans were securitized and our investment was recorded in two parts, retained securities from the securitization (treated as available for sale) and loans held for investment.

We employ leverage in order to achieve our return objectives. We do not have a predetermined target debt to equity ratio as we believe the appropriate leverage for the particular assets we are financing depends on the credit quality of those assets. As of March 31, 2006, our debt to equity ratio was approximately 7.3 to 1. On a pro forma basis, this ratio would be 6.1 to 1 after adjustment for the off-balance sheet securitization of subprime mortgage loans in April 2006. Also, on a pro forma basis, our debt to equity ratio would be 6.5 to 1 if the trust preferred securities we issued were considered equity for purposes of this computation. We maintain access to a broad array of capital resources in an effort to insulate our business from potential fluctuations in the availability of capital. We utilize multiple forms of financing including collateralized bond obligations (CBOs), other securitizations, term loans, and trust preferred securities, as well as short term financing in the form of repurchase agreements and our credit facility.

We seek to match fund our investments with respect to interest rates and maturities in order to minimize the impact of interest rate fluctuations on earnings and reduce the risk of refinancing our liabilities prior to the maturity of the investments. We seek to finance a substantial portion of our real estate securities and loans through the issuance of debt securities in the form of CBOs, which are obligations issued in multiple classes secured by an underlying portfolio of securities. Our CBO financings offer us the structural flexibility to buy and sell certain investments to manage risk and, subject to certain limitations, to optimize returns.

Market Considerations

Our ability to maintain our dividends and grow our business is dependent on our ability to invest our capital on a timely basis at yields which exceed our cost of capital. The primary market factor that bears on this is credit spread.

Generally speaking, tightening credit spreads increase the unrealized gains on our current investments but reduce the yields available on potential new investments, while widening credit spreads reduce the unrealized gains on our current investments (or caused unrealized losses) but increase the yields available on potential new investments.

In the first quarter of 2006, credit spreads again tightened to historical lows, reducing the yield we can earn on certain new investments. This tightening of credit spreads, net of the effect of rising interest rates, also caused the net unrealized gains on our securities and derivatives, recorded in accumulated other comprehensive income, and therefore our book value per share, to increase.

We continue to pursue opportunistic investments within our investment guidelines that offer a more attractive risk adjusted return, including our recent investments in subprime mortgage loans and other real estate related loans which we expect to produce a net, loss adjusted yield in the high teens.
 
14


If credit spreads widen and interest rates continue to increase, we expect that our new investment activities will benefit and our earnings will increase, although our net book value per share may decrease.

Certain aspects of these effects are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Interest Rate, Credit and Spread Risk” as well as in “Quantitative and Qualitative Disclosures About Market Risk.”

Organization

Our initial public offering occurred in October 2002. The following table presents information on shares of our common stock issued since our formation:

Year
 
Shares Issued
 
Range of Issue Prices (1)
 
Net Proceeds (millions)
 
Formation
   
16,488,517
   
N/A
   
N/A
 
2002
   
7,000,000
 
 
13.00
 
$
80.0
 
2003
   
7,886,316
 
 
$20.35-$22.85
 
$
163.4
 
2004
   
8,484,648
 
 
$26.30-$31.40
 
$
224.3
 
2005
   
4,053,928
 
 
$29.60
 
$
108.2
 
Three Months 2006
   
54,000
   
N/A
 
$
1.1
 
March 31, 2006
   
43,967,409
             
 
(1) Excludes prices of shares issued pursuant to the exercise of options and shares issued to Newcastle's independent directors.
 
As of March 31, 2006, approximately 2.9 million shares of our common stock were held by an affiliate of our manager and its principals. In addition, an affiliate of our manager held options to purchase approximately 1.2 million shares of our common stock at March 31, 2006.

We are organized and conduct our operations to qualify as a REIT for U.S. federal income tax purposes. As such, we will generally not be subject to U.S. federal corporate income tax on that portion of our income that is distributed to stockholders if we distribute at least 90% of our REIT taxable income to our stockholders by prescribed dates and comply with various other requirements.

We conduct our business by investing in three primary business segments: (i) real estate securities and real estate related loans, (ii) residential mortgage loans and (iii) operating real estate.

Revenues attributable to each segment are disclosed below (unaudited) (in thousands).

For the Three Months Ended March 31,
 
Real Estate Securities and Real Estate Related Loans
 
Residential
Mortgage
Loans
 
Operating
Real Estate
 
Unallocated
 
Total
 
                       
2006
 
$
95,193
 
$
26,029
 
$
2,184
 
$
142
 
$
123,548
 
2005
 
$
69,546
 
$
12,694
 
$
1,276
 
$
147
 
$
83,663
 
 
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APPLICATION OF CRITICAL ACCOUNTING POLICIES

Management's discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP"). The preparation of financial statements in conformity with GAAP requires the use of estimates and assumptions that could affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses. Actual results could differ from these estimates. The following is a summary of our accounting policies that are most effected by judgments, estimates and assumptions.

Variable Interest Entities

In December 2003, Financial Accounting Standards Board Interpretation (“FIN”) No. 46R “Consolidation of Variable Interest Entities” was issued as a modification of FIN 46. FIN 46R clarified the methodology for determining whether an entity is a variable interest entity (“VIE”) and the methodology for assessing who is the primary beneficiary of a VIE. VIEs are defined as entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. A VIE is required to be consolidated by its primary beneficiary, and only by its primary beneficiary, which is defined as the party who will absorb a majority of the VIE’s expected losses or receive a majority of the expected residual returns as a result of holding variable interests.

To date, we have consolidated our existing CBO transactions (the “CBO Entities”) because we own the entire equity interest in each of them, representing a substantial portion of their capitalization, and we control the management and resolution of their assets. We have determined that certain of the CBO Entities are VIEs and that we are the primary beneficiary of each of these VIEs and will therefore continue to consolidate them. We have also determined that the application of FIN 46R did not result in a change in our accounting for any other entities which were previously consolidated. However, it did cause us to consolidate one entity which was previously not consolidated, ICH CMO, as described below under “− Liquidity and Capital Resources.” Furthermore, as a result of FIN 46R, we are precluded from consolidating our wholly owned subsidiary which has issued trust preferred securities as described in “Liquidity and Capital Resources” below. We will continue to analyze future CBO entities, as well as other investments, pursuant to the requirements of FIN 46R. These analyses require considerable judgment in determining the primary beneficiary of a VIE since they involve subjective probability weighting of subjectively determined possible cash flow scenarios. The result could be the consolidation of an entity acquired or formed in the future that would otherwise not have been consolidated or the non-consolidation of such an entity that would otherwise have been consolidated.

Valuation and Impairment of Securities

We have classified our real estate securities as available for sale. As such, they are carried at fair value with net unrealized gains or losses reported as a component of accumulated other comprehensive income. Fair value is based primarily upon broker quotations, as well as counterparty quotations, which provide valuation estimates based upon reasonable market order indications or a good faith estimate thereof. These quotations are subject to significant variability based on market conditions, such as interest rates and credit spreads. Changes in market conditions, as well as changes in the assumptions or methodology used to determine fair value, could result in a significant increase or decrease in our book equity. We must also assess whether unrealized losses on securities, if any, reflect a decline in value which is other than temporary and, accordingly, write the impaired security down to its value through earnings. For example, a decline in value is deemed to be other than temporary if it is probable that we will be unable to collect all amounts due according to the contractual terms of a security which was not impaired at acquisition, or if we do not have the ability and intent to hold a security in an unrealized loss position until its anticipated recovery (if any). Temporary declines in value generally result from changes in market factors, such as market interest rates and credit spreads, or from certain macroeconomic events, including market disruptions and supply changes, which do not directly impact our ability to collect amounts contractually due. We continually evaluate the credit status of each of our securities and, if necessary, the collateral supporting our securities. This evaluation includes a review of the credit of the issuer of the security (if applicable), the credit rating of the security, the key terms of the security (including credit support), debt service coverage and loan to value ratios, the performance of the pool of underlying loans and the estimated value of the collateral supporting such loans, including the effect of local, industry and broader economic trends and factors. These factors include loan default expectations and loss severities, which are analyzed in connection with a particular security’s credit support, as well as prepayment rates. The result of this evaluation is considered in relation to the amount of the unrealized loss and the period elapsed since it was incurred. Significant judgment is required in this analysis.

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Revenue Recognition on Securities

Income on these securities is recognized using a level yield methodology based upon a number of cash flow assumptions that are subject to uncertainties and contingencies. Such assumptions include the rate and timing of principal and interest receipts (which may be subject to prepayments and defaults). These assumptions are updated on at least a quarterly basis to reflect changes related to a particular security, actual historical data, and market changes. These uncertainties and contingencies are difficult to predict and are subject to future events, and economic and market conditions, which may alter the assumptions. For securities acquired at a discount for credit losses, the net income recognized is based on a “loss adjusted yield” whereby a gross interest yield is recorded to Interest Income, offset by a provision for probable, incurred credit losses which is accrued on a periodic basis to Provision for Credit Losses. The provision is determined based on an evaluation of the credit status of securities, as described in connection with the analysis of impairment above.

Valuation of Derivatives

Similarly, our derivative instruments are carried at fair value pursuant to Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities," as amended. Fair value is based on counterparty quotations. To the extent they qualify as cash flow hedges under SFAS No. 133, net unrealized gains or losses are reported as a component of accumulated other comprehensive income; otherwise, they are reported currently in income. To the extent they qualify as fair value hedges, net unrealized gains or losses on both the derivative and the related portion of the hedged item are reported currently in income. Fair values of such derivatives are subject to significant variability based on many of the same factors as the securities discussed above. The results of such variability could be a significant increase or decrease in our book equity and/or earnings.

Impairment of Loans

We purchase, directly and indirectly, real estate related, commercial mortgage and residential mortgage loans, including manufactured housing loans and subprime mortgage loans, to be held for investment. We periodically evaluate each of these loans or loan pools for possible impairment. Impairment is indicated when it is deemed probable that we will be unable to collect all amounts due according to the contractual terms of the loan, or, for loans acquired at a discount for credit losses, when it is deemed probable that we will be unable to collect as anticipated. Upon determination of impairment, we would establish a specific valuation allowance with a corresponding charge to earnings. We continually evaluate our loans receivable for impairment. Our residential mortgage loans, including manufactured housing loans and subprime mortgage loans, are aggregated into pools for evaluation based on like characteristics, such as loan type and acquisition date. Individual loans are evaluated based on an analysis of the borrower’s performance, the credit rating of the borrower, debt service coverage and loan to value ratios, the estimated value of the underlying collateral, the key terms of the loan, and the effect of local, industry and broader economic trends and factors. Pools of loans are also evaluated based on similar criteria, including trends in defaults and loss severities for the type and seasoning of loans being evaluated. This information is used to estimate specific impairment charges on individual loans as well as provisions for estimated unidentified incurred losses on pools of loans. Significant judgment is required both in determining impairment and in estimating the resulting loss allowance.

Our investment in the subprime mortgage loans at March 31, 2006 was considered held for sale and were therefore recorded at the lower of cost or fair value. Subsequent to the securitization of such loans in April 2006, our remaining direct investment in subprime mortgage loans was considered held for investment as described above.

Revenue Recognition on Loans

Income on these loans is recognized similarly to that on our securities and is subject to similar uncertainties and contingencies, which are also analyzed on at least a quarterly basis. For loan pools acquired at a discount for credit losses, the net income recognized is based on a “loss adjusted yield” whereby a gross interest yield is recorded to Interest Income, offset by a provision for probable, incurred credit losses which is accrued on a periodic basis to Provision for Credit Losses. The provision is determined based on an evaluation of the loans as described under “Impairment of Loans” above. A rollforward of the provision is included in Note 4 to our consolidated financial statements.

Impairment of Operating Real Estate

We own operating real estate held for investment. We review our operating real estate for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Upon determination of impairment, we would record a write-down of the asset, which would be charged to earnings. Significant judgment is required both in determining impairment and in estimating the resulting write-down. To date, we have determined that no write-downs have been necessary on the operating real estate in our portfolio. In addition, when operating real estate is classified as held for sale, it must be recorded at the lower of its carrying amount or fair value less costs of sale. Significant judgment is required in determining the fair value of such properties.
 
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Accounting Treatment for Certain Investments Financed with Repurchase Agreements

We owned $337.3 million of assets purchased from particular counterparties which are financed via $293.8 million of repurchase agreements with the same counterparties at March 31, 2006. Currently, we record such assets and the related financings gross on our balance sheet, and the corresponding interest income and interest expense gross on our income statement. In addition, if the asset is a security, any change in fair value is reported through other comprehensive income (since it is considered “available for sale”).

However, in a transaction where assets are acquired from and financed under a repurchase agreement with the same counterparty, the acquisition may not qualify as a sale from the seller’s perspective; in such cases, the seller may be required to continue to consolidate the assets sold to us, based on their “continuing involvement” with such investments. The result is that we may be precluded from presenting the assets gross on our balance sheet as we currently do, and may instead be required to treat our net investment in such assets as a derivative.

If it is determined that these transactions should be treated as investments in derivatives, the interest rate swaps entered into by us to hedge our interest rate exposure with respect to these transactions would no longer qualify for hedge accounting, but would, as the underlying asset transactions, also be marked to market through the income statement.

This potential change in accounting treatment does not affect the economics of the transactions but does affect how the transactions are reported in our financial statements. Our cash flows, our liquidity and our ability to pay a dividend would be unchanged, and we do not believe our taxable income would be affected. Our net income and net equity would not be materially affected. In addition, this would not affect Newcastle’s status as a REIT or cause it to fail to qualify for its Investment Company Act exemption. This issue has been submitted to accounting standard setters for resolution. If we were to change our current accounting treatment for these transactions, our total assets and total liabilities would each be reduced by approximately $294 million at March 31, 2006.
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RESULTS OF OPERATIONS

The following table summarizes the changes in our results of operations from the three months ended March 31, 2005 to the three months ended March 31, 2006 (dollars in thousands):

   
Three Months Ended March 31, 2006/2005
      
   
Period to Period
Change
 
Period to Period
Percent Change
 
 Explanation
 
Interest income
 
$
34,871
   
44.1
%
 
(1)
 
Rental and escalation income
   
744
   
58.9
%
 
(2)
 
Gain on sale of investments
   
214
   
12.5
%
 
(3)
 
Other income
   
4,056
   
246.0
%
 
(4)
 
Interest expense
   
28,199
   
57.8
%
 
(1)
 
Property operating expense
   
125
   
18.0
%
 
(2)
 
Loan and security servicing expense
   
423
   
26.7
%
 
(1)
 
Provision for credit losses
   
1,295
   
181.9
%
 
(5)
 
Provision for losses, loans held for sale
   
4,127
   
N/A
   
(6)
 
General and administrative expense
   
739
   
82.9
%
 
(7)
 
Management fee to affiliate
   
208
   
6.4
%
 
(8)
 
Incentive compensation to affiliate
   
880
   
44.6
%
 
(8)
 
Depreciation and amortization
   
63
   
46.3
%
 
(9)
 
Equity in earnings of unconsolidated subsidiaries
   
(658
)
 
(35.5
%)
 
(10)
 
Income from continuing operations
 
$
3,168
   
11.5
%
     

(1)
Changes in interest income and expense are primarily related to our acquisition and disposition during the periods of interest bearing assets and related financings, as follows:

   
Three Months Ended March 31, 2006/2005
 
   
Period to Period Increase (Decrease)
 
   
Interest Income
 
Interest Expense
 
Real estate security and loan portfolios (A)
 
$
14,745
 
$
12,424
 
Agency RMBS
   
5,995
   
5,672
 
Subprime mortgage loan portfolio
   
9,588
   
7,093
 
Other real estate related loans
   
7,280
   
2,221
 
Other (B)
   
1,513
   
2,636
 
Other real estate related loans (C)