Table of Contents

 

 

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 September 30, 2008

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  x    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  x    Accelerated filer  ¨    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  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: 52,789,050 shares outstanding as of November 5, 2008.

 

 

 


Table of Contents

NEWCASTLE INVESTMENT CORP.

FORM 10-Q

INDEX

 

         PAGE
PART I.   FINANCIAL INFORMATION   
Item 1.   Financial Statements    1
  Consolidated Balance Sheets as of September 30, 2008 (unaudited) and December 31, 2007    1
  Consolidated Statements of Operations (unaudited) for the three and nine months ended September 30, 2008 and 2007    2
  Consolidated Statements of Stockholders’ Equity (unaudited) for the nine months ended September 30, 2008    3
  Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2008 and 2007    4
  Notes to Consolidated Financial Statements (unaudited)    6
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations    18
Item 3.   Quantitative and Qualitative Disclosures About Market Risk    37
Item 4.   Controls and Procedures    40
PART II.   OTHER INFORMATION   
Item 1.   Legal Proceedings    41
Item 1A.   Risk Factors    41
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds    44
Item 3.   Defaults upon Senior Securities    44
Item 4.   Submission of Matters to a Vote of Security Holders    44
Item 5.   Other Information    44
Item 6.   Exhibits    45
SIGNATURES    46


Table of Contents

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except share data)

 

 

     September 30, 2008
(Unaudited)
    December 31, 2007  

Assets

    

Real estate securities, available for sale

   $ 2,784,744     $ 4,835,884  

Real estate related loans, net

     1,686,707       1,856,978  

Residential mortgage loans, net

     560,111       634,605  

Subprime mortgage loans subject to call option

     396,943       393,899  

Investments in unconsolidated subsidiaries

     442       24,477  

Operating real estate, held for sale

     13,150       34,399  

Cash and cash equivalents

     166,623       55,916  

Restricted cash

     127,686       133,126  

Derivative assets

     245       4,114  

Receivables and other assets

     48,575       64,372  
                
   $ 5,785,226     $ 8,037,770  
                

Liabilities and Stockholders’ Equity

    

Liabilities

    

CBO bonds payable

   $ 4,362,958     $ 4,716,535  

Other bonds payable

     396,134       546,798  

Repurchase agreements

     699,025       1,634,362  

Financing of subprime mortgage loans subject to call option

     396,943       393,899  

Junior subordinated notes payable (security for trust preferred)

     100,100       100,100  

Derivative liabilities

     141,411       133,510  

Dividends payable

     15,447       40,251  

Due to affiliates

     1,532       7,741  

Accrued expenses and other liabilities

     11,777       16,949  
                
     6,125,327       7,590,145  
                

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, 1,600,000 shares of 8.05% Series C Cumulative Redeemable Preferred Stock, and 2,000,000 shares of 8.375% Series D Cumulative Redeemable Preferred Stock, liquidation preference $25.00 per share, issued and outstanding

     152,500       152,500  

Common stock, $0.01 par value, 500,000,000 shares authorized, 52,789,050 and 52,779,179 shares issued and outstanding at September 30, 2008 and December 31, 2007, respectively

  

 

528

 

 

 

528

 

Additional paid-in capital

     1,033,416       1,033,326  

Dividends in excess of earnings

     (557,210 )     (236,213 )

Accumulated other comprehensive income (loss)

     (969,335 )     (502,516 )
                
     (340,101 )     447,625  
                
   $ 5,785,226     $ 8,037,770  
                

See notes to consolidated financial statements

 

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Table of Contents

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(dollars in thousands, except share data)

 

 

     Three Months ended
September 30,
    Nine Months Ended
September 30,
 
     2008     2007     2008     2007  

Revenues

        

Interest income

   $ 113,549     $ 169,766     $ 361,461     $ 523,846  
                                
     113,549       169,766       361,461       523,846  
                                

Expenses

        

Interest expense

     73,651       117,415       236,739       368,064  

Loan and security servicing expense

     1,718       2,091       5,236       7,772  

Provision for credit losses

     2,077       2,820       6,450       7,945  

General and administrative expense

     2,135       1,297       5,619       4,025  

Management fee to affiliate

     4,597       4,597       13,791       13,048  

Incentive compensation to affiliate

     —         —         —         6,209  

Depreciation and amortization

     73       74       218       218  
                                
     84,251       128,294       268,053       407,281  
                                

Operating Income

     29,298       41,472       93,408       116,565  
                                

Other Income (Loss)

        

Gain (loss) on sale of investments, net

     (2,569 )     4,825       3,920       14,014  

Other income (loss), net

     (17,912 )     (7,033 )     (35,793 )     (569 )

Other-than-temporary impairment

     (121,047 )     (67,860 )     (269,216 )     (73,813 )

Loan impairment

     (39,831 )     —         (76,916 )     —    

Provision for losses, loans held for sale

     —         —         —         (5,754 )

Gain (loss) on extinguishment of debt

     5,315       (7,752 )     13,848       (15,032 )

Equity in earnings of unconsolidated subsidiaries

     419       488       8,189       2,154  
                                
     (175,625 )     (77,332 )     (355,968 )     (79,000 )
                                

Income (loss) from continuing operations

     (146,327 )     (35,860 )     (262,560 )     37,565  

Income (loss) from discontinued operations

     227       (37 )     (8,724 )     (158 )
                                

Net Income (Loss)

     (146,100 )     (35,897 )     (271,284 )     37,407  

Preferred dividends

     (3,375 )     (3,375 )     (10,126 )     (9,265 )
                                

Income (Loss) Applicable to Common Stockholders

   $ (149,475 )   $ (39,272 )   $ (281,410 )   $ 28,142  
                                

Income (Loss) Per Share of Common Stock

        

Basic

   $ (2.83 )   $ (0.74 )   $ (5.33 )   $ 0.55  
                                

Diluted

   $ (2.83 )   $ (0.74 )   $ (5.33 )   $ 0.55  
                                

Income (loss) from continuing operations per share of common stock, after preferred dividends

        

Basic

   $ (2.84 )   $ (0.74 )   $ (5.17 )   $ 0.55  
                                

Diluted

   $ (2.84 )   $ (0.74 )   $ (5.17 )   $ 0.55  
                                

Income (loss) from discontinued operations per share of common stock

        

Basic

   $ 0.01     $ (0.00 )   $ (0.16 )   $ (0.00 )
                                

Diluted

   $ 0.01     $ (0.00 )   $ (0.16 )   $ (0.00 )
                                

Weighted Average Number of Shares of Common Stock Outstanding

        

Basic

     52,788,766       52,779,179       52,784,048       50,894,424  
                                

Diluted

     52,788,766       52,779,179       52,784,048       51,045,418  
                                

Dividends Declared per Share of Common Stock

   $ 0.25     $ 0.72     $ 0.75     $ 2.13  
                                

See notes to consolidated financial statements

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Unaudited)

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2008

(dollars in thousands)

 

 

    Preferred Stock   Common Stock   Additional
Paid-in
Capital
  Dividends
in Excess of
Earnings
    Accum. Other
Comp. Income
(Loss)
    Total
Stockholders’
Equity
 
    Shares   Amount   Shares   Amount        

Stockholders’ equity - December 31, 2007

  6,100,000   $ 152,500   52,779,179   $ 528   $ 1,033,326   $ (236,213 )   $ (502,516 )   $ 447,625  

Dividends declared

  —       —     —       —       —       (49,713 )     —         (49,713 )

Issuance of common stock to directors

  —       —     9,871     —       90     —         —         90  

Comprehensive income:

               

Net (loss)

  —       —     —       —       —       (271,284 )     —         (271,284 )

Net unrealized (loss) on securities

  —       —     —       —       —       —         (448,925 )     (448,925 )

Reclassification of net realized (gain) on securities into earnings

  —       —     —       —       —       —         (7,138 )     (7,138 )

Foreign currency translation

  —       —     —       —       —       —         (5,037 )     (5,037 )

Net unrealized (loss) on derivatives designated as cash flow hedges

  —       —     —       —       —       —         (4,472 )     (4,472 )

Reclassification of net realized (gain) on derivatives designated as cash flow hedges into earnings

  —       —     —       —       —       —         (1,247 )     (1,247 )
                     

Total comprehensive income (loss)

                  (738,103 )
                                                 

Stockholders’ equity - September 30, 2008

  6,100,000   $ 152,500   52,789,050   $ 528   $ 1,033,416   $ (557,210 )   $ (969,335 )   $ (340,101 )
                                                 

See notes to consolidated financial statements

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(dollars in thousands)

 

 

     Nine Months Ended September 30,  
     2008     2007  

Cash Flows From Operating Activities

    

Net income (loss)

   $ (271,284 )   $ 37,407  

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities (inclusive of amounts related to discontinued operations):

    

Depreciation and amortization

     565       1,028  

Accretion of discount and other amortization

     (27,543 )     (18,751 )

Deferred rent

     183       234  

Provision for credit losses

     6,450       7,945  

Provision for losses, loans held for sale

     —         5,754  

Non-cash directors' compensation

     90       60  

(Gain) on sale of investments

     (4,345 )     (14,155 )

Unrealized (gain) loss on non-hedge derivatives and hedge ineffectiveness

     39,456       829  

Other-than-temporary impairment

     278,267       73,813  

Loan impairment

     76,916       969,747  

(Gain) loss on extinguishment of debt

     (13,848 )     10,278  

Equity in earnings of unconsolidated subsidiaries

     (8,189 )     (2,154 )

Distributions of earnings from unconsolidated subsidiaries

     8,189       2,154  

Purchase of loans held for sale

     —         (1,089,202 )

Change in:

    

Restricted cash

     2,374       (8,268 )

Receivables and other assets

     16,275       (13,138 )

Due to affiliates

     (6,209 )     (5,724 )

Accrued expenses and other liabilities

     (5,172 )     (5,030 )
                

Net cash provided by (used in) operating activities

     92,175       (47,173 )
                

Cash Flows From Investing Activities

    

Purchase of real estate securities

     (67,733 )     (416,408 )

Proceeds from sale of real estate securities

     1,151,012       237,892  

Proceeds from settlement of loans

     12,636       —    

Purchase of and advances on loans

     —         (896,500 )

Repayments of loan and security principal

     276,134       925,431  

Margin received on derivative instruments

     72,535       73,978  

Return of margin on derivative instruments

     (68,969 )     (90,097 )

Margin deposits on total rate of return swaps (treated as derivative instruments)

     (27,389 )     (60,085 )

Return of margin deposits on total rate of return swaps (treated as derivative instruments)

     36,256       67,632  

Net proceeds from termination of derivative instruments

     (37,591 )     26,801  

Purchase and improvement of real estate held for sale

     (603 )     (1,537 )

Contributions to unconsolidated subsidiaries

     —         (12,191 )

Proceeds from sale of real estate held for sale

     11,226       —    

Distributions of capital from unconsolidated subsidiaries

     24,035       962  

Change in restricted cash from investment in new CBOs

     (2,397 )     (2,516 )
                

Net cash provided by (used in) in investing activities

     1,379,152       (146,638 )
                

Continued on Page 5

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(dollars in thousands)

 

 

     Nine Months Ended September 30,  
     2008     2007  

Cash Flows From Financing Activities

    

Repayments of CBO bonds payable

     (331,228 )     (1,430,506 )

Issuance of other bonds payable

     —         1,835,071  

Repayments of other bonds payable

     (151,735 )     (88,067 )

Repayments of notes payable

     —         (43,633 )

Borrowings under repurchase agreements

     85,748       4,785,636  

Repayments of repurchase agreements

     (1,021,585 )     (3,962,140 )

Return of margin deposits under repurchase agreements

     91,032       —    

Margin deposits under repurchase agreement

     (86,864 )     —    

Issuance of repurchase agreements subject to ABCP facility

     —         247,409  

Repayments of repurchase agreements subject to ABCP facility

     —         (1,292,503 )

Draws under credit facility

     —         382,800  

Repayments of credit facility

     —         (476,600 )

Issuance of common stock

     —         200,165  

Costs related to issuance of common stock

     —         (358 )

Exercise of common stock options

     —         1,443  

Issuance of preferred stock

     —         50,000  

Costs related to issuance of preferred stock

     —         (1,770 )

Dividends paid

     (74,517 )     (111,376 )

Payment of deferred financing costs

     (337 )     (2,244 )

Restricted cash returned from refinancing activities

     128,866       135,885  
                

Net cash provided by (used in) financing activities

     (1,360,620 )     229,212  
                

Net Increase (Decrease) in Cash and Cash Equivalents

     110,707       35,401  

Cash and Cash Equivalents, Beginning of Period

     55,916       5,371  
                

Cash and Cash Equivalents, End of Period

   $ 166,623     $ 40,772  
                

Supplemental Disclosure of Cash Flow Information

    

Cash paid during the period for interest expense

   $ 209,991     $ 345,777  

Cash paid during the period for income taxes

   $ —       $ —    

Cash paid during the year for federal excise tax

   $ 316     $ —    

Supplemental Schedule of Non-Cash Investing and Financing Activities

    

Common stock dividends declared but not paid

   $ 13,197     $ 38,001  

Preferred stock dividends declared but not paid

   $ 2,250     $ 2,250  

Acquisition and financing of loans subject to call option

   $ —       $ 102,457  

 

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Table of Contents

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2008

(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 four primary segments: (i) investments financed with non-recourse collateralized bond obligations (“CBOs”), (ii) investments financed with other non-recourse debt, (iii) investments financed with recourse debt, including FNMA / FHLMC securities, and (iv) unlevered investments.

In the second quarter of 2008, Newcastle changed the structure of its internal organization such that the basis of the composition of its reportable segments changed from investment type to financing type. Management believes this presentation better reflects the benefits and risks of the company’s structure.

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"), an affiliate of Fortress Investment Group LLC, 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 5.0 million shares of Newcastle’s common stock were held by the Manager, through its affiliates, and its principals at September 30, 2008. In addition, the Manager, through its affiliates, held options to purchase approximately 1.6 million shares of Newcastle’s common stock at September 30, 2008.

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, 2007 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, 2007.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2008

(dollars in tables in thousands, except share data)

 

 

2. INFORMATION REGARDING BUSINESS SEGMENTS

Newcastle conducts its business through four primary segments: (i) investments financed with non-recourse collateralized bond obligations (“CBOs”), (ii) investments financed with other non-recourse debt, (iii) investments financed with recourse debt, including FNMA / FHLMC securities, and (iv) unlevered investments. In the second quarter of 2008, Newcastle changed the structure of its internal organization such that the basis of the composition of its reportable segments changed from investment type to financing type. Management believes this presentation better reflects the benefits and risks of the company’s structure.

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

 

     CBOs     Other
Non-Recourse (A)
    Recourse     Unlevered     Unallocated     Total  
Nine Months Ended September 30, 2008             

Gross revenues

   $ 232,652     $ 67,700     $ 39,417     $ 19,861     $ 1,831     $ 361,461  

Operating expenses

     (1,191 )     (9,999 )     (33 )     (602 )     (19,271 )     (31,096 )

Interest expense

     (151,917 )     (50,775 )     (27,733 )     (675 )     (5,639 )     (236,739 )

Depreciation and amortization

     —         —         —         —         (218 )     (218 )
                                                

Operating income (loss)

     79,544       6,926       11,651       18,584       (23,297 )     93,408  

Other-than-temporary and loan impairment

     (268,151 )     (1,222 )     (11,379 )     (65,380 )     —         (346,132 )

Other income (loss) excluding impairment

     5,798       (2,062 )     (22,966 )     9,979       (585 )     (9,836 )
                                                

Income (loss) from continuing operations

     (182,809 )     3,642       (22,694 )     (36,817 )     (23,882 )     (262,560 )

Income (loss) from discontinued operations

     —         —         —         (8,724 )     —         (8,724 )
                                                

Net income (loss)

     (182,809 )     3,642       (22,694 )     (45,541 )     (23,882 )     (271,284 )

Preferred dividends

     —         —         —         —         (10,126 )     (10,126 )
                                                

Income (loss) applicable to common stockholders

   $ (182,809 )   $ 3,642     $ (22,694 )   $ (45,541 )   $ (34,008 )   $ (281,410 )
                                                
Three Months Ended September 30, 2008             

Gross revenues

   $ 75,052     $ 21,443     $ 11,460     $ 4,895     $ 699     $ 113,549  

Operating expenses

     (371 )     (2,958 )     (8 )     (563 )     (6,627 )     (10,527 )

Interest expense

     (47,332 )     (16,339 )     (7,727 )     (373 )     (1,880 )     (73,651 )

Depreciation and amortization

     —         —         —         —         (73 )     (73 )
                                                

Operating income (loss)

     27,349       2,146       3,725       3,959       (7,881 )     29,298  

Other-than-temporary and loan impairment

     (122,729 )     —         (8,947 )     (29,202 )     —         (160,878 )

Other income (loss) excluding impairment

     2,761       (1,514 )     (17,532 )     1,536       2       (14,747 )
                                                

Income (loss) from continuing operations

     (92,619 )     632       (22,754 )     (23,707 )     (7,879 )     (146,327 )

Income (loss) from discontinued operations

     —         —         —         227       —         227  
                                                

Net income (loss)

     (92,619 )     632       (22,754 )     (23,480 )     (7,879 )     (146,100 )

Preferred dividends

     —         —         —         —         (3,375 )     (3,375 )
                                                

Income (loss) applicable to common stockholders

   $ (92,619 )   $ 632     $ (22,754 )   $ (23,480 )   $ (11,254 )   $ (149,475 )
                                                
September 30, 2008             

GAAP

            

Assets, carrying value

   $ 3,728,264     $ 872,979     $ 848,617     $ 165,752     $ 169,614     $ 5,785,226  

Liabilities, carrying value (B)

     4,462,657       815,004       725,056       753       121,857       6,125,327  

Preferred stock

             152,500       152,500  
                                                

GAAP book value

   $ (734,393 )   $ 57,975     $ 123,561     $ 164,999     $ (104,743 )   $ (492,601 )
                                                

GAAP book value per share

             $ (9.33 )

Fair Value

            

Assets, fair value (C)

   $ 3,452,473     $ 810,604     $ 780,698     $ 149,151     $ 169,614     $ 5,362,540  

Liabilities, fair value

     2,474,156       784,963       725,056       753       68,400       4,053,328  

Preferred stock

             152,500       152,500  
                                                

Adjusted book value

   $ 978,317     $ 25,641     $ 55,642     $ 148,398     $ (51,286 )   $ 1,156,712  
                                                

Adjusted book value per share (D)

             $ 21.91  

 

(A) Includes all of the manufactured housing loan financing (Note 5) of which $53.2 million (carrying value) is recourse.

 

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Table of Contents

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2008

(dollars in tables in thousands, except share data)

 

 

(B) Carrying values of recourse and nonrecourse debt at September 30, 2008 are as follows:

 

     CBOs    Other
Non-Recourse
   Recourse    Unlevered    Unallocated    Total

Nonrecourse

   $ 4,362,958    $ 739,949    $ —      $ —      $ —      $ 5,102,907

Recourse

   $ —      $ 53,128    $ 699,025    $ —      $ 100,100    $ 852,253

 

(C) Only financial instruments are reflected at fair value, other assets are reflected at their carrying value.
(D) Represents GAAP book value as if Newcastle had elected to measure all of its financial assets and liabilities at fair value under SFAS 159.

 

     CBOs     Other
Non-Recourse (A)
    Recourse     Unlevered     Unallocated     Total  

Nine Months Ended September 30, 2007

            

Gross revenues

   $ 287,441     $ 79,213     $ 129,669     $ 26,240     $ 1,283     $ 523,846  

Operating expenses

     (1,424 )     (12,447 )     (1,861 )     (19 )     (23,248 )     (38,999 )

Interest expense

     (211,907 )     (59,003 )     (87,981 )     (1,024 )     (8,149 )     (368,064 )

Depreciation and amortization

     —         —         —         —         (218 )     (218 )
                                                

Operating income (loss)

     74,110       7,763       39,827       25,197       (30,332 )     116,565  

Other-than-temporary and loan impairment

     —         —         —         —         —         —    

Other income (loss) excluding impairment

     (44,458 )     267       (37,354 )     2,540       5       (79,000 )
                                                

Income (loss) from continuing operations

     29,652       8,030       2,473       27,737       (30,327 )     37,565  

Income (loss) from discontinued operations

     —         —         —         (158 )     —         (158 )
                                                

Net income (loss)

     29,652       8,030       2,473       27,579       (30,327 )     37,407  

Preferred dividends

     —         —         —         —         (9,265 )     (9,265 )
                                                

Income (loss) applicable to common stockholders

   $ 29,652     $ 8,030     $ 2,473     $ 27,579     $ (39,592 )   $ 28,142  
                                                

Three Months Ended September 30, 2007

            

Gross revenues

   $ 96,760     $ 27,302     $ 35,440     $ 9,282     $ 982     $ 169,766  

Operating expenses

     (445 )     (4,248 )     (217 )     (14 )     (5,881 )     (10,805 )

Interest expense

     (70,865 )     (20,567 )     (23,699 )     (209 )     (2,075 )     (117,415 )

Depreciation and amortization

     —         —         —         —         (74 )     (74 )
                                                

Operating income (loss)

     25,450       2,487       11,524       9,059       (7,048 )     41,472  

Other-than-temporary and loan impairment

     —         —         —         —         —         —    

Other income (loss) excluding impairment

     (41,564 )     (255 )     (36,110 )     596       1       (77,332 )
                                                

Income (loss) from continuing operations

     (16,114 )     2,232       (24,586 )     9,655       (7,047 )     (35,860 )

Income (loss) from discontinued operations

     —         —         —         (37 )     —         (37 )
                                                

Net income (loss)

     (16,114 )     2,232       (24,586 )     9,618       (7,047 )     (35,897 )

Preferred dividends

     —         —         —         —         (3,375 )     (3,375 )
                                                

Income (loss) applicable to common stockholders

   $ (16,114 )   $ 2,232     $ (24,586 )   $ 9,618     $ (10,422 )   $ (39,272 )
                                                

 

(A) Includes all of the manufactured housing loan financing (Note 5) of which $102.2 million (carrying value) is recourse as of September 30, 2007.

In July 2008, Newcastle sold its long-lived assets in Canada which had a carrying value of $21.4 million at December 31, 2007. In connection with such assets, Newcastle recognized revenue of $1.9 million and $2.2 million for the nine months ended September 30, 2008 and 2007, respectively.

Newcastle has committed to a plan, and is actively working, to sell all of its operating real estate. As a result, all of the real estate has been classified as held for sale at September 30, 2008 and marked to the lower of cost or market, resulting in a recorded loss of $9.1 million for the nine months ended September 30, 2008. All of the related operations, including this loss, have been classified as discontinued operations for all periods presented. In July 2008, Newcastle closed on the sales of two real estate properties and received net proceeds of approximately $11.5 million.

 

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Table of Contents

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2008

(dollars in tables in thousands, except share data)

 

 

Unconsolidated Subsidiaries

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

 

     Operating Real Estate     Real Estate Loan  

Balance at December 31, 2007

   $ 13,391     $ 10,984  

Contributions to unconsolidated subsidiaries

     —         —    

Distributions from unconsolidated subsidiaries

     (20,307 )     (11,910 )

Equity in earnings of unconsolidated subsidiaries

     6,916       1,267  
                

Balance at September 30, 2008

   $ —       $ 341  
                

In April 2008, Newcastle closed on the sale of our interests in the operating real estate joint venture and received net proceeds of $19.8 million. As a result, Newcastle recorded a gain of approximately $6.2 million.

Gain (Loss) on Sale of Investments, Net and Other Income (Loss), Net

These items are comprised of the following:

 

     Nine Months Ended September 30,  
     2008     2007  

Gain (loss) on sale of investments, net

    

Gain on sale of real estate securities

   $ 6,459     $ 20,545  

Loss on sale of real estate securities

     (2,245 )     (6,390 )

Gain on disposition of loans held for sale

     1,434       —    

Loss on disposition of loans held for sale

     (1,303 )     —    

Realized gain (loss) on termination of derivative instruments

     (425 )     (201 )

Other gain (loss)

     —         60  
                
   $ 3,920     $ 14,014  
                

Other income (loss), net

    

Realized (loss) on total rate of return swaps

   $ (7,145 )   $ —    

Unrealized (loss) on total rate of return swaps

     (13,210 )     (5,644 )

Gain (loss) on non-hedge derivative instruments

     (17,906 )     5,976  

Unrealized (loss) recognized at de-designation of hedges

     (990 )     —    

Hedge ineffectiveness

     218       (1,238 )

Other income

     3,240       337  
                
   $ (35,793 )   $ (569 )
                

 

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Table of Contents

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2008

(dollars in tables in thousands, except share data)

 

 

3. REAL ESTATE SECURITIES

The following is a summary of Newcastle’s real estate securities at September 30, 2008, 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

Asset Type

   Outstanding
Face Amount
   Before
Impairment
   Other-Than-
Temporary
Impairment (A)
    After
Impairment
   Gross Unrealized     Carrying Value    Number
of
Securities
   Rating (E)    Coupon     Yield     Maturity
(Years)
              Gains    Losses                 

CMBS-Conduit

   $ 1,400,087    $ 1,337,273    $ (22,128 )   $ 1,315,145    $ —      $ (537,605 )   $ 777,540    175    BBB    5.79 %   6.54 %   6.5

CMBS- Single Borrower

     761,329      747,298      —         747,298      46      (129,109 )     618,235    70    BB+    5.79 %   6.74 %   3.6

CMBS-Large Loan

     90,881      90,873      —         90,873      —        (19,022 )     71,851    13    BB+    3.78 %   5.70 %   1.7

CMBS- CDO

     16,000      14,730      (14,730 )     —        —        —         —      1    CC      10.14 %   0.00 %   —  

REIT Debt

     652,516      662,395      —         662,395      105      (118,454 )     544,046    65    BBB-    6.24 %   5.78 %   4.9

ABS-Subprime

     564,054      532,485      (275,400 )     257,085      2,069      (42,123 )     217,031    121    BB-    4.74 %   11.72 %   4.6

ABS-Manufactured Housing

     61,395      59,741      (4,454 )     55,287      —        (6,375 )     48,912    9    BBB-    6.68 %   7.41 %   4.6

ABS-Franchise

     39,857      39,997      (615 )     39,382      —        (17,028 )     22,354    17    BBB      6.17 %   6.72 %   4.6

FNMA/FHLMC (B)

     466,249      469,571      —         469,571      3,679      (470 )     472,780    17    AAA      5.51 %   5.52 %   3.8
                                                                             

Subtotal/Average (C)

     4,052,368      3,954,363      (317,327 )     3,637,036      5,899      (870,186 )     2,772,749    488    BBB      5.67 %   6.67 %   4.9
                                                                             

Retained Securities (D)

     80,380      74,230      (65,046 )     9,184      239      —         9,423    7    CCC+    5.18 %   17.98 %   2.4

Residual Interests (D)

     2,572      59,036      (56,464 )     2,572      —        —         2,572    2    NR      0.00 %   30.00 %   0.6
                                                                             

Total/Average

   $ 4,135,320    $ 4,087,629    $ (438,837 )   $ 3,648,792    $ 6,138    $ (870,186 )   $ 2,784,744    497    BBB    5.66 %   6.72 %   4.9
                                                                             

 

(A) Represents the cumulative impairment against amortized cost basis recorded through earnings.
(B) FNMA/FHLMC securities have an implied AAA rating. Amortized cost basis and carrying value include principal receivable of $2.9 million.
(C) The total outstanding face amount of fixed rate securities was $3.0 billion, and of floating rate securities was $1.1 billion.
(D) Represents the retained bonds and equity from Subprime Portfolios I and II. The residuals do not have stated coupons and therefore their coupons have been treated as zero for purposes of the table.

Unrealized losses that are considered other-than-temporary are recognized currently in income. During the nine months ended September 30, 2008, Newcastle recorded other-than-temporary impairment charges of $269.2 million, relating to securities with an aggregate post impairment amortized cost basis of $176.2 million at September 30, 2008. Based on management’s analysis on these securities, the performance of the underlying loans and changes in market factors, Newcastle noted adverse changes in the expected cash flows on each of these securities and concluded that they were other-than-temporarily impaired. The remaining unrealized losses on Newcastle’s securities are primarily the result of changes in market factors, rather than issuer-specific credit impairment. Newcastle has performed analyses in relation to such securities using management’s best estimate of the cash flows that a market participant would use in determining fair value, which support its belief that the carrying values of such securities are fully recoverable over their expected holding period. Such market factors include changes in market interest rates and credit spreads, or certain macroeconomic events, including market disruptions and supply changes, which do not directly impact our ability to collect amounts contractually due. Management continually evaluates the credit status of each of Newcastle’s securities and the collateral supporting those 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 when determining management’s estimate of cash flows and in relation to the amount of the unrealized loss and the period elapsed since it was incurred. Significant judgment is required in this analysis.

 

          Amortized Cost Basis    Gross Unrealized               Weighted Average

Securities in an Unrealized Loss Position

   Outstanding
Face Amount
   Before
Impairment
   Other-Than-
Temporary
Impairment
   After
Impairment
   Gains    Losses     Carrying Value    Number of
Securities
   Rating (E)    Coupon     Yield     Maturity
(Years)

Less Than Twelve Months

   $ 407,056    $ 370,406    $ —      $ 370,406    $ —      $ (26,677 )   $ 343,728    44    A-    6.02 %   8.03 %   4.5

Twelve or More Months

     2,722,360      2,672,526      —        2,672,526      —        (843,509 )     1,829,017    318    BBB-    5.68 %   6.17 %   5.2
                                                                            

Total

   $ 3,129,416    $ 3,042,932    $ —      $ 3,042,932    $ —      $ (870,186 )   $ 2,172,745    362    BBB    5.73 %   6.40 %   5.1
                                                                            

 

(E) Represents weighted average of the ratings of all securities in each asset type, expressed as S&P equivalent rating. For each security rated by multiple rating agencies, the lowest rating is used.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2008

(dollars in tables in thousands, except share data)

 

 

The table below summarizes the geographic distribution of the collateral securing our CMBS at September 30, 2008 (in thousands):

 

Geographic Location

   Outstanding Face Amount    Percentage  

Northeastern U.S.

   $ 564,056    24.9 %

Western U.S.

     522,797    23.0 %

Southeastern U.S.

     449,303    19.8 %

Midwestern U.S.

     294,385    13.0 %

Southwestern U.S.

     235,660    10.4 %

Other

     176,199    7.8 %

Foreign

     25,897    1.1 %
             
   $ 2,268,297    100.0 %
             

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 September 30, 2008. 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
   Loan
Count
   Wtd. Avg.
Yield
    Weighted
Average
Maturity
(Years) (A)
   Floating Rate
Loans as a %
of Face
Amount
    Delinquent Face
Amount (B)
 

Mezzanine Loans

   $ 746,644    $ 743,164    22    7.45 %   3.3    86.8 %   $ —    

Corporate Bank Loans

     524,628      486,517    15    8.29 %   3.3    100.0 %     31,462  

B-Notes

     388,168      365,669    14    6.57 %   3.0    84.9 %     (C )

Whole Loans

     86,224      86,132    3    5.95 %   2.5    100.0 %     —    

ICH Loans

     5,293      5,225    3    7.48 %   3.3    0.0 %     —    
                                            

Total Real Estate Related Loans

   $ 1,750,957    $ 1,686,707    57    7.44 %   3.2    90.7 %   $ 31,462  
                                            

Residential Loans

   $ 86,037    $ 86,369    284    4.94 %   4.3    0.0 %   $ 7,990  

Manufactured Housing Loans

     485,598      473,742    14,194    8.49 %   5.9    0.0 %     4,607  
                                            

Total Residential Mortgage Loans (D)

   $ 571,635    $ 560,111    14,478    7.93 %   5.7    0.0 %   $ 12,597  
                                            

Subprime Mortgage Loans Subject to

                  

Call Option

   $ 406,217    $ 396,943             
                          

 

(A) The weighted average maturities were calculated based on constant prepayment rates (CPR) of 15% and 30% for the residential loan pools, and 8% and 9% for the manufactured housing loan pools.
(B) This face amount of loans is 60 or more days past due, in foreclosure, under bankruptcy filing or real estate owned. This amount includes a non-accrual loan with a face amount of $8.7 million at September 30, 2008.
(C) A loan with a face amount of $50.0 million had a maturity default in October 2008. The loan was placed on non-accrual status as of September 30, 2008. No provision for loan loss was recorded during the quarter ended September 30, 2008 as the estimated fair value of the collateral exceeded the carrying value of the loan.
(D) Carrying value includes interest receivable of $0.4 million for the residential housing loans and principal and interest receivable of $12.1 million for the manufactured housing loans.

The following is a reconciliation of the related loss allowance.

 

     Real Estate
Related Loans
    Residential
Mortgage Loans
 

Balance at December 31, 2007

   $ (600 )   $ (6,917 )

Provision for credit losses

     (200 )     (6,250 )

Provision for impaired loans

     (75,694 )     (1,222 )

Realized losses

     31,503       4,917  
                

Balance at September 30, 2008

   $ (44,991 )   $ (9,472 )
                

As of September 30, 2008, Newcastle held an aggregate of $94.1 million notional amount of total rate of return swaps on 3 reference assets on which it had deposited $35.0 million of margin. These total rate of return swaps had an aggregate fair value of approximately ($15.0) million, a weighted average receive interest rate of LIBOR + 2.98%, a weighted average pay interest rate of LIBOR + 1.03%, and a weighted average swap maturity of 0.4 years.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2008

(dollars in tables in thousands, except share data)

 

 

The following table presents information on the retained interests in Newcastle’s securitizations of subprime mortgage loans and the sensitivity of their fair value to maturity date for immediate 10% and 20% adverse changes in the assumptions utilized in calculating such fair value, at September 30, 2008:

 

     Subprime Portfolio  
     I     II  

Total securitized loans (unpaid principal balance)

   $ 756,072     $ 951,107  

Average loan seasoning (months)

     37       20  

Loans subject to call option (carrying value)

   $ 293,921     $ 103,022  

Retained interests (fair value) (A)

   $ 5,549     $ 6,446  

Weighted average life (years) of residual interest

     0.1       0.6  

Weighted average expected credit losses (B)

     17.5 %     30.7 %

Effect on fair value of retained interests of 10% adverse change

   $ (547 )   $ (664 )

Effect on fair value of retained interests of 20% adverse change

   $ (978 )   $ (1,162 )

Weighted average constant prepayment rate (C)

     13.8 %     9.2 %

Effect on fair value of retained interests of 10% adverse change

   $ (109 )   $ (332 )

Effect on fair value of retained interests of 20% adverse change

   $ (236 )   $ (648 )

Weighted average discount rate

     14.9 %     18.7 %

Effect on fair value of retained interests of 10% adverse change

   $ (230 )   $ (106 )

Effect on fair value of retained interests of 20% adverse change

   $ (437 )   $ (208 )

 

(A) The retained interests include residual interests and retained bonds of the securitizations. Their fair value is estimated based on pricing models.
(B) Represents the percentage of losses on the original principal balance of the loans at the time of the respective securitizations (April 2006 and July 2007) to the maturity of the loans.
(C) Represents the weighted average voluntary prepayment rate for the loans from the time of the respective securitizations (April 2006 and July 2007) to the maturity of such loans.

The sensitivity analysis is hypothetical and should be used with caution. In particular, the results are calculated by stressing a particular economic assumption independent of changes in any other assumption; in practice, changes in one factor may result in changes in another, which might counteract or amplify the sensitivities. Also, changes in the fair value based on a 10% or 20% variation in an assumption generally may not be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear.

The following table summarizes certain characteristics of the underlying subprime mortgage loans in the securitizations as of September 30, 2008:

 

     Subprime Portfolio  
     I     II  

Loan unpaid principal balance (UPB)

   $ 756,072     $ 951,107  

Delinquencies of 60 or more days (UPB)

   $ 154,623     $ 169,721  

Net credit losses for the nine months ended September 30, 2008

   $ 28,360     $ 10,285  

Cumulative net credit losses

   $ 31,930     $ 10,285  

Cumulative net credit losses as a % of original UPB

     2.13 %     0.95 %

Percentage of ARM loans (A)

     59.0 %     69.0 %

Percentage of loans with loan-to-value ratio >90%

     10.5 %     17.5 %

Percentage of interest-only loans

     27.6 %     4.4 %

 

(A) 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 an option ARM.

Delinquencies include loans 60 or more days past due, in foreclosure or real estate owned. Newcastle received net cash inflows of $5.5 million and $12.0 million from the retained interests of Subprime Portfolios I and II, respectively, during the nine months ended September 30, 2008.

The weighted average yields of the retained notes of Subprime Portfolios I and II were 20.3% and 15.0%, respectively, as of September 30, 2008. 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 Portfolios I and II, respectively.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2008

(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 September 30, 2008:

 

Debt Obligation/Collateral

  Month
Issued
    Outstanding
Face
Amount
  Carrying
Value
  Unhedged
Weighted
Average

Funding Cost (A)
  Final Stated
Maturity
  Weighted
Average
Funding
Cost (B)
  Weighted
Average
Maturity
(Years)
  Face
Amount

of Floating
Rate

Debt
  Collateral
Amortized
Cost Basis (C)
  Collateral
Carrying
Value (D)
  Collateral
Weighted
Average
Maturity
(Years)
  Face
Amount
of
Floating Rate
Collateral (C)
  Aggregate
Notional
Amount of
Current
Hedges

CBO Bonds Payable

                         

Portfolio V

  Mar 2004     $ 410,085   $ 408,029   4.60%   Mar 2039   4.65%   3.8   $ 381,750   $ 438,277   $ 334,914   4.3   $ 189,182   $ 177,300

Portfolio VI

  Sep 2004       454,500     452,045   4.64%   Sep 2039   4.82%   4.4     442,500     479,886     352,945   4.7     224,911     208,773

Portfolio VII

  Apr 2005       447,000     443,796   4.41%   Apr 2040   4.91%   5.4     439,600     445,014     310,331   5.7     187,125     242,333

Portfolio VIII

  Dec 2005       421,800     418,732   4.42%   Dec 2050   5.28%   6.7     415,800     424,993     277,677   6.7     111,828     341,506

Portfolio IX

  Nov 2006       807,500     806,565   4.58%   Nov 2052   4.80%   5.3     799,900     774,165     699,792   4.0     592,280     161,655

Portfolio X

  May 2007       585,750     586,732   4.52%   May 2052   4.65%   5.0     585,750     760,758     748,841   3.4     599,489     91,968

Portfolio XI

  Jul 2007       1,247,750     1,247,059   4.06%   Jul 2052   5.22%   6.4     1,247,750     1,216,188     947,545   4.9     310,642     968,912
                                                           
      4,374,385     4,362,958       4.95%   5.5     4,313,050     4,539,281     3,672,045   4.7     2,215,457     2,192,447
                                                           

Other Bonds Payable

                         

Manufactured housing loans (E)

  Jan 2006       148,006     147,843   LIBOR+0.97%   Jan 2009   6.14%   0.3     148,006     186,394     186,394   6.4     2,970     137,428

Manufactured housing loans (F)

  Aug 2006       249,551     248,291   LIBOR+1.17%   Aug 2011   7.04%   2.2     249,551     287,348     287,348   5.6     49,343     235,086
                                                           
      397,557     396,134       6.70%   1.5     397,557     473,742     473,742   5.9     52,313     372,514
                                                           

Repurchase Agreements (G)

                         

Real estate related loans

  Rolling       236,374     236,374   LIBOR+1.04%   Various   4.96%   0.5     236,374     331,710     322,762   2.3     331,710     —  

Other real estate securities (H)

  Rolling       11,981     11,981   LIBOR+2.50%   Apr 2009   9.24%   0.6     11,981     —       —     —       —       —  
                                                           
      248,355     248,355       5.17%   0.5     248,355     331,710     322,762   2.3     331,710     —  

FNMA/FHLMC securities

  Rolling       450,670     450,670   LIBOR-0.22%   Oct 2008   4.53%   0.1     450,670     469,571     472,779   3.8     —       126,370
                                                           
      699,025     699,025       4.76%   0.2     699,025     801,281     795,541   3.1     331,710     126,370
                                                           

Corporate

                         

Junior subordinated notes payable

  Mar 2006       100,100     100,100   7.57%(I)   Apr 2036   7.71%   27.5     —       —       —     —       —       —  
                                                           
      100,100     100,100       7.71%   27.5     —       —       —     —       —       —  
                                                           

Subtotal debt obligations

      5,571,067     5,558,217       5.10%   4.9   $ 5,409,632   $ 5,814,304   $ 4,941,328   4.6   $ 2,599,480   $ 2,691,331
                                                           

Financing on subprime mortgage loans subject to call option

  (J )     406,217     396,943                    
                                 

Total debt obligations

    $ 5,977,284   $ 5,955,160                    
                                 

 

(A) Weighted average, including floating and fixed rate classes and excluding the amortization of deferred financing costs.
(B) Including the effect of applicable hedges.
(C) Including restricted cash held in CBOs.
(D) Collateral carrying value represents the aggregate of fair value for real estate securities and amortized cost basis for loans in accordance to GAAP, and restricted cash held in CBOs.
(E) Of which $14.0 face amount is recourse financing.
(F) Of which $39.3 face amount is recourse financing.
(G) Subject to potential mandatory prepayments based on collateral value. The counterparties on these repurchase agreements include: JP Morgan Chase ($314.4 million, of which $251.8 million is financing for FNMA/FHLMC securities), Goldman Sachs ($198.9 million of FNMA/FHLMC financing), Deutsche Bank ($88.6 million), Credit Suisse ($57.1 million) and Citigroup ($40.0 million).
(H) Debt carrying value exceeds collateral amortized cost basis as these repurchase agreements are secured by investments in Newcastle’s CBO bonds, which are eliminated in consolidation.
(I) LIBOR + 2.25% after April 2016.
(J) Issued in April 2006 and July 2007. See Note 4 regarding the securitizations of Subprime Portfolios I and II.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2008

(dollars in tables in thousands, except share data)

 

 

6. FAIR VALUE OF FINANCIAL INSTRUMENTS

Newcastle’s non-cash financial instruments fall into four major categories:

 

   

real estate securities, which are marked to market through other comprehensive income,

 

   

derivatives, which are generally marked to market through other comprehensive income (or through income if they are not effective hedges),

 

   

real estate related and residential mortgage loans, which are generally not marked to market, but for which fair value is disclosed, and

 

   

debt obligations, which are generally not marked to market, but for which fair value is disclosed.

Newcastle held the following financial instruments at September 30, 2008:

 

    Principal
Balance or
Notional
Amount
  Carrying Value   Fair Value   

Fair Value Method (A)

  Weighted
Average
Yield/Funding
Cost
  Weighted
Average
Maturity
(Years)

Assets:

            

Real estate securities, available for sale*

  $ 4,135,320   $ 2,784,744   $ 2,784,744   

Broker quotations, counterparty quotations, pricing models

  6.72%   4.9

Real estate related loans

    1,750,957     1,686,707     1,343,014   

Broker quotations, counterparty quotations, pricing models

  7.44%   3.2

Residential mortgage loans

    571,635     560,111     481,120   

Pricing models

  7.93%   5.7

Subprime mortgage loans subject to call option (B)

    406,217     396,943     396,943   

(B)

  9.09%   (B)

Interest rate swaps, treated as hedges (C)(F)*

    17,864     245     245   

Counterparty quotations

  N/A   (C)

Liabilities:

            

CBO bonds payable

    4,374,385     4,362,958     2,374,456   

Counterparty quotations, pricing models

  4.95%   5.5

Other bonds payable

    397,557     396,134     366,094   

Pricing models

  6.70%   1.5

Repurchase agreements

    699,025     699,025     699,025   

Market comparables, pricing models

  4.76%   0.2

Financing of subprime mortgage loans subject to call option (B)

    406,217     396,943     396,943   

(B)

  9.09%   (B)

Junior subordinated notes payable

    100,100     100,100     46,643   

Pricing models

  7.71%   27.5

Interest rate swaps, treated as hedges (C)(F)*

    2,691,331     115,164     115,164   

Counterparty quotations

  N/A   (C)

Total rate of return swaps (D)(F)*

    94,066     14,949     14,949   

Broker quotations, counterparty quotations

  N/A   (D)

Non-hedge derivatives (E)(F)*

    410,712     11,298     11,298   

Counterparty quotations

  N/A   (E)

 

* Measured at fair value on a recurring basis.
(A) Based on 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 are obtained or, finally, internal pricing models are used. Internal pricing models are only used for (i) securities and loans which 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 results 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 current swap agreements as follows:

 

Maturing In

   Weighted Average Month of
Maturity
   Aggregate Notional
Amount
   Weighted Average
Fixed Pay Rate
  Aggregate
Fair Value

Agreements which receive 1-Month LIBOR:

          

2011

   December    $ 115,761    5.004%   $ 4,373

2012

   April      47,447    5.214%     1,801

2013

   August      55,130    3.915%     212

2014

   October      17,268    5.097%     842

2015

   October      1,342,949    5.250%     68,117

2016

   April      552,669    5.139%     24,315

2017

   August      174,034    5.235%     11,450

Agreements which receive 3-Month LIBOR:

          

2011

   February      32,000    5.078%     1,149

2014

   June      354,073    4.196%     2,660
                  
      $ 2,691,331      $ 114,919
                  

A positive fair value is recorded as a liability. Newcastle has recorded $0.2 million of gross interest rate swap assets and $115.2 million of gross interest rate swap liabilities.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2008

(dollars in tables in thousands, except share data)

 

 

(D) Represents total rate of return swaps which are treated as non-hedge derivatives. See Note 4 for a further discussion of these swaps. A positive fair value represents a liability; therefore, Newcastle has a net total rate of return swap liability.
(E) These include twelve interest rate swaps with a total notional balance of $276.4 million and two interest rate caps with notional balances of $116.9 million and $17.5 million, respectively. The interest rate swaps were recorded as a liability of $11.3 million and the caps had zero fair value at September 30, 2008. In October 2008, ten interest rate swaps with a total notional balance of $214.3 million were terminated in connection with the sale of certain FNMA/FHLMC securities. The maturity dates of the remaining $32.6 million interest rate swap, the $29.5 million interest rate swap, the $116.9 million cap and the $17.5 million cap are Jan 2016, Jun 2016, Mar 2009 and Jul 2009, respectively.
(F) Newcastle’s derivatives fall into two categories. Derivatives held within Newcastle’s CBOs, all of which were liabilities at period end, are not subject to Newcastle’s credit risk as they are senior to all the debt obligations of the related CBO. Derivatives held outside Newcastle’s CBOs are primarily 100% collateralized by margin (based on their current fair value) and therefore are not subject to Newcastle’s or its counterparty’s credit risk. As a result, no adjustments have been made to the fair value quotations received related to credit risk. Newcastle’s significant derivative counterparties include Bank of America, Deutsche Bank, Wachovia and Credit Suisse.

Pursuant to SFAS 157, the methodologies used for valuing such instruments have been categorized into three broad levels as follows:

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 or counterparty quotes) 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.

Pursuant to SFAS 157, these levels form a hierarchy. 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 at September 30, 2008:

 

               Fair Value
     Principal
Balance or
Notional
Amount
   Carrying
Value
   Level 2    Level 3A    Level 3B    Total

Assets:

                 

Real estate securities, available for sale

   $ 4,135,320    $ 2,784,744    $ 472,780    $ 2,153,777    $ 158,187    $ 2,784,744

Interest rate swaps, treated as hedges

     17,864      245      245      —        —        245

Liabilities:

                 

Interest rate swaps, treated as hedges

     2,691,331      115,164      115,164      —        —        115,164

Total rate of return swaps

     94,066      14,949      14,949      —        —        14,949

Non-hedge derivatives

     410,712      11,298      11,298      —        —        11,298

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2008

(dollars in tables in thousands, except share data)

 

 

Newcastle’s investments in instruments measured at fair value using Level 3 inputs changed during the nine months ended September 30, 2008 as follows:

 

     Level 3A     Level 3B     Total  

Assets

      

Balance at January 1, 2008

   $ 130,968     $ 177,518     $ 308,486  

Total gains (losses) (A)

      

Included in net income (loss) (B)

     (3,786 )     (144,420 )     (148,206 )

Included in other comprehensive income

     (21,694 )     124,869       103,175  

Amortization included in interest income

     183       12,784       12,967  

Settlements or repayments

     (4,109 )     (39,070 )     (43,179 )

Transfers in (out) of Level 3

     (60,359 )     94,469       34,110  
                        

Balance at June 30, 2008

     41,203       226,150       267,353  
                        

Total gains (losses) (A)

      

Included in net income (loss) (B)

     (5,857 )     (116,017 )     (121,874 )

Included in other comprehensive income

     (290,538 )     34,862       (255,676 )

Amortization included in interest income

     1,960       7,062       9,022  

Settlements or repayments

     20,939       (16,364 )     4,575  

Transfers in (out) of Level 3 (C)

     2,386,070       22,494       2,408,564  
                        

Balance at September 30, 2008

   $ 2,153,777     $ 158,187     $ 2,311,964  
                        

 

(A) None of the gains (losses) recorded in earnings during the periods is attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates.
(B) These gains (losses) are recorded in the following line items in the consolidated statement of operations:

 

     Three Months Ended
September 30, 2008
    Nine Months Ended
September 30, 2008
 

Gain (loss) on sale of investments, net

   $ (613 )   $ (650 )

Other income (loss), net

     (213 )     (213 )

Other-than-temporary impairment

     (121,048 )     (269,217 )
                

Total

   $ (121,874 )   $ (270,080 )
                
(C) As a result of the relative illiquidity in the mortgage-backed securities market, management has determined that there is little or no price transparency in the broker quotations used in the valuation of our CMBS, ABS and REIT debt as of September 30, 2008 and therefore classified such securities as Level 3A assets under the fair value hierarchy.

During the nine months ended September 30, 2008, Newcastle recorded $75.7 million of impairment on seven real estate loans (Note 4) with an aggregate post impairment amortized cost basis of $41.9 million. These loans were written down to fair value at the time of the impairment, based on internal pricing models (level 3B valuations).

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
September 30,
   Nine Months Ended
September 30,
     2008    2007    2008    2007

Weighted average number of shares of common stock outstanding, basic

   52,788,766    52,779,179    52,784,048    50,894,424

Dilutive effect of stock options, based on the treasury stock method

   —      —      —      150,994
                   

Weighted average number of shares of common stock outstanding, diluted

   52,788,766    52,779,179    52,784,048    51,045,418
                   

As of September 30, 2008, Newcastle’s outstanding options were summarized as follows:

 

Held by the Manager

   1,612,772

Issued to the Manager and subsequently transferred to certain of the Manager’s employees

   871,837

Held by the independent directors

   14,000
    

Total

   2,498,609
    

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2008

(dollars in tables in thousands, except share data)

 

 

8. RECENT ACTIVITIES

In January 2008, Newcastle repurchased $16.0 million face amount of a class of Portfolio V’s CBO bond for $6.7 million. As a result, Newcastle extinguished $16.0 million face amount of CBO debt and recorded a gain on extinguishment of debt of $9.2 million.

In February 2008, Newcastle repaid in full the debt associated with its first CBO in the amount of $331.2 million.

In February 2008, Newcastle terminated its credit facility. At the date of termination, no amounts were outstanding under the credit facility (and Newcastle did not incur any material costs related to the termination); at that time, previously incurred and deferred financing costs of $0.6 million were written off through gain (loss) on extinguishment of debt in the statement of operations.

In March 2008, Newcastle repurchased $2.9 million face amount of a class of Portfolio VIII’s CBO bond for $0.6 million. As a result, Newcastle extinguished $2.9 million face amount of CBO debt and recorded a gain on extinguishment of debt of $2.3 million.

In the first quarter of 2008, Newcastle sold face amounts of approximately $762.5 million of FNMA/FHLMC securities and $525.2 million of non-FNMA/FHLMC securities. Concurrent with the sales, Newcastle terminated the related interest rate swap and interest rate cap agreements, which were de-designated as hedges for accounting purposes at December 31, 2007. As a result, a portion of the gain on sale from these assets was offset by the loss on the termination of the derivatives. In connection with the investments sold in the first quarter, Newcastle recognized a net mark-to-market loss of $17.2 million in December 2007.

In the first quarter of 2008, Newcastle repaid $924.0 million of repurchase agreements.

In April 2008, Newcastle closed on a sale of its interest in the operating real estate joint venture and received net proceeds of approximately $19.9 million, resulting in a gain of approximately $6.2 million.

In April 2008, a $400 million term financing agreement was not extended. At such time, $99.6 million was drawn and the final maturity of such amount is April 2009.

In April 2008, a $400 million term financing agreement was not extended. At such time, $40.0 million was drawn and the final maturity of such amount is May 2010.

In July 2008, Newcastle closed on the sales of two real estate properties and received net proceeds of approximately $11.5 million.

In July 2008, Newcastle repurchased $5.0 million face amount of a class of Portfolio VIII’s CBO bond for $0.6 million. As a result, Newcastle extinguished $5.0 million face amount of CBO debt and recorded a gain on extinguishment of debt of $4.4 million in the third quarter of 2008.

In September 2008, Newcastle repurchased $1.0 million face amount of a class of Portfolio V’s CBO bond for $0.1 million. As a result, $1.0 million face amount of CBO debt was extinguished, resulting in a gain of approximately $0.9 million.

In October 2008, Newcastle sold $276.6 million face amount of FNMA/FHLMC securities, all of which were in an unrealized gain position at September 30, 2008. Concurrent with the sales, Newcastle terminated the related interest rate swap agreements which were de-designated as hedges for accounting purposes at September 30, 2008 as the forecasted transactions were no longer probable of occurring. As a result, Newcastle recorded $8.0 million of non-hedge derivative loss in the third quarter of 2008. In the fourth quarter of 2008, Newcastle will record a loss of approximately $2.2 million, representing the gain from the sale of the securities offset by the loss on the termination of the interest rate swap agreements due to market rate changes from September 30, 2008 to the dates of the sales. In connection with these sales in October, Newcastle reduced its recourse financing (pro forma as of September 30, 2008) by approximately $263.5 million and received net proceeds of approximately $15.1 million, representing proceeds from the asset sales net of repayment of the related financings.

In March 2008, Newcastle’s board of directors approved expanding the previously approved share repurchase to allow a potential repurchase of up to $125 million of Newcastle’s common stock or preferred stock. As of November 5, 2008, no shares have been repurchased.

These financial statements include a discussion of material events which have occurred subsequent to September 30, 2008 (referred to as “subsequent events”) through November 7, 2008. Events subsequent to that date have not been considered in these financial statements.

 

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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, when appropriate and available, 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 portfolio management, asset quality, diversification, match funded financing and credit risk management.

We currently own a diversified portfolio of 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 FNMA/FHLMC securities. 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 FNMA/FHLMC securities which have an implied AAA rating. We also own, directly and indirectly, interests 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 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 a result of our negative GAAP equity, our GAAP debt to equity ratio is not a meaningful measure as of September 30, 2008.) Our general investment guidelines adopted by our board of directors limit total leverage (as defined under the governing documents) to a maximum 9.0 to 1 debt to equity ratio. As of September 30, 2008, our debt to equity ratio, as computed under this method, was approximately 5.0 to 1.0.

We strive to 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. As we discuss in more detail under “–Market Considerations” below, the ongoing credit and liquidity crisis has limited the array of capital resources available to us and made the terms of capital resources we are able to obtain generally less favorable to us.

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 term debt, which generally represents obligations issued in multiple classes secured by an underlying portfolio of assets. Specifically, 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.

We conduct our business through four primary segments: (i) investments financed with non-recourse collateralized bond obligations (“CBOs”), (ii) investments financed with other non-recourse debt, (iii) investments financed with recourse debt, including FNMA / FHLMC securities, and (iv) unlevered investments. In the second quarter of 2008, Newcastle changed the structure of its internal organization such that the basis of the composition of its reportable segments changed from investment type to financing type. Revenues attributable to each segment are disclosed below (in thousands).

 

For the Nine Months

Ended September 30,

   CBOs    Other
Non-Recourse
   Recourse    Unlevered    Unallocated    Total

2008

   $ 232,652    $ 67,700    $ 39,417    $ 19,861    $ 1,831    $ 361,461

2007

   $ 287,441    $ 79,213    $ 129,669    $ 26,240    $ 1,283    $ 523,846

 

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Market Considerations

Financial Institutions

Many market participants have become increasingly uncertain about the health of a number of financial institutions and the financial system in general. Continuing write-downs and capital related issues affecting financial market participants have contributed to the recent wave of significant events affecting financial institutions, including the insolvency of Lehman Brothers, the government’s placing Fannie Mae, Freddie Mac and AIG under its supervision and the announced distressed sales of all or portions of Bear Stearns, Merrill Lynch, Wachovia and Washington Mutual. Although the United States and other governments have begun to take a number of significant steps to improve market conditions and the strength of major financial institutions, such efforts to date have not brought stability or liquidity to the capital markets, and we cannot predict the future conditions of these markets or the impact of such condition on our business.

We did not have any meaningful exposure to Lehman Brothers and have not experienced any meaningful losses as a result of its insolvency. However, the consolidation or elimination of Lehman Brothers, Bear Stearns and several other counterparties has increased our concentration of counterparty risk, decreased the universe of potential counterparties and reduced our ability to obtain competitive financing rates and terms.

Financial Markets in which We Operate

Our ability to generate income is dependent on our ability to invest our capital on a timely basis at attractive levels. The two primary market factors that affect this ability are (1) credit spreads and (2) the availability of financing on favorable terms.

Generally speaking, widening credit spreads reduce any unrealized gains on our current investments (or cause or increase unrealized losses) and increase our costs for new financings, but increase the yields available on potential new investments, while tightening credit spreads increase the unrealized gains (or reduce unrealized losses) on our current investments and reduce our costs for new financings, but reduce the yields available on potential new investments. By reducing unrealized gains (or causing unrealized losses), widening credit spreads also impact our ability to realize gains on existing investments if we were to sell such assets.

In the first nine months of 2008, credit spreads widened substantially. This net widening of credit spreads caused the net unrealized losses on our securities and derivatives, recorded in accumulated other comprehensive income, to increase and, therefore, caused our book value per share to be negative at the end of each of the first three quarters of 2008. One of the key drivers of the widening of credit spreads has been the continued disruption and liquidity concerns throughout the credit markets. The severity and scope of the disruption intensified meaningfully during the third quarter of 2008 and caused credit spreads to widen further during this period. The disruption and spread widening increased appreciably in October 2008.

Widening credit spreads, while reducing our book value per share, also result in higher yields on new investment opportunities. However, we must have access to capital at attractive terms in order to take advantage of these investment opportunities. Currently, we are unable to take meaningful advantage of the increased yields available on investments due to a lack of available capital, and we may continue to experience the same restrictions to some degree throughout the rest of 2008 and into 2009. Non-recourse term financing not subject to margin requirements is generally not available, and we must maintain our current sources of capital in order to meet our working capital needs.

Other Market Considerations

In addition, the ongoing credit and liquidity crisis has adversely affected us and the market in which we operate in a number of other ways. For example, it has reduced the market trading activity for many real estate securities (including, to a less significant extent, FNMA/FHLMC) and loans, resulting in less liquid markets for those securities and loans. As the securities held by us and many other companies in our industry are marked to market at the end of each quarter, the decreased liquidity and concern over market conditions have resulted in significant reductions in mark to market valuations of many real estate securities and loans. These lower valuations, and decreased expectations of future cash flows, have affected us by, among other things, decreasing our net book value, contributing to our decision to record significant impairment charges during the last six consecutive fiscal quarters and requiring us to pay additional amounts under certain financing arrangements.

If current adverse market conditions persist or worsen, it is likely that we will record additional impairments in the future. Such impairments could be significant and could negatively impact our ability to comply with the covenants in a significant number of our financings, which would negatively impact our liquidity and financial condition. For more information on the impact of impairments on our financial covenants, please see our discussion below under “–Liquidity and Capital Resources” and “–Debt Obligations.”

In order to maintain sufficient liquidity, we have elected to retain the majority of our investment proceeds (including those from asset sales) in lieu of using those proceeds to make new investments, and to reduce our dividend below the level of our operating income. This approach has increased our available cash while reducing the earnings from our investments. We may elect to adjust any future dividend payments to reflect our current and expected cash from operations or to satisfy future liquidity needs.

 

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We do not currently know the full extent to which this market disruption will affect us or the markets in which we operate, and we are unable to predict its length or ultimate severity. If the disruption continues, we will likely experience further tightening of liquidity, additional impairment charges, challenges in complying with the terms of our financing agreements, increased margin requirements, and additional challenges in raising capital and obtaining investment financing on attractive terms.

Future cash flows and our liquidity may be materially impacted if conditions do not improve. Should the current conditions worsen, or persist for an extended period of time, our available capital could be reduced upon the expiration or termination of our capital resources.

As of the date of this Quarterly Report on Form 10-Q, based on our cash balances and committed financing, as well as proceeds from select asset sales, we believe we have sufficient liquidity to maintain our ongoing operations in the current market environment.

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.”

 

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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. Management believes that the estimates and assumptions utilized in the preparation of the consolidated financial statements are prudent and reasonable. Actual results have been in line with management’s estimates and judgments used in applying each of the accounting policies described below. 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.

We will continue to analyze future 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, to the extent impairment losses are considered temporary as described below. Fair value is based primarily upon broker quotations, including 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, credit spreads and market liquidity. A significant portion of our securities are currently not traded in active markets and therefore have little or no price transparency. For a further discussion on this trend, see “– Market Considerations” above.

As of September 30, 2008, our securities valuation methodology and results can be summarized as follows (dollars in thousands):

 

               Fair Value     

Asset Type

   Outstanding
Face
Amount
   Amortized
Cost

Basis (A)
   Multiple
Quotes (B)
   Single
Quote) (C)
   Based on
Internal
Pricing
Models (D)
   Total

CMBS

   $ 2,268,297    $ 2,153,316    $ 779,494    $ 660,679    $ 27,453    $ 1,467,626

ABS – subprime

     564,054      257,085      44,191      54,102      118,738      217,031

Subprime retained

     80,380      9,184      —        —        9,423      9,423

Subprime residuals

     2,572      2,572      —        —        2,572      2,572

ABS – other real estate

     101,252      94,669      5,517      65,749      —        71,266

FNMA / FHLMC

     466,249      469,571      —        472,780      —        472,780

REIT debt

     652,516      662,395      385,554      158,492      —        544,046
                                         

Total

   $ 4,135,320    $ 3,648,792    $ 1,214,756    $ 1,411,802    $ 158,186    $ 2,784,744
                                         

 

(A) After impairment, including impairment taken during the period ended September 30, 2008.
(B) Management generally obtained 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. Management determined which quote to use based on its knowledge of the market and the amount it estimates it could receive in a current sale.
(C) 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).

 

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(D) Assets whose fair value was estimated based on internal pricing models are further detailed as follows:

 

     Amortized
Cost

Basis
   Fair Value    Impairment
Recorded
In Current
Year
    Unrealized
Gains (Losses)
in Accum.
OCI
 

CMBS

   $ 27,647    $ 27,453    $ (20,235 )   $ (195 )

ABS – subprime

     116,980      118,738      (142,837 )     1,759  

Subprime retained

     9,184      9,423      (51,750 )     239  

Subprime residuals

     2,572      2,572      (43,640 )     —    

ABS – other RE

     —        —        —         —    
                              

Total

   $ 156,383    $ 158,186    $ (258,462 )   $ 1,803  
                              

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. For securities valued using quotations, a 100 basis point change in credit spreads would impact estimated fair value by approximately $86.2 million. For securities valued using pricing models, the inputs include the discount rate, assumptions relating to prepayments, default rates and loss severities, as well as other variables. We validated the inputs and outputs of our models by comparing them to available independent third party market parameters and models for reasonableness. We believe the assumptions we used are within the range that a market participant would use and factor in the relative illiquidity currently in the markets. In comparison to the prior year end, we have used slower prepayment speeds, higher default rates and higher severity assumptions as inputs to our pricing models in order to reflect current market conditions. For securities valued with internal models, a 10% increase in the default rate assumption would result in a $25.6 million decrease in estimated fair value.

Pursuant to SFAS 157, as described below, our securities must be categorized by the “level” of inputs used in estimating their fair values. Level 1 would be assets valued based on quoted prices for identical instruments in active markets; we have no level 1 assets. Level 2 would be assets valued based on quoted prices in active markets for similar instruments, on quoted prices in less active or inactive markets, or on other “observable” market inputs. Level 3 would be assets valued based significantly on “unobservable” market inputs. We have further broken level 3 into level 3A, third party indications, and level 3B, internal models.

We generally classify the broker quotations we receive as level 3A inputs, except for certain liquid securities. They are quoted prices in generally inactive and illiquid markets for identical or similar securities. These quotations are generally received via email and contain disclaimers which state that they are not “actionable” – meaning that the party giving the quotation is not bound to actually purchase the security at the quoted price. Based on procedures we have performed with respect to prior quotations received from these brokers in comparison to transactions we have completed with respect to these securities, as well as on our knowledge and experience of these markets, we have generally determined that these quotes represent a reasonable estimate of fair value. In addition, management has performed its own analysis of fair value to confirm that the quotations received represented a reasonable estimate of fair value as defined under SFAS 157.

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 fair 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).

Also, for those securities within the scope of EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets”, whenever there is an adverse change in estimated cash flows that a market participant would use in determining the current fair value of the security from the cash flows previously projected, an other-than-temporary impairment is considered to have occurred.

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 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 when determining management’s estimate of cash flows and 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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Furthermore, the analysis of whether we have the intent and ability to hold the securities until recovery can also be subject to significant judgment, particularly in times of market illiquidity such as we are currently experiencing. If we sell assets for liquidity reasons, without a significant change in facts and circumstances, with respect to which we had previously expressed an intent and ability to hold, this could “taint” the reliability of our expressed intent and ability and cause us to record significant incremental impairments in the future.

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 must 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, 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. Furthermore, we must assess our intent and ability to hold our loan investments on a periodic basis. If we do not have the intent to hold a loan for the foreseeable future or until its expected payoff, the loan must be classified as “held for sale” and recorded at the lower of cost or estimated fair value.

Revenue Recognition on Loans

Income on these loans is recognized using a methodology that is similar to the methodology used 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 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. 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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Recent Accounting Pronouncements

In June 2007, Statement of Position No. 07-1, ‘‘Clarification of the Scope of the Audit and Accounting Guide — Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies’’ (‘‘SOP 07-1’’) was issued. SOP 07-1 addresses whether the accounting principles of the Audit and Accounting Guide for Investment Companies may be applied to an entity by clarifying the definition of an investment company and whether those accounting principles may be retained by a parent company in consolidation or by an investor in the application of the equity method of accounting. SOP 07-1 eliminates the previously existing exemption for REITs from being considered investment companies. We are currently evaluating the potential effect on our financial condition, liquidity and results of operations upon adoption of SOP 07-1. If we, or any of our subsidiaries, are considered an investment company under this new guidance, it would result in material changes to our financial statements. The primary change would be the recording of all of our (or our subsidiaries’) investments at fair value, with changes in fair value being recorded through the income statement. In February 2008, the FASB indefinitely postponed the adoption of SOP 07-1.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 applies to reporting periods beginning after November 15, 2007. We adopted SFAS 157 on January 1, 2008. To the extent they are measured at fair value, SFAS 157 did not materially change our fair value measurements for any of our existing financial statement elements. SFAS 157 did change the reported value for our derivative obligations, but this did not have a material effect on our liabilities or accumulated other comprehensive income. As a result, the adoption of SFAS 157 did not have a material impact on our financial condition, liquidity or results of operations.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose to measure many financial instruments, and certain other items, at fair value. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 applies to reporting periods beginning after November 15, 2007. We adopted SFAS 159 on January 1, 2008. We did not elect to measure any items at fair value pursuant to the provisions of SFAS 159. As a result, the adoption of SFAS 159 did not have a material impact on our financial condition, liquidity or results of operations.

In December 2007, the American Securitization Forum (“ASF”) issued the “Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans” (the “ASF Framework”). The ASF Framework provides guidance for servicers to streamline borrower evaluation procedures and to facilitate the use of foreclosure and loss prevention efforts in an attempt to reduce the number of U.S. subprime residential mortgage borrowers who might default in the coming year because the borrowers cannot afford to pay the increased interest rate after their variable loan rate resets. The ASF Framework is focused on U.S. subprime first-lien adjustable-rate residential mortgages that have an initial fixed interest rate period of 36 months or less, are included in securitized pools, were originated between January 1, 2005 and July 31, 2007, and have an initial interest rate reset date between January 1, 2008 and July 31, 2010.

The ASF Framework requires a borrower to meet specific conditions, primarily related to the ability of the borrower to meet the initial terms of the loan and obtain refinancing, to qualify for a fast track loan modification under which the qualifying borrower’s interest rate will be kept at the existing initial rate, generally for five years following the upcoming reset. To qualify for fast-track modification, a loan must currently be no more than 30 days delinquent and no more than 60 days delinquent in the past 12 months, have a loan-to-value ratio greater than 97%, be subject to payment increases greater than 10% upon reset, and be for the primary residence of the borrower.

In January 2008, the SEC’s Office of Chief Accountant (the “OCA”) issued a letter (the “OCA Letter”) addressing accounting issues that may be raised by the ASF Framework. The OCA Letter expressed the view that if a qualifying subprime loan is modified pursuant to the ASF Framework and that loan could legally be modified, the OCA will not object to the continued status of the transferee as a QSPE under SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, because it would be reasonable to conclude that defaults on such loans are “reasonably foreseeable” in the absence of any modification.

The servicer for Subprime Portfolios I and II may make loan modifications in accordance with the ASF Framework in 2008, but we do not expect any such modifications to have a material effect on the accounting for our subprime mortgage loans subject to call options or retained interests in the securitizations of Subprime Portfolios I and II. Furthermore, we do not expect that the ASF Framework will affect the off balance sheet treatment of the securitizations of Subprime Portfolios I and II.

In February 2008, the FASB issued FASB Staff Position No. FAS 140-3 (“FSP FAS 140-3”), “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions.” FSP FAS 140-3 provides guidance on accounting for a transfer of a financial asset and a repurchase financing. It presumes that an initial transfer of a financial asset and a repurchase financing are considered part of the same arrangement (a linked transaction) unless certain criteria are met. If the criteria are not met, the linked transaction would be recorded as a net investment, likely as a derivative, instead of recording the purchased financial asset on a gross basis along with a repurchase financing. FSP FAS 140-3 applies to reporting periods beginning after

 

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November 15, 2008 and is only applied prospectively to transactions that occur on or after the adoption date. As a result of the prospective nature of the adoption, we do not expect the adoption of FSP FAS 140-3 to have a material impact on our financial condition, liquidity or results of operations, unless we enter into transactions of this type after January 1, 2009.

In March 2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments and Hedging Activities.” SFAS 161 applies to reporting periods beginning after November 15, 2008. SFAS 161 requires enhanced disclosures about an entity’s derivative and hedging activities. It does not change the accounting for such activities. As a result, while the adoption of SFAS 161 will change our disclosures, we do not expect it to have a material impact on our financial condition, liquidity or results of operations.

In September 2008, the FASB issued exposure drafts of two proposed standards, “Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140,” and “Amendments to FASB Interpretation No. 46(R).” These proposed standards would fundamentally change the requirements to consolidate (or deconsolidate) special purpose and variable interest entities and would be effective for us in 2010. We are currently evaluating the potential impact of these proposed standards on us.

 

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RESULTS OF OPERATIONS

The following table summarizes the changes in our results of operations from the three and nine months ended September 30, 2007 to the three and nine months ended September 30, 2008 (dollars in thousands):

 

    Nine Months     Three Months        
    Amount Change     Percent Change     Amount Change     Percent Change     Explanations of
Material
Changes
 

Interest income

  $ (162,385 )   (31.0 )%   $ (56,217 )   (33.1 )%   (1 )

Interest expense

    (131,325 )   (35.7 )%     (43,764 )   (37.3 )%   (1 )

Loan and security servicing expense

    (2,536 )   (32.6 )%     (373 )   (17.8 )%   (1 )

Provision for credit losses

    (1,495 )   (18.8 )%     (743 )   (26.3 )%   (2 )

General and administrative expense

    1,594     39.6 %     838     64.6 %   (3 )

Management fee to affiliate

    743     5.7 %     —       0.0 %   (4 )

Incentive compensation to affiliate

    (6,209 )   (100.0 )%     —       0.0 %   (4 )

Depreciation and amortization

    —       0.0 %     (1 )   (1.4 )%   N/A  

Gain (loss) on sale of investments, net

    (10,094 )   (72.0 )%     (7,394 )   (153.2 )%   (5 )

Other income (loss), net

    (35,224 )   N.M.       (10,879 )   N.M.     (6 )

Other-than-temporary impairment

    (195,403 )   N.M.       (53,187 )   N.M.     (7 )

Loan impairment

    (76,916 )   N.M.       (39,831 )   N.M.     (7 )

Provision for credit losses, loans held for sale

    5,754     N.M.       —       N.M.     (8 )

Gain (loss) on extinguishment of debt

    28,880     N.M.       13,067     N.M.     (9 )

Equity in earnings of unconsolidated subsidiaries

    6,035     280.2 %     (69 )   (14.1 )%   (10 )
                             

Income (loss) from continuing operations

  $ (300,125 )   (798.9 )%   $ (110,467 )   (308.1 )%  
                             

 

N.M.—Not meaningful

 

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

 

     Nine Months     Three Months  
     Period to Period Increase (Decrease)     Period to Period Increase (Decrease)  
     Interest Income     Interest Expense     Interest Income     Interest Expense  

Disposition of securities and loans

   $ (52,169 )   $ (42,304 )   $ (15,371 )   $ (12,571 )

New debt obligations

     44,024       30,736       —         —    

Repayment of debt obligations

     (74,524 )     (59,362 )     (10,541 )     (8,592 )

Paydown

     (23,040 )     (13,372 )     (9,470 )     (4,409 )

Other (primarily changes in rates)

     (56,676 )     (47,023 )     (20,835 )     (18,192 )
                                
   $ (162,385 )   $ (131,325 )   $ (56,217 )   $ (43,764 )
                                

Changes in loan and security servicing expense are also primarily due to these acquisitions and paydowns.

 

(2) This change is primarily due to a decreased provision for our pools of manufactured housing loans as a result of paydowns.
(3) This change is primarily due to increases in insurance expenses, market data services, software license fees and professional fees.
(4) The increase in management fees is a result of our increased size resulting from our equity issuances. As a result of impairment charges, we will not owe incentive compensation to our manager for an indefinite period of time.
(5) This change is a result of a decrease of net gain on the sale of securities, loans and termination of derivatives during the nine and three months ended September 30, 2008 compared to the same periods ended September 30, 2007.
(6) This change is primarily due to unrealized losses on total rate of return swaps and realized losses on the termination of derivative instruments in 2008.
(7) This change is due to impairment charges recorded during 2008 as a result of continued credit market disruption.
(8) This change results from a 2007 unrealized loss on a pool of subprime mortgage loans which was considered held for sale as of June 30, 2007.
(9) This change is primarily due to a gain on a repurchase of our own debt offset by a write off of deferred financing fees upon the repayment of debt obligations recorded during the nine months ended September 30, 2008.
(10) This change is primarily the result of a gain on the sale of our interests in an operating real estate joint venture recorded during the nine months ended September 30, 2008.

 

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LIQUIDITY AND CAPITAL RESOURCES

Liquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain investments, and other general business needs. Additionally, to maintain our status as a REIT under the Internal Revenue Code, we must distribute annually at least 90% of our REIT taxable income. Our primary sources of funds for liquidity consist of net cash provided by operating activities, borrowings under loans, and the potential issuance of debt and equity securities, when available. Additional sources of liquidity include investments that are readily saleable prior to their maturity. Our debt obligations are generally secured directly by our investment assets.

As of the date of this Quarterly Report on Form 10-Q, management believes that our cash on hand, when combined with our cash flow provided by operations, as well as proceeds from the repayment or sale of investments and borrowings, is sufficient to satisfy our liquidity needs with respect to our current investment portfolio. In this regard, we had unencumbered assets with a carrying value of approximately $91.1 million at September 30, 2008, excluding unrestricted cash of $166.6 million. We had $360.6 million of recourse financing (including financing under total rate of return swaps) on non-FNMA/FHLMC investments as of September 30, 2008, excluding the trust preferred debt. Subsequent to September 30, 2008 through November 5, 2008, we have posted $51.8 million of cash to satisfy margin calls due to unprecedented levels of volatility experienced during this period. As of November 5, 2008, we had an unrestricted cash balance of $108.4 million and $38.0 million of restricted cash held in CBO financing structures pending its investment in real estate securities and loans. We currently do not expect to be required to make material additional distributions in connection with the REIT tax code provisions related to 2008.

We expect to meet our long-term liquidity requirements, specifically the repayment of our debt obligations, through additional borrowings and the liquidation or refinancing of our assets at maturity. Our ability to meet our long-term liquidity requirements relating to capital required for the growth of our investment portfolio is subject to obtaining additional equity and debt financing. Decisions by investors and lenders to enter into such transactions with us will depend upon a number of factors, such as our historical and projected financial performance, compliance with the terms of our current credit arrangements, industry and market trends, the availability of capital and our investors’ and lenders’ policies and rates applicable thereto, and the relative attractiveness of alternative investment or lending opportunities. We strive to maintain access to a broad array of capital resources in an effort to insulate our business from potential fluctuations in the availability of capital. Our core business strategy is dependent upon our ability to finance our real estate securities, loans and other real estate related assets with match funded debt at rates that provide a positive net spread. Currently, spreads for such liabilities have widened and demand for such liabilities has become extremely limited, thereby restricting our ability to execute future financings. This restriction is exacerbated by the requirement to post margin on existing obligations.

Our cash flow provided by operations differs from our net income due to these primary factors: (i) accretion of discount or premium on our real estate securities and loans (including the accrual of interest and fees payable at maturity), discount on our debt obligations, deferred financing costs and interest rate cap premiums, and deferred hedge gains and losses, (ii) gains and losses from sales of assets financed with CBOs, (iii) the provision for credit losses and impairments recorded in connection with our loan assets, as well as other-than-temporary impairment recorded on our securities, (iv) unrealized gains or losses on our non-hedge derivatives, particularly our total rate of return swaps, and (v) the non-cash charges associated with our early extinguishment of debt. Proceeds from the sale of assets which serve as collateral for our CBO financings, including gains thereon, are required to be retained in the CBO structure until the related bonds are retired and are therefore not available to fund current cash needs outside of these structures.

As of November 5, 2008, we were committed to fund up to $60.9 million and $19.1 million with respect to a commercial construction loan and an undrawn term loan commitment, respectively, subject to certain conditions to be met by the borrowers. The commercial construction loan is expected to be funded over the next 18 months.

Our liquidity position is primarily a function of the amount of cash we receive from our investments relative to the amount of cash obligations we are required to satisfy. Our primary sources of cash are the interest and principal we earn from our directly held investments, the net proceeds from the sales of such investments and the distributions we receive from our CBOs. Proceeds from sales of assets in the current illiquid market environment are unpredictable and may vary materially from their estimated fair value. As described above, our cash obligations principally consist of:

 

 

repaying of our debt obligations as they become due ;

 

 

satisfying margin calls on our interest rate swaps or in connection with our assets financed with repurchase agreements and total rate of return swaps; and

 

 

funding new or existing investments.

Our liquidity would be adversely affected if we failed to maintain the levels of equity (generally excluding accumulated other comprehensive income) required by the terms of some of our non-CBO financing arrangements. These equity levels are reduced by losses, which can be caused by recording impairments or realizing losses on the sale of assets. We cannot predict the amount of any future impairments or other reductions to shareholders’ equity that we may record. If we record losses in future periods at levels generally consistent with the losses we have recorded in recent previous periods, we may fail to maintain the levels of equity required by these financings. Such failure would enable the applicable lender to terminate the financing, in which case we would be required to repay the outstanding obligation. Furthermore, these financing agreements are generally short-term in nature and the lender may not be willing or able to “roll” the financing upon maturity which would require us to repay it. Any required repayments would decrease the amount of our available cash, and it is possible that we may not have or be able to raise sufficient cash to satisfy every potential repayment obligation. For additional information on potential future impairments, please see “– Market Considerations” above.

 

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Our liquidity would also be adversely affected if the assets in the CBOs fail to satisfy the over collateralization tests of the applicable CBO. While rating downgrades have not materially affected compliance with these over collateralization tests in prior periods, downgrades by the rating agencies could result in one or more of our CBOs failing to satisfy these tests, in which case the principal and/or interest cash flow of the applicable CBO that would otherwise be distributed to the more junior classes of securities held by Newcastle would be redirected to pay down the most senior class of securities in the CBO until the test is satisfied. As a result, failure to satisfy these tests would prevent Newcastle from receiving some or all of the cash flow from the applicable CBO for an indeterminable period of time, which could, in turn, have a significantly negative impact on our liquidity, including our ability to pay a dividend. We cannot predict what actions the rating agencies may take with respect to any assets in our CBOs and, therefore, cannot predict what impact future rating agency actions will have on the over collateralization tests of our CBOs. For more information on our CBOs, their respective over collateralization tests and the potential noncompliance of three CBOs with these over collateralization tests as of their next measurement date in November 2008, please see “–Results of Operations” above as well as “–Debt Obligations” below. See “- Market Considerations” above for a further discussion of recent trends and events affecting our liquidity.

As described below, under “Interest Rate, Credit and Spread Risk,” we are subject to margin calls in connection with our assets financed with repurchase agreements or total rate of return swaps.

See “- Market Considerations” above for a further discussion of recent trends and events affecting our liquidity.

Investment Portfolio

The following summarizes our investment portfolio at September 30, 2008 (dollars in millions).

 

     Outstanding Face
Amount
   Amortized
Cost Basis
    Percentage of
Amortized
Cost Basis
    Number of
Investments
   Credit (1)     Weighted
Average Life
(years) (2)

Investment (3)

              

Commercial

              

CMBS

   $ 2,268    $ 2,153     36.1 %   259    BBB–     5.3

Mezzanine Loans

     759      755     12.7 %   23    67 %   3.3

B-Notes

     388      366     6.1 %   14    58 %   3.0

Whole Loans

     87      86     1.4 %   4    63 %   2.5

ICH Loans

     5      5     0.1 %   3    —       3.3
                              

Total Commercial Assets

     3,507      3,365     56.4 %        4.5
                              

Residential

              

Manufactured Housing and Residential Mortgage Loans

     572      548     9.2 %   14,478    696     5.7

Subprime Securities

     564      257     4.3 %   121    BB–     4.6

Subprime Retained Securities

     80      9     0.2 %   7    CCC+     2.4

Subprime Residual Interests

     3      3     0.1 %   2    647     0.6

Real Estate ABS

     101      95     1.6 %   26    BBB     4.6
                              
     1,320      912     15.4 %        4.9
                              

FNMA/FHLMC securities

     466      467     7.8 %   17    AAA     3.8
                              

Total Residential Assets

     1,786      1,379     23.2 %        4.6
                              

Corporate

              

REIT Debt

     653      662     11.1 %   65    BBB–     4.9

Corporate Bank Loans

     606      554     9.3 %   16    B–     3.0
                              

Total Corporate Assets

     1,259      1,216     20.4 %        4.0
                              

TOTAL

   $ 6,552    $ 5,960     100.0 %        4.4
                              

Reconciliation to GAAP total assets:

              

Net unrealized losses recorded in accumulated other comprehensive income

        (864 )         

Total rate of return swaps (4)

        (79 )         

Other assets

              

Subprime mortgage loans subject to call option (5)

        397           

Real estate held for sale

        13           

Cash and restricted cash

        295           

Other

        63           
                    

GAAP total assets

      $ 5,785           
                    

 

(1)

Credit represents minimum rating for rated assets, LTV (based on the appraised value at the time of purchase) for non-rated commercial assets, FICO score for non-rated residential assets and an implied AAA rating for FNMA/FHLMC securities.

(2)

Mezzanine Loans, B-Notes and Whole Loans are based on the fully extended maturity dates.

(3)

The following tables summarize certain supplemental data relating to our investments ($ in thousands):

 

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CMBS

 

Deal Vintage

(A)

   Minimum
Rating
  Number    Outstanding
Face Amount
   Amortized Cost
Basis
   Percentage of
Amortized Cost
Basis
    Delinquency
60+/FC/REO (B)
    Principal
Subordination (C)
    Weighted
Average Life
(years)

Pre 2004

   BBB+   78    $ 401,252    $ 397,188    18.4 %   1.0 %   9.5 %   4.2

2004

   BBB–   59      435,494      428,785    19.9 %   0.2 %   5.0 %   5.3

2005

   BB+   49      576,187      545,233    25.3 %   0.4 %   4.6 %   6.3

2006

   BBB–   37      455,308      429,361    20.0 %   0.1 %   4.8 %   3.8

2007

   BBB+   36      400,056      352,749    16.4 %   0.1 %   9.2 %   6.6
                                             

Total / WA

   BBB–   259    $ 2,268,297    $ 2,153,316    100.0 %   0.3 %   6.4 %   5.3
                                             

 

(A) The year in which the securities were issued.
(B) The percentage of underlying loans that are 60+ days delinquent, or in foreclosure or considered real estate owned (REO).
(C) The percentage of the outstanding face amount of securities and residual interests that is subordinate to our investments.

WA – Weighted average, in all tables.

Mezzanine Loans, B-Notes and Whole Loans

 

     Mezzanine     B-Note     Whole Loan     Total / WA  

Outstanding Face Amount

   $ 759,219     $ 388,168     $ 86,566     $ 1,233,953  

Amortized Cost Basis

   $ 754,571     $ 365,669     $ 86,474     $ 1,206,714  

Number

     23       14       4       41  

Weighted Average First $ Loan to Value (A)

     55.6 %     46.0 %     0.0 %     48.7 %

Weighted Average Last $ Loan to Value (A)

     67.0 %     58.4 %     62.9 %     64.0 %

Delinquency

     0 %     0 %     0 %     0 %

 

(A) Loan to value is based on the appraised value at the time of purchase.

Manufactured Housing Loans

 

Deal

   Outstanding
Face Amount
   Amortized
Cost Basis
   Pertcentage
of Amortized
Cost Basis
    Weightetd
Average
Loan Age
(months)
   Original
Balance
   Delinquency
90+/FC/REO (A)
    Actual
Cumulative
Loss to Date
    Projected
Cumulative
Loss to
Date
 

Portfolio I

   $ 195,807    $ 182,886    39.6 %   85    $ 327,855    0.9 %   3.9 %   5.6 %

Portfolio II

     289,791      278,787    60.4 %   115      434,743    0.6 %   2.2 %   3.8 %
                                                  

Total / WA

   $ 485,598    $ 461,673    100.0 %   103    $ 762,598    0.7 %   2.9 %   4.5 %
                                                  

 

(A) The percentage of loans that are 90+ days delinquent, or in foreclosure or considered real estate owned (REO).

Subprime Securities

 

     Security Characteristics  

Vintage (A)

   Minimum
Rating
  Number of
Securities
   Outstanding
Face Amount
   Amortized Cost
Basis (B)
   Percentage of
Amortized Cost
Basis
    Principal
Subordination (C)
    Excess
Spread (D)
 

2003

   A–   15    $ 29,792    $ 25,177    9.8 %   19.8 %   2.2 %

2004

   BBB   30      129,614      94,794    36.9 %   13.2 %   2.5 %

2005

   B   43      189,960      78,802    30.6 %   12.9 %   3.3 %

2006

   B   27      181,032      41,552    16.2 %   9.2 %   3.0 %

2007

   A+   6      33,656      16,760    6.5 %   21.0 %   3.1 %
                                         

Total / WA

   BB–   121    $ 564,054    $ 257,085    100.0 %   12.7 %   3.0 %
                                         

 

     Collateral Characteristics  

Vintage (A)

   Average
Loan Age
(months)
   Collateral
Factor (E)
   3 month
CPR (F)
    Delinquency (G)     Cumulative Losses
to Date
 

2003

   66    0.12    11.3 %   12.8 %   2.0 %

2004

   53    0.16    14.6 %   14.8 %   2.0 %

2005

   40    0.31    23.9 %   26.1 %   3.3 %

2006

   27    0.65    21.3 %   27.4 %   3.5 %

2007

   21    0.81    13.4 %   26.0 %   1.7 %
                            

Total / WA

   39    0.41    19.6 %   23.2 %   2.9 %
                            

 

(A) The year in which the securities were issued.
(B) Excludes subprime retained securities and residual interests of $11.8 million.
(C) The percentage of the amortized cost basis of securities and residual interests that is subordinate to our investments.
(D) The annualized amount of interest received on the underlying loans in excess of the interest paid on the securities, as a percentage of the outstanding collateral balance.
(E) The ratio of original unpaid principal balance of loans still outstanding.
(F) Three month average constant prepayment rate.
(G) The percentage of underlying loans that are 90+ days delinquent, or in foreclosure or considered real estate owned (REO).

 

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Subprime Retained Securities and Residual Interests

Represents $9.2 million and $2.6 million of amortized cost basis of retained bonds and residual interests, respectively, in the securitizations of Subprime Portfolios I and II. For further information on these securitizations, see Note 4 to our consolidated financial statements included herein. The following table summarizes our subprime portfolio securitizations:

 

          Security Characteristics     Portfolio Characteristics  

Deal

   Outstanding
Face Amount
   Amortized
Cost Basis
   Percentage of
Amortized Cost
Basis
    Average
Loan Age
(months)
   Original
Securitization
Balance
   Current
Balance
   Delinquency
90+/FC/REO (A)
    Actual
Cumulative
Loss to Date
    Projected
Cumulative
Loss to Date
 

Portfolio I

   $ 41,719    $ 5,311    45.2 %   37    $ 1,502,181    $ 756,073    17.9 %   2.1 %   1.4 %

Portfolio II

     41,234      6,446    54.8 %   20      1,087,942      951,107    14.7 %   0.9 %   0.3 %
                                                         

Total / WA

   $ 82,953    $ 11,757    100.0 %   28    $ 2,590,123    $ 1,707,180    16.1 %   1.5 %   0.8 %
                                                         

 

(A) The percentage of loans that are 90+ days, or in foreclosure or considered real estate owned (REO).

REIT Debt

 

Industry

   Average
Rating
  Number    Outstanding
Face
Amount
   Amortized
Cost Basis
   Percentage of
Amortized
Cost Basis
 

Retail

   BB+   16    $ 200,035    $ 202,529    30.6 %

Diversified

   BBB–   14      151,463      152,041    23.0 %

Office

   BBB   14      132,919      135,739    20.5 %

Multifamily

   BBB+   8      44,508      45,683    6.9 %

Hotel

   BBB–   4      42,720      43,403    6.5 %

Healthcare

   BBB–   4      36,600      37,197    5.6 %

Storage

   A–   2      23,406      24,102    3.6 %

Industrial

   BBB   3      20,865      21,701    3.3 %
                             

Total / WA

   BBB–   65    $ 652,516    $ 662,395    100.0 %
                             

Corporate Bank Loans

 

Industry

   Average
Rating
  Number    Outstanding
Face
Amount
   Amortized
Cost Basis
   Percentage of
Amortized
Cost Basis
 

Real Estate

   B–   5    $ 174,310    $ 168,296    30.4 %

Resorts

   BB–   1      110,488      100,888    18.2 %

Media

   CCC+   2      112,000      101,814    18.4 %

Retail

   B–   1      100,000      94,515    17.1 %

Restaurant

   CCC   2      44,223      34,949    6.3 %

Transportation

   C   1      27,000      26,137    4.7 %

Gaming

   CCC–   3      29,557      19,067    3.4 %

Theatres

   B   1      8,541      8,541    1.5 %
                             

Total / WA

   B–   16    $ 606,119    $ 554,207    100.0 %
                             

 

(4)

Total rate of return swaps are reflected in the consolidated balance sheet on a net basis, as derivatives. For purposes of the investment statistics, they are reflected on a gross basis, based on the underlying reference asset. As of September 30, 2008, we held an aggregate of $94.1 million notional amount of total rate of return swaps on 3 reference assets on which we had deposited $35.0 million of margin. These total rate of return swaps had an aggregate fair value of approximately ($15.0) million, a weighted average receive interest rate of LIBOR + 2.98%, a weighted average pay interest rate of LIBOR + 1.03%, and a weighted average maturity of 0.4 years.

(5)

The subprime mortgage loans subject to call option are excluded from the statistics because they result from an option, not an obligation, to repurchase such loans, are noneconomic until such option is exercised, and are offset by an equal liability on the consolidated balance sheet.

 

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Debt Obligations

Our debt obligations, as summarized in Note 5 to our consolidated financial statements, existing at September 30, 2008 (gross of $22.1 million of discounts) had contractual maturities as follows (in thousands):

 

     Nonrecourse    Recourse (1) (2)    Total

Period from October 1, 2008 through December 31, 2008

   $ —      $ 582,357    $ 582,357

2009

     134,005      105,159