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, 2009
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
(Registrants 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ¨ Yes No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ¨ Accelerated filer x 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 issuers classes of common stock, as of the last practicable date.
Common stock, $0.01 par value per share: 52,905,335 shares outstanding as of November 4, 2009.
CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS
This report contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements relate to, among other things, the operating performance of our investments, the stability of our earnings, and our financing needs. Forward-looking statements are generally identifiable by use of forward-looking terminology such as may, will, should, potential, intend, expect, endeavor, seek, anticipate, estimate, overestimate, underestimate, believe, could, project, predict, continue or other similar words or expressions. Forward-looking statements are based on certain assumptions, discuss future expectations, describe future plans and strategies, contain projections of results of operations or of financial condition or state other forward-looking information. Our ability to predict results or the actual outcome of future plans or strategies is inherently uncertain. Although we believe that the expectations reflected in such forward-looking statements are based on reasonable assumptions, our actual results and performance could differ materially from those set forth in the forward-looking statements. These forward-looking statements involve risks, uncertainties and other factors that may cause our actual results in future periods to differ materially from forecasted results. Factors which could have a material adverse effect on our operations and future prospects include, but are not limited to:
| our ability to take advantage of opportunities in additional asset classes at attractive risk-adjusted prices; |
| our ability to deploy capital accretively; |
| the risks that default and recovery rates on our loan portfolios exceed our underwriting estimates; |
| the relationship between yields on assets which are paid off and yields on assets in which such monies can be reinvested; |
| the relative spreads between the yield on the assets we invest in and the cost of financing; |
| changes in economic conditions generally and the real estate and bond markets specifically; |
| adverse changes in the financing markets we access affecting our ability to finance our investments, or in a manner that maintains our historic net spreads; |
| changing risk assessments by lenders that potentially lead to increased margin calls, not extending our repurchase agreements or other financings in accordance with their current terms or entering into new financings with us; |
| changes in interest rates and/or credit spreads, as well as the success of any hedging strategy we may undertake in relation to such changes; |
| the quality and size of the investment pipeline and the rate at which we can invest our cash, including cash inside our CDOs; |
| impairments in the value of the collateral underlying our investments and the relation of any such impairments to our judgments as to whether changes in the market value of our securities, loans or real estate are temporary or not and whether circumstances bearing on the value of such assets warrant changes in carrying values; |
| legislative/regulatory changes, including but not limited to, any modification of the terms of loans; |
| reductions in cash flows received from our investments, particularly our CDOs; |
| completion of pending investments; |
| the availability and cost of capital for future investments; |
| competition within the finance and real estate industries; and |
| other risks detailed from time to time below, particularly under the heading Risk Factors, and in our other SEC reports. |
Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. The factors noted above could cause our actual results to differ significantly from those contained in any forward-looking statement.
Readers are cautioned not to place undue reliance on any of these forward-looking statements, which reflect our managements views only as of the date of this report. We are under no duty to update any of the forward-looking statements after the date of this report to conform these statements to actual results.
SPECIAL NOTE REGARDING EXHIBITS
In reviewing the agreements included as exhibits to this Quarterly Report on Form 10-Q, please remember they are included to provide you with information regarding their terms and are not intended to provide any other factual or disclosure information about the Company or the other parties to the agreements. The agreements contain representations and warranties by each of the parties to the applicable agreement. These representations and warranties have been made solely for the benefit of the other parties to the applicable agreement and:
| should not in all instances be treated as categorical statements of fact, but rather as a way of allocating the risk tone of the parties if those statements provide to be inaccurate; |
| have been qualified by disclosures that were made to the other party in connection with the negotiation of the applicable agreement, which disclosures are not necessarily reflected in the agreement; |
| may apply standards of materiality in a way that is different from what may be viewed as material to you or other investors; and |
| were made only as of the date of the applicable agreement or such other date or dates as may be specified in the agreement and are subject to more recent developments. |
Accordingly, these representations and warranties may not describe the actual state of affairs as of the date they were made or at any other time. Additional information about the Company may be found elsewhere in this Quarterly Report on Form 10-Q and the Companys other public filings, which are available without charge through the SECs website at http://www.sec.gov.
FORM 10-Q
INDEX
ITEM 1. | FINANCIAL STATEMENTS |
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)
September 30, 2009 (Unaudited) |
December 31, 2008 | |||||||
Assets |
||||||||
Real estate securities, available for sale |
$ | 1,761,209 | $ | 1,668,748 | ||||
Real estate related loans, held for sale, net |
606,504 | 843,212 | ||||||
Residential mortgage loans, held for sale, net |
368,939 | 409,632 | ||||||
Subprime mortgage loans subject to call option |
401,713 | 398,026 | ||||||
Investments in unconsolidated subsidiaries |
173 | 384 | ||||||
Operating real estate, held for sale |
10,116 | 11,866 | ||||||
Cash and cash equivalents |
73,249 | 49,746 | ||||||
Restricted cash |
140,728 | 44,282 | ||||||
Receivables and other assets |
36,276 | 47,727 | ||||||
$ | 3,398,907 | $ | 3,473,623 | |||||
Liabilities and Stockholders Equity (Deficit) |
||||||||
Liabilities |
||||||||
CDO bonds payable |
$ | 4,111,136 | $ | 4,359,981 | ||||
Other bonds payable |
315,845 | 380,620 | ||||||
Repurchase agreements |
78,039 | 276,472 | ||||||
Financing of subprime mortgage loans subject to call option |
401,713 | 398,026 | ||||||
Junior subordinated notes payable |
101,634 | 100,100 | ||||||
Derivative liabilities |
242,578 | 333,977 | ||||||
Due to affiliates |
1,497 | 1,532 | ||||||
Payables to brokers, dealers and clearing organizations |
7,337 | | ||||||
Accrued expenses and other liabilities |
7,457 | 16,447 | ||||||
5,267,236 | 5,867,155 | |||||||
Stockholders Equity (Deficit) |
||||||||
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, 52,905,335 and 52,789,050 shares issued and outstanding at September 30, 2009 and December 31, 2008, respectively |
529 | 528 | ||||||
Additional paid-in capital |
1,033,506 | 1,033,416 | ||||||
Accumulated deficit |
(2,213,287 | ) | (3,272,403 | ) | ||||
Accumulated other comprehensive income (loss) |
(841,577 | ) | (307,573 | ) | ||||
(1,868,329 | ) | (2,393,532 | ) | |||||
$ | 3,398,907 | $ | 3,473,623 | |||||
See notes to consolidated financial statements
1
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, |
|||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
Interest income |
$ | 75,222 | $ | 113,549 | $ | 287,033 | $ | 361,461 | ||||||||
Interest expense |
52,438 | 73,651 | 167,154 | 236,739 | ||||||||||||
Net interest income |
22,784 | 39,898 | 119,879 | 124,722 | ||||||||||||
Impairment |
||||||||||||||||
Provision for credit losses on loan pools |
| 2,077 | | 6,450 | ||||||||||||
Valuation allowance (reversal) on loans (held for sale in 2009) |
(6,926 | ) | 39,831 | 83,093 | 76,916 | |||||||||||
Other-than-temporary impairment on securities |
130,555 | 121,047 | 526,691 | 269,216 | ||||||||||||
Portion of other-than-temporary impairment on securities recognized in other comprehensive income |
(32,827 | ) | | (88,105 | ) | | ||||||||||
90,802 | 162,955 | 521,679 | 352,582 | |||||||||||||
Net interest income (loss) after impairment |
(68,018 | ) | (123,057 | ) | (401,800 | ) | (227,860 | ) | ||||||||
Other Income (Loss) |
||||||||||||||||
Gain (loss) on settlement of investments, net |
(1,709 | ) | (2,569 | ) | 7,788 | 3,920 | ||||||||||
Gain on extinguishment of debt |
132,534 | 5,315 | 186,209 | 13,848 | ||||||||||||
Other income (loss), net |
(2,252 | ) | (17,912 | ) | 2,193 | (35,793 | ) | |||||||||
Equity in earnings (losses) of unconsolidated subsidiaries |
296 | 419 | 281 | 8,189 | ||||||||||||
128,869 | (14,747 | ) | 196,471 | (9,836 | ) | |||||||||||
Expenses |
||||||||||||||||
Loan and security servicing expense |
1,097 | 1,718 | 3,869 | 5,236 | ||||||||||||
General and administrative expense |
2,230 | 2,135 | 6,821 | 5,619 | ||||||||||||
Management fee to affiliate |
4,492 | 4,597 | 13,475 | 13,791 | ||||||||||||
Depreciation and amortization |
73 | 73 | 218 | 218 | ||||||||||||
7,892 | 8,523 | 24,383 | 24,864 | |||||||||||||
Income (loss) from continuing operations |
52,959 | (146,327 | ) | (229,712 | ) | (262,560 | ) | |||||||||
Income (loss) from discontinued operations |
79 | 227 | (96 | ) | (8,724 | ) | ||||||||||
Net Income (Loss) |
53,038 | (146,100 | ) | (229,808 | ) | (271,284 | ) | |||||||||
Preferred dividends |
(3,375 | ) | (3,375 | ) | (10,126 | ) | (10,126 | ) | ||||||||
Income (Loss) Applicable to Common Stockholders |
$ | 49,663 | $ | (149,475 | ) | $ | (239,934 | ) | $ | (281,410 | ) | |||||
Income (Loss) Per Share of Common Stock |
||||||||||||||||
Basic |
$ | 0.94 | $ | (2.83 | ) | $ | (4.54 | ) | $ | (5.33 | ) | |||||
Diluted |
$ | 0.94 | $ | (2.83 | ) | $ | (4.54 | ) | $ | (5.33 | ) | |||||
Income (loss) from continuing operations per share of common stock, after preferred dividends |
||||||||||||||||
Basic |
$ | 0.94 | $ | (2.84 | ) | $ | (4.54 | ) | $ | (5.17 | ) | |||||
Diluted |
$ | 0.94 | $ | (2.84 | ) | $ | (4.54 | ) | $ | (5.17 | ) | |||||
Income (loss) from discontinued operations per share of common stock |
||||||||||||||||
Basic |
$ | | $ | 0.01 | $ | | $ | (0.16 | ) | |||||||
Diluted |
$ | | $ | 0.01 | $ | | $ | (0.16 | ) | |||||||
Weighted Average Number of Shares of Common Stock Outstanding |
||||||||||||||||
Basic |
52,905,335 | 52,788,766 | 52,850,034 | 52,784,048 | ||||||||||||
Diluted |
52,905,335 | 52,788,766 | 52,850,034 | 52,784,048 | ||||||||||||
Dividends Declared per Share of Common Stock |
$ | | $ | 0.25 | $ | | $ | 0.75 | ||||||||
See notes to consolidated financial statements
2
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT) (Unaudited)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2009
(dollars in thousands)
Preferred Stock | Common Stock | Additional Paid-in Capital |
Accumulated Deficit |
Accum. Other Comp. Income (Loss) |
Total Stockholders Equity (Deficit) |
||||||||||||||||||||
Shares | Amount | Shares | Amount | ||||||||||||||||||||||
Stockholders equity (deficit) - December 31, 2008 |
6,100,000 | $ | 152,500 | 52,789,050 | $ | 528 | $ | 1,033,416 | $ | (3,272,403 | ) | $ | (307,573 | ) | $ | (2,393,532 | ) | ||||||||
Issuance of common stock to directors |
| | 116,285 | 1 | 90 | | | 91 | |||||||||||||||||
Reclassification adjustment upon adoption of FSP 115-2 and 124-2 |
| | | | | 1,288,924 | (1,288,924 | ) | | ||||||||||||||||
Comprehensive income: |
|||||||||||||||||||||||||
Net (loss) |
| | | | | (229,808 | ) | | (229,808 | ) | |||||||||||||||
Net unrealized gain on securities |
| | | | | | 229,077 | 229,077 | |||||||||||||||||
Reclassification of net realized loss on securities into earnings |
| | | | | | 431,328 | 431,328 | |||||||||||||||||
Net unrealized gain on derivatives designated as cash flow hedges |
| | | | | | 88,514 | 88,514 | |||||||||||||||||
Reclassification of net realized loss on derivatives designated as cash flow hedges into earnings |
| | | | | | 6,001 | 6,001 | |||||||||||||||||
Total comprehensive income (loss) |
525,112 | ||||||||||||||||||||||||
Stockholders equity (deficit) - September 30, 2009 |
6,100,000 | $ | 152,500 | 52,905,335 | $ | 529 | $ | 1,033,506 | $ | (2,213,287 | ) | $ | (841,577 | ) | $ | (1,868,329 | ) | ||||||||
See notes to consolidated financial statements
3
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(dollars in thousands)
Nine Months Ended September 30, | ||||||||
2009 | 2008 | |||||||
Cash Flows From Operating Activities |
||||||||
Net income (loss) |
$ | (229,808 | ) | $ | (271,284 | ) | ||
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 |
223 | 565 | ||||||
Accretion of discount and other amortization |
(31,153 | ) | (27,543 | ) | ||||
Deferred rent |
| 183 | ||||||
Provision for credit losses on loan pools |
| 6,450 | ||||||
Valuation allowance on loans held for sale |
83,093 | 76,916 | ||||||
Non-cash directors compensation |
91 | 90 | ||||||
(Gain) on sale of investments |
(7,788 | ) | (4,345 | ) | ||||
Unrealized (gain) loss on non-hedge derivatives and hedge ineffectiveness |
(1,946 | ) | 39,456 | |||||
Other-than-temporary impairment on securities |
438,586 | 278,267 | ||||||
Impairment on real estate held for sale |
400 | | ||||||
(Gain) loss on extinguishment of debt |
(186,208 | ) | (13,848 | ) | ||||
Equity in (earnings) losses of unconsolidated subsidiaries |
(281 | ) | (8,189 | ) | ||||
Distributions of earnings from unconsolidated subsidiaries |
281 | 8,189 | ||||||
Change in: |
||||||||
Restricted cash |
897 | 2,374 | ||||||
Receivables and other assets |
6,174 | 16,275 | ||||||
Due to affiliates |
(35 | ) | (6,209 | ) | ||||
Accrued expenses and other liabilities |
(982 | ) | (5,172 | ) | ||||
Net cash provided by (used in) operating activities |
71,544 | 92,175 | ||||||
Cash Flows From Investing Activities |
||||||||
Purchase of real estate securities |
(1,800 | ) | (67,733 | ) | ||||
Proceeds from sale of real estate securities |
135,999 | 1,151,012 | ||||||
Purchase of and advances on loans |
(14,723 | ) | | |||||
Proceeds from settlement of loans |
| 12,636 | ||||||
Repayments of loan and security principal |
72,544 | 276,134 | ||||||
Margin received on derivative instruments |
3,550 | 72,535 | ||||||
Return of margin on derivative instruments |
| (68,969 | ) | |||||
Margin deposits on total rate of return swaps (treated as derivative instruments) |
| (27,389 | ) | |||||
Return of margin deposits on total rate of return swaps (treated as derivative instruments) |
37 | 36,256 | ||||||
Net proceeds (payments) from termination of derivative instruments |
| (37,591 | ) | |||||
Payments on settlement of derivative instruments |
(11,610 | ) | | |||||
Purchase and improvement of operating real estate |
| (603 | ) | |||||
Proceeds from sale of real estate held for sale |
1,350 | 11,226 | ||||||
Distributions of capital from unconsolidated subsidiaries |
109 | 24,035 | ||||||
Change in restricted cash from investment in new CDOs |
| (2,397 | ) | |||||
Net cash provided by (used in) in investing activities |
185,456 | 1,379,152 | ||||||
Continued on Page 5
See notes to consolidated financial statements
4
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(dollars in thousands)
Nine Months Ended September 30, | ||||||||
2009 | 2008 | |||||||
Cash Flows From Financing Activities |
||||||||
Repayments of CDO bonds payable |
(50,696 | ) | (331,228 | ) | ||||
Repayments of other bonds payable |
(65,058 | ) | (151,735 | ) | ||||
Borrowings under repurchase agreements |
| 85,748 | ||||||
Repayments of repurchase agreements |
(198,488 | ) | (1,021,585 | ) | ||||
Return of margin deposits under repurchase agreements |
7,586 | 91,032 | ||||||
Margin deposits under repurchase agreements |
(7,303 | ) | (86,864 | ) | ||||
Dividends paid |
| (74,517 | ) | |||||
Payment of deferred financing costs |
(1,900 | ) | (337 | ) | ||||
Restricted cash returned from refinancing activities |
82,362 | 128,866 | ||||||
Net cash provided by (used in) financing activities |
(233,497 | ) | (1,360,620 | ) | ||||
Net Increase (Decrease) in Cash and Cash Equivalents |
23,503 | 110,707 | ||||||
Cash and Cash Equivalents, Beginning of Period |
49,746 | 55,916 | ||||||
Cash and Cash Equivalents, End of Period |
$ | 73,249 | $ | 166,623 | ||||
Supplemental Disclosure of Cash Flow Information |
||||||||
Cash paid during the period for interest expense |
$ | 124,787 | $ | 209,991 | ||||
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 | ||||
Preferred stock dividends declared but not paid |
$ | | $ | 2,250 |
See notes to consolidated financial statements
5
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(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 debt obligations (CDOs), (ii) investments financed with other non-recourse debt, (iii) investments financed with recourse debt, including FNMA / FHLMC securities, and (iv) unlevered investments.
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 Newcastles 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 Newcastles common stock were held by the Manager, through its affiliates, and the principals of an affiliate of the Manager at September 30, 2009. In addition, the Manager, through its affiliates, held options to purchase approximately 1.7 million shares of Newcastles common stock at September 30, 2009.
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 Newcastles 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 Newcastles consolidated financial statements for the year ended December 31, 2008 and notes thereto included in Newcastles annual report on Form 10-K filed with the Securities and Exchange Commission. Capitalized terms used herein, and not otherwise defined, are defined in Newcastles consolidated financial statements for the year ended December 31, 2008.
Change in Presentation
Newcastle has changed the format of its consolidated statements of operations for all periods presented to be more consistent with the provisions of Article 9 of Regulation S-X. Article 9 of Regulation S-X is applicable to bank holding companies and Newcastle believes that, as a finance company, Article 9s provisions are more closely aligned with its operations than those in Article 5, which applies to commercial and industrial companies. This change in format did not have any effect on any of the reported line items within the statements of operations, or on net income (loss) or net income (loss) per share.
2. INFORMATION REGARDING BUSINESS SEGMENTS
Newcastle conducts its business through four primary segments: (i) investments financed with non-recourse collateralized debt obligations (CDOs), (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 companys structure.
6
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
Summary financial data on Newcastles segments is given below, together with a reconciliation to the same data for Newcastle as a whole:
CDOs (A) | Other Non-Recourse (A) (B) |
Recourse | Unlevered | Unallocated | Total | |||||||||||||||||||
Nine Months Ended September 30, 2009 |
||||||||||||||||||||||||
Interest income |
$ | 221,385 | $ | 58,043 | $ | 6,200 | $ | 1,333 | $ | 72 | $ | 287,033 | ||||||||||||
Interest expense |
107,475 | 50,440 | 3,021 | | 6,218 | 167,154 | ||||||||||||||||||
Net interest income (expense) |
113,910 | 7,603 | 3,179 | 1,333 | (6,146 | ) | 119,879 | |||||||||||||||||
Impairment |
478,631 | (7,876 | ) | 41,365 | 9,559 | | 521,679 | |||||||||||||||||
Other income (loss) |
189,588 | 2,435 | 4,270 | 177 | 1 | 196,471 | ||||||||||||||||||
Depreciation and amortization |
| | | | 218 | 218 | ||||||||||||||||||
Other operating expenses |
1,318 | 2,527 | 30 | 1 | 20,289 | 24,165 | ||||||||||||||||||
Income (loss) from continuing operations |
(176,451 | ) | 15,387 | (33,946 | ) | (8,050 | ) | (26,652 | ) | (229,712 | ) | |||||||||||||
Income (loss) from discontinued operations |
| | | (96 | ) | | (96 | ) | ||||||||||||||||
Net income (loss) |
(176,451 | ) | 15,387 | (33,946 | ) | (8,146 | ) | (26,652 | ) | (229,808 | ) | |||||||||||||
Preferred dividends |
| | | | (10,126 | ) | (10,126 | ) | ||||||||||||||||
Income (loss) applicable to common stockholders |
$ | (176,451 | ) | $ | 15,387 | $ | (33,946 | ) | $ | (8,146 | ) | $ | (36,778 | ) | $ | (239,934 | ) | |||||||
Three Months Ended September 30, 2009 |
||||||||||||||||||||||||
Interest income |
$ | 54,446 | $ | 19,184 | $ | 1,398 | $ | 165 | $ | 29 | $ | 75,222 | ||||||||||||
Interest expense |
33,908 | 15,523 | 833 | | 2,174 | 52,438 | ||||||||||||||||||
Net interest income (expense) |
20,538 | 3,661 | 565 | 165 | (2,145 | ) | 22,784 | |||||||||||||||||
Impairment |
79,455 | (1,319 | ) | 8,894 | 3,772 | | 90,802 | |||||||||||||||||
Other income (loss) |
130,715 | (2,080 | ) | (41 | ) | 275 | | 128,869 | ||||||||||||||||
Depreciation and amortization |
| | | | 73 | 73 | ||||||||||||||||||
Other operating expenses |
436 | 657 | 5 | | 6,721 | 7,819 | ||||||||||||||||||
Income (loss) from continuing operations |
71,362 | 2,243 | (8,375 | ) | (3,332 | ) | (8,939 | ) | 52,959 | |||||||||||||||
Income (loss) from discontinued operations |
| | | 79 | | 79 | ||||||||||||||||||
Net income (loss) |
71,362 | 2,243 | (8,375 | ) | (3,253 | ) | (8,939 | ) | 53,038 | |||||||||||||||
Preferred dividends |
| | | | (3,375 | ) | (3,375 | ) | ||||||||||||||||
Income (loss) applicable to common stockholders |
$ | 71,362 | $ | 2,243 | $ | (8,375 | ) | $ | (3,253 | ) | $ | (12,314 | ) | $ | 49,663 | |||||||||
September 30, 2009 |
||||||||||||||||||||||||
Investments (C) |
$ | 2,332,674 | $ | 725,858 | $ | 83,403 | $ | 6,719 | $ | | $ | 3,148,654 | ||||||||||||
Cash and restricted cash |
137,813 | | 3,160 | 458 | 72,546 | 213,977 | ||||||||||||||||||
Other assets |
35,367 | | 591 | 21 | 297 | 36,276 | ||||||||||||||||||
Debt |
(4,111,136 | ) | (717,558 | ) | (78,039 | ) | | (101,634 | ) | (5,008,367 | ) | |||||||||||||
Derivative liabilities |
(212,745 | ) | (26,916 | ) | (2,917 | ) | | | (242,578 | ) | ||||||||||||||
Other liabilities |
(9,469 | ) | (757 | ) | (458 | ) | (145 | ) | (5,462 | ) | (16,291 | ) | ||||||||||||
Preferred stock |
| | | | (152,500 | ) | (152,500 | ) | ||||||||||||||||
GAAP book value (D) |
$ | (1,827,496 | ) | $ | (19,373 | ) | $ | 5,740 | $ | 7,053 | $ | (186,753 | ) | $ | (2,020,829 | ) | ||||||||
7
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
CDOs (A) | Other Non-Recourse (A) (B) |
Recourse | Unlevered | Unallocated | Total | |||||||||||||||||||
Nine Months Ended September 30, 2008 |
||||||||||||||||||||||||
Interest income |
$ | 232,652 | $ | 67,700 | $ | 39,417 | $ | 19,861 | $ | 1,831 | $ | 361,461 | ||||||||||||
Interest expense |
151,917 | 50,775 | 27,733 | 675 | 5,639 | 236,739 | ||||||||||||||||||
Net interest income (expense) |
80,735 | 16,925 | 11,684 | 19,186 | (3,808 | ) | 124,722 | |||||||||||||||||
Impairment |
268,151 | 7,385 | 11,379 | 65,667 | | 352,582 | ||||||||||||||||||
Other income (loss) |
5,798 | (2,062 | ) | (22,966 | ) | 9,979 | (585 | ) | (9,836 | ) | ||||||||||||||
Depreciation and amortization |
| | | | 218 | 218 | ||||||||||||||||||
Other operating expenses |
1,191 | 3,836 | 33 | 315 | 19,271 | 24,646 | ||||||||||||||||||
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 |
||||||||||||||||||||||||
Interest income |
$ | 75,052 | $ | 21,443 | $ | 11,460 | $ | 4,895 | $ | 699 | $ | 113,549 | ||||||||||||
Interest expense |
47,332 | 16,339 | 7,727 | 373 | 1,880 | 73,651 | ||||||||||||||||||
Net interest income (expense) |
27,720 | 5,104 | 3,733 | 4,522 | (1,181 | ) | 39,898 | |||||||||||||||||
Impairment |
122,729 | 1,725 | 8,947 | 29,554 | | 162,955 | ||||||||||||||||||
Other income (loss) |
2,761 | (1,514 | ) | (17,532 | ) | 1,536 | 2 | (14,747 | ) | |||||||||||||||
Depreciation and amortization |
| | | | 73 | 73 | ||||||||||||||||||
Other operating expenses |
371 | 1,233 | 8 | 211 | 6,627 | 8,450 | ||||||||||||||||||
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 | ) | |||||||
(A) | Assets held within CDOs and other non-recourse structures are not available to satisfy obligations outside of such financings, except to the extent Newcastle receives net cash flow distributions from such structures. Furthermore, economic losses from such structures cannot exceed Newcastles invested equity in them. Therefore, economically their book value cannot be less than zero, except for the amounts described in note (B) below. |
(B) | Includes all of the manufactured housing loan financing, of which $13.3 million (carrying value) was recourse as of September 30, 2009. |
(C) | Investments in the unlevered segment include $2.9 million of real estate securities, $3.6 million of a real estate related loan and $0.2 million of interests in a joint venture at September 30, 2009. The real estate related loan was pledged as collateral for the junior subordinated notes and will be released at the end of the interest rate modification period. |
(D) | Newcastle cannot economically lose more than its investment amount in any given non-recourse financing structure. Therefore, impairment recorded in excess of such investment, which results in negative GAAP book value for a given non-recourse financing structure, cannot economically be incurred and will eventually be reversed through amortization, sales at gains, or as gains at the deconsolidation or termination of such non-recourse financing structure. For non-recourse financing structures with negative GAAP book value, except as noted in (B) above, the aggregate negative GAAP book value which will eventually be recorded as income is $1.0 billion as of September 30, 2009. |
8
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(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:
Real Estate Loan | ||||
Balance at December 31, 2008 |
$ | 283 | ||
Distributions from unconsolidated subsidiaries |
(390 | ) | ||
Equity in earnings of unconsolidated subsidiaries |
280 | |||
Balance at September 30, 2009 |
$ | 173 | ||
Gain (Loss) on Settlement of Investments, Net and Other Income (Loss), Net
These items are comprised of the following:
Nine Months Ended September 30, | ||||||||
2009 | 2008 | |||||||
Gain (loss) on settlement of investments, net |
||||||||
Gain on sale of real estate securities |
$ | 25,774 | $ | 6,459 | ||||
Loss on sale of real estate securities |
(18,413 | ) | (2,245 | ) | ||||
Loss on repayment of real estate securities |
(103 | ) | | |||||
Gain on disposition of loans held for sale |
526 | 1,434 | ||||||
Loss on disposition of loans held for sale |
| (1,303 | ) | |||||
Realized gain (loss) on termination of derivative instruments |
4 | (425 | ) | |||||
$ | 7,788 | $ | 3,920 | |||||
Other income (loss), net |
||||||||
Realized (loss) on total rate of return swaps |
$ | | $ | (7,145 | ) | |||
Unrealized (loss) on total rate of return swaps |
| (13,210 | ) | |||||
Gain (loss) on non-hedge derivative instruments |
11,232 | (17,906 | ) | |||||
Unrealized (loss) recognized at de-designation of hedges |
(8,797 | ) | (990 | ) | ||||
Hedge ineffectiveness |
(489 | ) | 218 | |||||
Other income (loss) |
247 | 3,240 | ||||||
$ | 2,193 | $ | (35,793 | ) | ||||
9
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
3. REAL ESTATE SECURITIES
The following is a summary of Newcastles real estate securities at September 30, 2009, all of which are classified as available for sale and are therefore reported at fair value with changes in fair value recorded in other comprehensive income, except for securities that are other-than-temporarily impaired.
Amortized Cost Basis | Weighted Average | ||||||||||||||||||||||||||||||||||
Outstanding Face Amount |
Before Impairment |
Other-Than- Temporary Impairment (A) |
After Impairment |
Gross Unrealized | Carrying Value (B) | Number of Securities |
Rating (C) | Coupon | Yield | Maturity (Years) | |||||||||||||||||||||||||
Asset Type |
Gains | Losses | |||||||||||||||||||||||||||||||||
CMBS-Conduit |
$ | 1,673,905 | $ | 1,491,313 | $ | (621,310 | ) | $ | 870,003 | $ | 46,136 | $ | (336,183 | ) | $ | 579,956 | 205 | BBB- | 5.77 | % | 7.95 | % | 3.6 | ||||||||||||
CMBS- Single Borrower |
609,954 | 593,857 | (47,088 | ) | 546,769 | 1,007 | (198,333 | ) | 349,443 | 67 | BB- | 4.24 | % | 5.38 | % | 2.4 | |||||||||||||||||||
CMBS-Large Loan |
89,225 | 89,213 | (2,087 | ) | 87,126 | | (49,799 | ) | 37,327 | 12 | B+ | 2.03 | % | 2.02 | % | 1.9 | |||||||||||||||||||
CMBS- CDO |
16,000 | 14,731 | (14,731 | ) | | | | | 1 | C | 10.13 | % | 0.00 | % | | ||||||||||||||||||||
REIT Debt |
561,270 | 559,784 | (8,285 | ) | 551,499 | 12,578 | (53,543 | ) | 510,534 | 61 | BB | 6.10 | % | 6.01 | % | 4.3 | |||||||||||||||||||
ABS-Subprime |
482,817 | 444,991 | (238,903 | ) | 206,088 | 5,873 | (40,620 | ) | 171,341 | 104 | B | 1.40 | % | 10.65 | % | 3.8 | |||||||||||||||||||
ABS-Manufactured Housing |
51,753 | 50,229 | | 50,229 | 559 | (7,159 | ) | 43,629 | 9 | BBB | 6.69 | % | 7.23 | % | 5.6 | ||||||||||||||||||||
ABS-Franchise |
35,626 | 36,053 | (18,682 | ) | 17,371 | 54 | (4,764 | ) | 12,661 | 17 | BB+ | 3.86 | % | 4.04 | % | 3.0 | |||||||||||||||||||
FNMA/FHLMC (D) |
47,848 | 49,482 | | 49,482 | 2,111 | | 51,593 | 3 | AAA | 5.83 | % | 5.53 | % | 3.9 | |||||||||||||||||||||
Subtotal/Average (E) |
3,568,398 | 3,329,653 | (951,086 | ) | 2,378,567 | 68,318 | (690,401 | ) | 1,756,484 | 479 | BB | 4.89 | % | 6.83 | % | 3.5 | |||||||||||||||||||
Retained Securities (F) |
66,213 | 65,998 | (63,108 | ) | 2,890 | | (918 | ) | 1,972 | 6 | C | 2.26 | % | 12.05 | % | 1.8 | |||||||||||||||||||
Residual Interest (F) |
133 | 29,412 | (29,279 | ) | 133 | | | 133 | 1 | NR | 0.00 | % | 30.00 | % | | ||||||||||||||||||||
Debt Security Total/Average |
$ | 3,634,744 | 3,425,063 | (1,043,473 | ) | 2,381,590 | 68,318 | (691,319 | ) | 1,758,589 | 486 | BB | 4.84 | % | 6.84 | % | 3.5 | ||||||||||||||||||
Equity Securities |
1,388 | | 1,388 | 1,478 | (246 | ) | 2,620 | 2 | |||||||||||||||||||||||||||
Total |
$ | 3,426,451 | $ | (1,043,473 | ) | $ | 2,382,978 | $ | 69,796 | $ | (691,565 | ) | $ | 1,761,209 | 488 | ||||||||||||||||||||
(A) | Represents the cumulative impairment against amortized cost basis recorded through earnings, net of the effect of the cumulative adjustment as a result of the adoption of FSP 115-2 and 124-2 (see below). |
(B) | See Note 6 regarding the estimation of fair value, which is equal to carrying value for all securities. |
(C) | Represents the weighted average of the ratings of all securities in each asset type, expressed as an S&P equivalent rating. For each security rated by multiple rating agencies, the lowest rating is used. FNMA/FHLMC securities have an implied AAA rating. Ratings provided were determined by third party rating agencies as of a particular date, may not be current and are subject to change (including the assignment of a negative watch) at any time. |
(D) | Amortized cost basis and carrying value include principal receivable of $1.1 million. |
(E) | The total outstanding face amount of fixed rate securities was $2.6 billion, and of floating rate securities was $1.0 billion. |
(F) | Represents the retained bonds and equity from Securitization Trust 2006 and Securitization Trust 2007 (Note 4). The residuals do not have stated coupons and therefore their coupons have been treated as zero for purposes of the table. |
10
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
Unrealized losses that are considered other-than-temporary are recognized currently in income. During the nine months ended September 30, 2009, Newcastle recorded other-than-temporary impairment charges of $526.7 million (gross of $88.1 million of the portion of other-than-temporary impairment recognized in other comprehensive income) with respect to real estate securities. Based on managements analysis of these securities, the performance of the underlying loans and changes in market factors, Newcastle noted adverse changes in the expected cash flows on certain of these securities and concluded that they were other-than-temporarily impaired in accordance with FSP FAS 115-2 and 124-2 (see below). The remaining unrealized losses on Newcastles securities are primarily the result of market factors. Pursuant to the FSP, these noncredit unrealized losses are recognized in accumulated other comprehensive income.
Amortized Cost Basis | Gross Unrealized | Weighted Average | |||||||||||||||||||||||||||||||||
Securities in |
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 |
$ | 307,923 | $ | 316,454 | $ | (229,467 | ) | $ | 86,987 | $ | | $ | (16,015 | ) | 70,972 | 79 | B | 3.19 | % | 7.70 | % | 2.9 | |||||||||||||
Twelve or More Months |
2,398,735 | 2,306,606 | (493,030 | ) | 1,813,576 | | (675,550 | ) | 1,138,026 | 304 | BB | 4.97 | % | 5.67 | % | 3.6 | |||||||||||||||||||
Total |
$ | 2,706,658 | $ | 2,623,060 | $ | (722,497 | ) | $ | 1,900,563 | $ | | $ | (691,565 | ) | $ | 1,208,998 | 383 | BB | 4.77 | % | 5.77 | % | 3.5 | ||||||||||||
In April 2009, the FASB issued FSP FAS 115-2 and 124-2 Recognition and Presentation of Other-Than-Temporary Impairments. With the release of the FASBs Accounting Standards Codification (ASC), the guidance in the FSP has been incorporated primarily within the ASC 320, Investments Debt and Equity Securities; ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality and ASC 325-40, Beneficial Interests in Securitized Financial Assets. The FSP changes the guidance for determining, recording and disclosing other-than-temporary impairment (OTTI). This guidance applies to debt securities in an unrealized loss position (i.e. their fair value is less than their amortized cost basis) as follows:
Old Guidance |
Current Guidance | |
Must express an intent and ability to hold securities until an expected recovery in value to amortized cost basis, or else record OTTI for the difference between fair value and amortized cost.
If no recovery to amortized cost basis is expected, must record OTTI in the same amount. |
Must not have the intent to sell a security nor be in a position where a required sale is more likely than not, or else record OTTI for the difference between fair value and amortized cost.
Otherwise, must record OTTI relating to the portion of the unrealized loss which represents a credit loss, if any. |
Newcastle performed an assessment of all of its debt securities that are in an unrealized loss position (unrealized loss position exists when a securitys amortized cost basis, excluding the effect of other than temporary impartment, exceeds its fair value) in accordance with the guidance of FSP FAS 115-2 and 124-2 and determined the following:
September 30, 2009 | |||||||||||||
Fair Value | Amortized Cost Basis |
Unrealized Losses | |||||||||||
Credit (B) | Non-Credit (C) | ||||||||||||
Securities Newcastle intends to sell |
$ | | $ | | $ | | N/A | ||||||
Securities Newcastle is more likely than not to be required to sell (A) |
| | | N/A | |||||||||
Securities Newcastle has no intent to sell and is not more likely than not to be required to sell: |
|||||||||||||
Credit impaired securities |
160,513 | 252,654 | (722,497 | ) | (92,141 | ) | |||||||
Non credit impaired securities |
1,048,455 | 1,647,634 | | (599,178 | ) | ||||||||
Total debt securities in an unrealized loss position |
1,208,968 | 1,900,288 | (722,497 | ) | (691,319 | ) | |||||||
(A) | Newcastle may, at times, be more likely than not to be required to sell certain securities for liquidity purposes. While the amount of the securities to be sold may be an estimate, and the securities to be sold have not yet been identified, this FSP requires Newcastle to make its best estimate, which is subject to significant judgment regarding future events, and may differ materially from actual future sales. |
(B) | Excluding the effect of previously recorded other-than-temporary impairment, which must be reconsidered as a result of this FSP. This amount is required to be recorded as other-than-temporary impairment through the income statement. Of this amount, $624.8 million relates to prior periods (and was recorded as part of the reclassification adjustment upon adoption, as described below) and $97.7 million relates to the three months ended September 30, 2009. In measuring the portion of credit losses, Newcastles management estimates the expected cash flow for each of the securities. This evaluation includes a review of the credit status and the performance of the collateral supporting those securities, including the credit of the issuer, key terms of the securities and the effect of local, industry and broader economic trends. Significant inputs in estimating the cash flows include managements expectations of prepayment speeds, default rates and loss severities. Credit losses are measured as the decline in the present value of the expected future cash flows discounted at the investments effective interest rate. |
(C) | This amount represents unrealized losses on securities that are due to non-credit factors and is required to be recorded through other comprehensive income. |
11
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
As a result of this reassessment, Newcastle has recorded a reclassification adjustment upon adoption of FSP 115-2 and 124-2 of $1.3 billion of loss from Accumulated Deficit to Accumulated Other Comprehensive Income (Loss). The reclassification adjustment had no impact on total consolidated assets, liabilities or equity and did not impact Newcastles liquidity. This represents a substantive reversal of a large portion of the impairment charge recorded in the fourth quarter of 2008, which was originally recorded as a result of Newcastles inability to express the intent and ability to hold its securities until an expected recovery in value (if any).
The following table summarizes the activity related to credit losses on debt securities for the period from adoption of FSP 115-2 and 124-2 through September 30, 2009:
Beginning balance of credit losses on debt securities for which a portion of an other-than- temporary impairment was recognized in other comprehensive income |
$ | (363,125 | ) | |
Additions for credit losses on securities for which an OTTI was not previously recognized |
(121,465 | ) | ||
Increases to credit losses on securities for which an OTTI was previously recognized and a portion of an other-than-temporary impairment was recognized in other comprehensive income |
(88,702 | ) | ||
Additions for credit losses on securities for which an OTTI was previously recognized without any portion of other-than-temporary impairment recognized in other comprehensive income |
(273,239 | ) | ||
Reduction for credit losses on securities for which no other-than-temporary impairment was recognized in other comprehensive income at September 30, 2009 |
120,260 | |||
Reduction for securities sold during the period |
3,774 | |||
Reduction for increases in cash flows expected to be collected that are recognized over the remaining life of the security |
13,175 | |||
Ending balance of credit losses on debt securities for which a portion of an other-than- temporary impairment was recognized in other comprehensive income |
$ | (709,322 | ) | |
In January 2009, the FASB issued FSP EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20. This FSP (codified primarily in ASC 325-40, Beneficial Interests in Securitized Financial Assets) amends previous guidance to achieve more consistent determination of whether an other-than-temporary impairment has occurred, with the same objective as ASC 320, Investments Debt and Equity Securities. In particular, it changed a requirement to analyze a securitys estimated cash flows from a market participants perspective to an analysis from the perspective of the holder. The adoption of EITF 99-20-1 did not have a material impact on Newcastles impairment analysis for the nine months ended September 30, 2009 because Newcastle generally analyzes cash flows of securities in a manner consistent with market practice.
The table below summarizes the geographic distribution of the collateral securing our CMBS at September 30, 2009 (in thousands):
Geographic Location |
Outstanding Face Amount | Percentage | ||||
Western U.S. |
$ | 597,007 | 25.0 | % | ||
Northeastern U.S. |
563,625 | 23.6 | % | |||
Southeastern U.S. |
464,788 | 19.5 | % | |||
Midwestern U.S. |
313,508 | 13.1 | % | |||
Southwestern U.S. |
259,985 | 10.9 | % | |||
Other |
168,268 | 7.0 | % | |||
Foreign |
21,903 | 0.9 | % | |||
$ | 2,389,084 | 100.0 | % | |||
Geographic concentrations of investments expose Newcastle to the risk of economic downturns within the relevant regions, particularly given the current unfavorable market conditions. These market conditions may make regions more vulnerable to downturns in certain market factors. Any such downturn in a region where Newcastle holds significant investments could have a material, negative impact on Newcastle.
12
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
4. REAL ESTATE RELATED LOANS HELD FOR SALE, RESIDENTIAL MORTGAGE LOANS HELD FOR SALE AND SUBPRIME MORTGAGE LOANS
The following is a summary of real estate related loans held for sale, residential mortgage loans held for sale and subprime mortgage loans at September 30, 2009. 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 |
$ | 753,902 | $ | 276,196 | 23 | 52.86 | % | 1.7 | 86.9 | % | $ | 44,942 | |||||||
Corporate Bank Loans |
340,804 | 198,198 | 10 | 25.90 | % | 2.6 | 100.0 | % | 49,997 | ||||||||||
B-Notes |
308,085 | 73,599 | 11 | 44.37 | % | 1.6 | 84.2 | % | 131,592 | ||||||||||
Whole Loans |
97,680 | 58,511 | 4 | 18.94 | % | 1.9 | 97.6 | % | | ||||||||||
Total Real Estate Related Loans Held for Sale, Net |
$ | 1,500,471 | $ | 606,504 | 48 | 39.75 | % | 1.9 | 90.0 | % | $ | 226,531 | |||||||
Residential Loans |
$ | 71,293 | $ | 44,794 | 246 | 13.65 | % | 5.9 | 100.0 | % | $ | 7,151 | |||||||
Manufactured Housing Loans |
427,813 | 324,145 | 12,710 | 13.42 | % | 7.0 | 11.0 | % | 6,454 | ||||||||||
Total Residential Mortgage Loans Held for Sale, Net (C) |
$ | 499,106 | $ | 368,939 | 12,956 | 13.45 | % | 6.8 | 23.7 | % | $ | 13,605 | |||||||
Subprime Mortgage Loans Subject to Call Option |
$ | 406,217 | $ | 401,713 | |||||||||||||||
(A) | The weighted average maturities were calculated based on constant prepayment rates (CPR) of 7% and 30% for the residential loan pools, and 4% and 6% for the manufactured housing loan pools. |
(B) | Includes loans that are non-performing, in foreclosure, considered real estate owned and real estate related loans under bankruptcy filing. |
(C) | Carrying value includes interest receivable of $0.2 million for the residential housing loans and principal and interest receivable of $8.1 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, 2008 |
$ | (827,328 | ) | $ | (136,206 | ) | ||
Charge-offs |
48,348 | 8,534 | ||||||
Recoveries |
| | ||||||
Valuation (allowance) reversal on loans held for sale |
(85,773 | ) | 2,682 | |||||
Balance at September 30, 2009 |
$ | (864,753 | ) | $ | (124,990 | ) | ||
The charge-offs of $48.3 million for the nine months ended September 30, 2009 represent five bank loans and one B-note which were sold or converted to equity interests during the period.
Securitization of Subprime Mortgage Loans
The following table presents information on the retained interests in Newcastles securitizations of subprime mortgage loans and the sensitivity of their fair value for immediate 10% and 20% adverse changes in the assumptions utilized in calculating such fair value, at September 30, 2009:
Subprime Portfolio | ||||||||
I | II | |||||||
Total securitized loans (unpaid principal balance) (A) |
$ | 607,665 | $ | 817,634 | ||||
Loans subject to call option (carrying value) |
$ | 298,059 | $ | 103,654 | ||||
Retained interests (fair value) (B) |
$ | 1,235 | $ | 870 | ||||
Weighted average life (years) of residual interest |
| 0.2 | ||||||
Weighted average expected credit losses (C) |
24.7 | % | 46.7 | % | ||||
Effect on fair value of retained interests of 10% adverse change |
$ | (126 | ) | $ | (127 | ) | ||
Effect on fair value of retained interests of 20% adverse change |
$ | (266 | ) | $ | (223 | ) | ||
Weighted average constant prepayment rate (D) |
9.8 | % | 3.8 | % | ||||
Effect on fair value of retained interests of 10% adverse change |
$ | (21 | ) | $ | (18 | ) | ||
Effect on fair value of retained interests of 20% adverse change |
$ | (34 | ) | $ | (34 | ) | ||
Weighted average discount rate |
19.6 | % | 24.3 | % | ||||
Effect on fair value of retained interests of 10% adverse change |
$ | (111 | ) | $ | (9 | ) | ||
Effect on fair value of retained interests of 20% adverse change |
$ | (201 | ) | $ | (17 | ) |
13
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
(A) | Average loan seasoning of 50 months and 32 months for Subprime Portfolios I and II, respectively, at September 30, 2009. |
(B) | The retained interests include residual interests and retained bonds of the securitizations. Their fair value is estimated based on pricing models. |
(C) | Represents the percentage of losses on the original principal balance of the loans from the date of the respective securitizations (April 2006 and July 2007) to the maturity of the loans. |
(D) | Represents the weighted average voluntary prepayment rate for the loans from the date of the respective securitizations (April 2006 and July 2007) to the maturity of the 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, and related financing, in the securitizations as of September 30, 2009:
Subprime Portfolio | ||||||||
I | II | |||||||
Loan unpaid principal balance (UPB) |
$ | 607,665 | $ | 817,634 | ||||
Weighted average coupon rate of loans |
7.11 | % | 6.96 | % | ||||
Delinquencies of 60 or more days (UPB) (A) |
$ | 135,984 | $ | 240,517 | ||||
Net credit losses for the nine months ended September 30, 2009 |
$ | 69,646 | $ | 64,524 | ||||
Cumulative net credit losses |
$ | 114,490 | $ | 84,488 | ||||
Cumulative net credit losses as a % of original UPB |
7.62 | % | 7.77 | % | ||||
Percentage of ARM loans (B) |
54.3 | % | 67.0 | % | ||||
Percentage of loans with loan-to-value ratio >90% |
10.60 | % | 17.30 | % | ||||
Percentage of interest-only loans |
24.0 | % | 4.3 | % | ||||
Face amount of debt (C) |
$ | 580,277 | $ | 759,592 | ||||
Weighted average funding cost of debt (D) |
1.71 | % | 2.48 | % |
(A) | Delinquencies include loans 60 or more days past due, in foreclosure, or real estate owned. |
(B) | ARM loans are adjustable-rate mortgage loans. An option ARM is an adjustable-rate mortgage that provides the borrower with an option to choose from several payment amounts each month for a specified period of the loan term. None of the loans in the subprime portfolios are an option ARM. |
(C) | Excludes face amount of $27.4 million and $38.8 million of retained notes for Subprime Portfolios I and II, respectively, at September 30, 2009. |
(D) | Includes the effect of applicable hedges. |
Newcastle received net cash inflows of $0.7 million and $1.1 million from the retained interests of Subprime Portfolios I and II, respectively, during the nine months ended September 30, 2009.
The weighted average yields of the retained notes of Subprime Portfolios I and II were 9.33% and 20.0%, respectively, as of September 30, 2009. 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.
14
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
5. DEBT OBLIGATIONS
The following table presents certain information regarding Newcastles debt obligations and related hedges at September 30, 2009:
Collateral | |||||||||||||||||||||||||||||||||||||||
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 |
Outstanding Face Amount (C) |
Amortized Cost Basis (C) |
Carrying Value (C) |
Weighted Average Maturity (Years) |
Floating Rate Face Amount (C) |
Aggregate Notional Amount of Current Hedges | |||||||||||||||||||||||||
CDO Bonds Payable |
|||||||||||||||||||||||||||||||||||||||
CDO IV (D) |
Mar 2004 | $ | 376,883 | $ | 375,386 | 1.19% | Mar 2039 | 2.96 | % | 3.0 | $ | 353,501 | $ | 422,860 | $ | 361,331 | $ | 235,115 | 3.6 | $ | 179,527 | $ | 177,300 | ||||||||||||||||
CDO V |
Sep 2004 | 454,500 | 452,575 | 0.97% | Sep 2039 | 2.88 | % | 3.5 | 442,500 | 512,177 | 399,975 | 249,096 | 3.6 | 221,861 | 208,508 | ||||||||||||||||||||||||
CDO VI (D) |
Apr 2005 | 438,772 | 437,105 | 0.75% | Apr 2040 | 3.29 | % | 4.2 | 431,111 | 483,916 | 306,748 | 204,072 | 3.8 | 161,556 | 241,922 | ||||||||||||||||||||||||
CDO VII (D) |
Dec 2005 | 413,106 | 410,481 | 0.74% | Dec 2050 | 4.17 | % | 5.9 | 406,700 | 494,990 | 212,065 | 144,970 | 3.8 | 95,474 | 298,355 | ||||||||||||||||||||||||
CDO VIII |
Nov 2006 | 729,313 | 728,534 | 0.94% | Nov 2052 | 1.99 | % | 4.1 | 721,713 | 828,566 | 415,451 | 409,597 | 2.9 | 575,536 | 161,655 | ||||||||||||||||||||||||
CDO IX |
May 2007 | 532,125 | 532,869 | 0.78% | May 2052 | 1.59 | % | 5.1 | 532,125 | 821,217 | 389,512 | 391,426 | 1.9 | 636,737 | 91,795 | ||||||||||||||||||||||||
CDO X |
Jul 2007 | 1,175,000 | 1,174,186 | 0.37% | Jul 2052 | 4.53 | % | 5.3 | 1,175,000 | 1,380,524 | 1,023,928 | 850,820 | 3.5 | 329,399 | 945,813 | ||||||||||||||||||||||||
4,119,699 | 4,111,136 | 3.21 | % | 4.6 | 4,062,650 | 4,944,250 | 3,109,010 | 2,485,096 | 3.2 | 2,200,090 | 2,125,348 | ||||||||||||||||||||||||||||
Other Bonds Payable |
|||||||||||||||||||||||||||||||||||||||
MH loans (E) |
Jan 2006 | 112,465 | 112,465 | LIBOR+0.75% | Jan 2009 | (E) | 5.03 | % | | 112,465 | 175,377 | 118,846 | 118,846 | 8.0 | 2,380 | | |||||||||||||||||||||||
MH loans (F) |
Aug 2006 | 204,237 | 203,380 | LIBOR+1.00% | Aug 2011 | 6.40 | % | 1.7 | 204,237 | 252,436 | 205,298 | 205,298 | 6.3 | 44,607 | | ||||||||||||||||||||||||
316,702 | 315,845 | 5.91 | % | 1.1 | 316,702 | 427,813 | 324,144 | 324,144 | 7.0 | 46,987 | | ||||||||||||||||||||||||||||
Repurchase Agreements (G) |
|||||||||||||||||||||||||||||||||||||||
RE securities, loans and properties |
Various | 36,420 | 36,420 | LIBOR+2.26% | Various | 2.50 | % | 0.6 | 36,420 | 178,485 | 37,747 | 37,747 | 0.7 | 164,602 | | ||||||||||||||||||||||||
FNMA/FHLMC securities |
Rolling | 41,619 | 41,619 | LIBOR+0.16% | Oct 2009 | 5.03 | % | 0.1 | 41,619 | 42,163 | 43,381 | 45,462 | 3.9 | | 38,766 | ||||||||||||||||||||||||
78,039 | 78,039 | 3.85 | % | 0.3 | 78,039 | 220,648 | 81,128 | 83,209 | 1.3 | 164,602 | 38,766 | ||||||||||||||||||||||||||||
Corporate |
|||||||||||||||||||||||||||||||||||||||
Junior subordinated notes payable (H) |
Mar 2006 | 101,700 | 101,634 | 1.00%(H) | Apr 2035 | 7.28 | % | 26.4 | | | | | | | | ||||||||||||||||||||||||
101,700 | 101,634 | 7.28 | % | 26.4 | | | | | | | | ||||||||||||||||||||||||||||
Subtotal debt obligations |
4,616,140 | 4,606,654 | 3.49 | % | 4.8 | $ | 4,457,391 | $ | 5,592,711 | $ | 3,514,282 | $ | 2,892,449 | 3.4 | $ | 2,411,679 | $ | 2,164,114 | |||||||||||||||||||||
Financing on subprime mortgage loans subject to call option |
(I | ) | 406,217 | 401,713 | |||||||||||||||||||||||||||||||||||
Total debt obligations |
$ | 5,022,357 | $ | 5,008,367 | |||||||||||||||||||||||||||||||||||
(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 for reinvestments in CDOs. The face amount and carrying value of Newcastles unlevered investments (real estate loans and securities) were $181.3 million and $6.7 million, respectively, as of September 30, 2009. |
(D) | CDOs IV, VI and VII were not in compliance with their applicable over collateralization tests as of September 30, 2009. Newcastle is not receiving cash flows from these CDOs (other than senior management fees) and expects these CDOs to remain out of compliance for the foreseeable future. |
(E) | See further description below. |
(F) | Of which $13.4 million face amount is recourse financing. |
(G) | The counterparties on these repurchase agreements include: Goldman Sachs ($41.6 million of FNMA/FHLMC financing), Deutsche Bank ($16.4 million) and Citigroup ($20.0 million). The non-FNMA/FHLMC financings are subject to scheduled repayments, with the final payment to be made in June 2010. |
(H) | In April 2009, Newcastle entered into an exchange agreement with the holder of the trust preferred securities under which Newcastle will effectively be accruing interest at a rate of 1.0% per annum beginning February 1, 2009 for a maximum of six quarters, after which the rate reverts to 7.574% through April 2016 and to LIBOR + 2.25% after April 2016. Pursuant to the exchange, a real estate loan, which was valued at $3.6 million on September 30, 2009, was pledged as collateral for the junior subordinated notes and will be released at the end of the interest rate modification period. For details, see Note 9 below. |
(I) | Issued in April 2006 and July 2007. See Note 4 regarding the securitizations of Subprime Portfolios I and II. |
15
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
In the first quarter of 2009, Newcastle repurchased $30.3 million face amount of three classes of CDO bonds for $3.2 million. As a result, Newcastle extinguished $30.3 million face amount of CDO debt and recorded a gain on extinguishment of debt of $26.9 million in the first quarter of 2009.
In January 2009, the debt for one of Newcastles manufactured housing loan portfolios ($112.5 million outstanding at September 30, 2009) became callable at the option of the lender. The principal and interest payments from the underlying loans, net of expenses and payments related to interest rate swap contracts, are used to repay the outstanding debt on a monthly basis.
In February 2009, Newcastle renegotiated the terms of a recourse loan agreement financing one of its manufactured housing loan portfolios. Under the amended terms of the agreement, certain debt covenants relating to equity requirements were removed.
In February 2009, Newcastle renegotiated the terms of a repurchase agreement financing its investment in a real estate related loan. Under the amended terms of the repurchase agreement, certain debt covenants relating to a concentration limit and equity requirements, as well as the mark-to-market (margin posting) requirement were removed.
In March 2009, Newcastle renegotiated the terms of a repurchase agreement financing its investment in a real estate related loan. Under the amended terms of the repurchase agreement, the mark-to-market (margin posting) provisions and certain financial covenants relating to net worth and leverage ratio were removed. Newcastle also agreed not to enter into any new debt financings subject to margin calls other than to finance FNMA/FHLMC securities.
In April 2009, Newcastle repurchased $29.5 million face amount of two classes of CDO bonds for $2.4 million. As a result, Newcastle extinguished $29.5 million face amount of CDO debt and recorded a gain on extinguishment of debt of $26.8 million in the second quarter of 2009.
On April 30, 2009, Newcastle entered into an exchange agreement with several collateralized debt obligations managed by a third party pursuant to which Newcastle agreed to exchange newly issued junior subordinated notes due in 2035 with an initial aggregate principal amount of $101.7 million (the Notes) for $100 million in aggregate liquidation amount of trust preferred securities that were previously issued by a subsidiary of Newcastle (the TRUPs) and were owned by the third party. The Notes accrue interest at a rate of 1.0% per year for a maximum of six quarters, beginning on February 1, 2009 and the aggregate principal amount of the Notes will increase to $104.9 million by July 30, 2010. Subsequent to that period, the rate reverts to that which Newcastle was required to pay on the TRUPs (7.574% through April 2016 and at a floating rate of 3-month LIBOR plus 2.25% thereafter). In conjunction with the exchange, the TRUPs were cancelled and Newcastle pledged 100% of its equity interests in NIC TP LLC, a special purpose subsidiary that holds Newcastles participation in a loan and related deposit account, which were valued at $3.6 million on September 30, 2009, as collateral. The pledged collateral will be released at the end of the interest rate modification period. Under the provisions of ASC 470-60, Troubled Debt Restructurings by Debtors, this exchange is considered a troubled debt restructuring which requires Newcastle to account for the effect of the interest modification prospectively and to record the expenses related to the modification immediately through earnings.
In September 2009, Newcastle repurchased $150.1 million face amount of six classes of CDO bonds for $16.7 million. As a result, Newcastle extinguished $150.1 million face amount of CDO debt and recorded a gain on extinguishment of debt of $132.5 million in the third quarter of 2009.
16
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
6. FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair Value Summary Table
Newcastle held the following financial instruments at September 30, 2009:
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* |
$ | 3,634,744 | $ | 1,761,209 | $ | 1,761,209 | Broker quotations, counterparty quotations, pricing services, pricing models | 6.84 | % | 3.5 | |||||||
Real estate related loans held for sale* |
1,500,471 | 606,504 | 606,504 | Broker quotations, counterparty quotations, pricing services, pricing models | 39.75 | % | 1.9 | ||||||||||
Residential mortgage loans held for sale* |
499,106 | 368,939 | 368,939 | Pricing models | 13.45 | % | 6.8 | ||||||||||
Subprime mortgage loans subject to call option (B) |
406,217 | 401,713 | 401,713 | (B) | 9.09 | % | (B | ) | |||||||||
Liabilities: |
|||||||||||||||||
CDO bonds payable |
$ | 4,119,699 | $ | 4,111,136 | $ | 821,284 | Counterparty quotations, pricing models | 3.21 | % | 4.6 | |||||||
Other bonds payable |
316,702 | 315,845 | 243,595 | Pricing models | 5.91 | % | 1.1 | ||||||||||
Repurchase agreements |
78,039 | 78,039 | 78,039 | Market comparables | 3.85 | % | 0.3 | ||||||||||
Financing of subprime mortgage loans subject to call option (B) |
406,217 | 401,713 | 401,713 | (B) | 9.09 | % | (B | ) | |||||||||
Junior subordinated notes payable |
101,700 | 101,634 | 28,956 | Pricing models | 7.28 | % | 26.4 | ||||||||||
Interest rate swaps, treated as hedges (C)(E)* |
2,164,114 | 215,662 | 215,662 | Counterparty quotations | N/A | (C | ) | ||||||||||
Non-hedge derivatives (D)(E)* |
256,765 | 26,916 | 26,916 | Counterparty quotations | N/A | (D | ) |
* | Measured at fair value on a recurring basis. |
(A) | Methods are listed in order of priority. In the case of real estate securities and real estate related loans, broker quotations are obtained if available and practicable, otherwise counterparty quotations or pricing service valuations are obtained or, finally, internal pricing models are used. Internal pricing models are only used for (i) securities and loans 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 Newcastles 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 | $ | 110,566 | 5.003 | % | $ | (8,498 | ) | ||||
2012 |
July | 19,995 | 5.388 | % | (1,666 | ) | ||||||
2014 |
October | 16,567 | 5.092 | % | (1,882 | ) | ||||||
2015 |
September | 1,276,989 | 5.254 | % | (129,761 | ) | ||||||
2016 |
May | 180,155 | 5.043 | % | (20,955 | ) | ||||||
2017 |
August | 174,034 | 5.235 | % | (25,735 | ) | ||||||
Agreements which receive 3-Month LIBOR: |
||||||||||||
2011 |
February | 32,000 | 5.078 | % | (1,870 | ) | ||||||
2014 |
June | 353,808 | 4.196 | % | (25,295 | ) | ||||||
$ | 2,164,114 | $ | (215,662 | ) | ||||||||
(D) | These include three interest rate swaps with a total notional balance of $256.8 million. The maturity dates of the $97.9 million, $1.8 million and $157.1 million interest rate swaps are January 2016, January 2016 and June 2016, respectively. Newcastle entered into these swap agreements to reduce its exposure to interest rate changes on the floating rate financings of its manufactured housing loan portfolios. These swaps were dedesignated as hedges for hedge accounting purposes. |
17
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
(E) | Newcastles derivatives fall into two categories. Derivatives held within Newcastles nonrecourse debt structures (primarily CDOs) with an aggregate notional balance of $2.4 billion, all of which were liabilities at period end, are not subject to Newcastles credit risk as they are senior to all the debt obligations of the related structure. Derivatives held outside Newcastles nonrecourse debt structures with an aggregate notional balance of $70.8 million are primarily 100% collateralized by margin (based on their current fair value) and therefore are not subject to Newcastles or its counterpartys credit risk. As a result, no adjustments have been made to the fair value quotations received related to credit risk. Newcastles significant derivative counterparties include Bank of America, Deutsche Bank, Wachovia and Credit Suisse. |
Securities Valuation
As of September 30, 2009, Newcastles securities valuation methodology and results are further detailed as follows:
Fair Value | ||||||||||||||||||
Asset Type |
Outstanding Face Amount (A) |
Amortized Cost Basis (B) |
Multiple Quotes (C) |
Single Quote (D) |
Internal Pricing Models (E) |
Total | ||||||||||||
CMBS |
$ | 2,389,084 | $ | 1,503,898 | $ | 713,499 | $ | 126,438 | $ | 126,789 | $ | 966,726 | ||||||
ABS subprime |
482,817 | 206,088 | 67,625 | 16,481 | 87,235 | 171,341 | ||||||||||||
Subprime retained |
66,213 | 2,890 | | | 1,972 | 1,972 | ||||||||||||
Subprime residuals |
133 | 133 | | | 133 | 133 | ||||||||||||
ABS other real estate |
87,379 | 67,600 | 19,694 | 25,718 | 10,878 | 56,290 | ||||||||||||
FNMA / FHLMC |
47,848 | 49,482 | | 51,593 | | 51,593 | ||||||||||||
REIT debt |
561,270 | 551,499 | 468,377 | 42,157 | | 510,534 | ||||||||||||
Debt security total |
$ | 3,634,744 | 2,381,590 | 1,269,195 | 262,387 | 227,007 | 1,758,589 | |||||||||||
Equity securities |
1,388 | | | 2,620 | 2,620 | |||||||||||||
Total |
$ | 2,382,978 | $ | 1,269,195 | $ | 262,387 | $ | 229,627 | 1,761,209 | |||||||||
(A) | Net of incurred losses. |
(B) | Net of discounts (or gross premiums) and after other-than-temporary impairment, including impairment taken during the period ended September 30, 2009. |
(C) | 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. Newcastles methodology is to not use quotes from selling brokers, unless those quotes are the only marks available, or unless the quotes provided by other (non-selling) brokers are, in managements judgment, not representative of fair value. Even if Newcastle receives two or more quotes on a particular security that come from non-selling brokers, it does not use an average because management believes using an actual quote more closely represents a transactable price for the security than an average level. Furthermore, in some cases there is a wide disparity between the quotes Newcastle receives. Management believes using an average of the quotes in these cases would generally not represent the fair value of the asset. Based on Newcastles own fair value analysis using internal models, management selects one of the quotes which is believed to more accurately reflect fair value. Newcastle never adjusts quotes received. |
(D) | Management was unable to obtain quotations from more than one source on these securities. The one source was generally the seller (the party that sold us the security). |
(E) | Securities 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 Accumulated OCI |
Assumption Ranges | |||||||||||||||||
Discount Rate |
Prepayment |
Cumulative |
Loss | ||||||||||||||||||
CMBS Conduit |
$ | 152,878 | $ | 99,821 | $ | 216,138 | $ | (53,057 | ) | 20% | N/A | 15% - 45% | 35% -48% | ||||||||
CMBS Large loan / Single borrower |
79,707 | 26,968 | 51,635 | (52,739 | ) | 20% - 75% | N/A | 0% - 100% | 0% -100% | ||||||||||||
ABS subprime |
118,136 | 87,235 | 62,302 | (30,901 | ) | 20% | 1% - 13% | 22% - 91% | 50% - 90% | ||||||||||||
Subprime retained |
2,890 | 1,972 | 3,203 | (918 | ) | 20% | 3% | 61% - 74% | 70% | ||||||||||||
Subprime residuals |
133 | 133 | 716 | | 30% | 3% | 74% | 70% | |||||||||||||
ABS other RE |
13,856 | 10,878 | 4,029 | (2,978 | ) | 20% | 2% | 58% | 70% | ||||||||||||
Debt security total |
$ | 367,600 | $ | 227,007 | $ | 338,023 | $ | (140,593 | ) | ||||||||||||
Equity securities |
1,388 | 2,620 | 1,232 | ||||||||||||||||||
Total |
$ | 368,988 | $ | 229,627 | $ | 338,023 | $ | (139,361 | ) | ||||||||||||
All of the assumptions listed have some degree of market observability, based on Newcastles knowledge of the market, relationships with market participants, and use of common market data sources. Collateral prepayment, default and loss severity projections are in the form of curves or vectors that vary for each monthly collateral cash flow projection. Methods used to develop these projections vary by asset class (e.g., CMBS projections are developed differently than Home Equity ABS projections) but conform to industry conventions. We use assumptions that generate our best estimate of future cash flows of each respective security.
The prepayment vector specifies the percentage of the collateral balance that is expected to voluntarily pay off at each point in the future. The prepayment vector is based on projections from the a widely published investment bank model which considers factors such as collateral FICO score,
18
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
loan-to-value ratio, debt-to-income ratio, and vintage on a loan level basis. This vector is scaled up or down to match recent collateral-specific prepayment experience, as obtained from remittance reports and market data services.
Loss severities are based on recent collateral-specific experience with additional consideration given to collateral characteristics. Collateral age is taken into consideration because severities tend to initially increase with collateral age before eventually stabilizing. We typically use projected severities that are higher than the historic experience for collateral that is relatively new (e.g., 2007 vintage origination) to account for this effect. Collateral characteristics such as loan size, lien position, and location (state) also effect loss severity. We consider whether a collateral pool has experienced a significant change in its composition with respect to these factors when assigning severity projections.
Default vectors are determined from the current pipeline of loans that are more than 90 days delinquent, in foreclosure, or are real estate owned (REO). These significantly delinquent loans determine the first 24 months of the default vector. Beyond month 24, the default vector transitions to a steady-state value that is generally equal to or greater than that given by the widely published investment bank model.
The discount rates we use are derived from a range of observable pricing on securities backed by similar collateral and offered in a live market. As the markets in which we transact have become less liquid, we have had to rely on fewer data points in this analysis.
(F) | Lifetime average constant prepayment rate. |
Valuation Hierarchy
Pursuant to ASC 820, Fair Value Measurements and Disclosures, the methodologies used for valuing such instruments have been categorized into three broad levels which 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, 2009:
Principal Balance or Notional Amount |
Carrying Value | Fair Value | ||||||||||||||||
Level 2 | Level 3A | Level 3B | Total | |||||||||||||||
Assets: |
||||||||||||||||||
Real estate securities, available for sale: |
||||||||||||||||||
CMBS |
$ | 2,389,084 | $ | 966,726 | $ | | $ | 839,937 | $ | 126,789 | $ | 966,726 | ||||||
ABS subprime |
482,817 | 171,341 | | 84,106 | 87,235 | 171,341 | ||||||||||||
Subprime retained |
66,213 | 1,972 | | | 1,972 | 1,972 | ||||||||||||
Subprime residuals |
133 | 133 | | | 133 | 133 | ||||||||||||
ABS other real estate |
87,379 | 56,290 | | 45,412 | 10,878 | 56,290 | ||||||||||||
FNMA / FHLMC |
47,848 | 51,593 | 51,593 | | | 51,593 | ||||||||||||
REIT debt |
561,270 | 510,534 | | 510,534 | | 510,534 | ||||||||||||
Debt security total |
3,634,744 | 1,758,589 | 51,593 | 1,479,989 | 227,007 | 1,758,589 | ||||||||||||
Equity securities |
2,620 | | | 2,620 | 2,620 | |||||||||||||
Total |
$ | 1,761,209 | $ | 51,593 | $ | 1,479,989 | $ | 229,627 | $ | 1,761,209 | ||||||||
Liabilities: |
||||||||||||||||||
Interest rate swaps, treated as hedges |
2,164,114 | 215,662 | 215,662 | | | 215,662 | ||||||||||||
Non-hedge derivatives |
256,765 | 26,916 | 26,916 | | | 26,916 |
Newcastles investments in instruments measured at fair value using Level 3 inputs changed during the nine months ended September 30, 2009 as follows:
Level 3A | Level 3B | Total | ||||||||||
Assets |
||||||||||||
Balance at December 31, 2008 |
$ | 1,304,776 | $ | 179,763 | $ | 1,484,539 | ||||||
Total gains (losses) |
||||||||||||
Included in net income (loss) (A) |
(127,689 | ) | (307,827 | ) | (435,516 | ) | ||||||
Reclassification related to the adoption of FSP 115-2 (codified in ASC 320, 310-30 and 325-40) included in Other Comprehensive income (loss) |
979,089 | 309,835 | 1,288,924 | |||||||||
Included in other comprehensive income (loss) |
(557,010 | ) | (70,936 | ) | (627,946 | ) | ||||||
Amortization included in interest income |
49,010 | 23,668 | 72,678 | |||||||||
Purchases, sales and repayments |
(16,323 | ) | (56,740 | ) | (73,063 | ) | ||||||
Transfers between Level 3A and Level 3B |
(151,864 | ) | 151,864 | | ||||||||
Transfers into Level 3 (B) |
| | | |||||||||
Transfers out of Level 3 (B) |
| | | |||||||||
Balance at September 30, 2009 |
$ | 1,479,989 | $ | 229,627 | $ | 1,709,616 | ||||||
19
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
(A) | These gains (losses) are recorded in the following line items in the consolidated statement of operations: |
Nine Months Ended September 30, 2009 |
||||
Gain (loss) on settlement of investments, net |
$ | 3,070 | ||
Other income (loss), net |
| |||
Other-than-temporary impairment |
(438,586 | ) | ||
Total |
$ | (435,516 | ) | |
Other-than-temporary impairment recorded in earnings during the nine months ended September 30, 2009 is attributable to the change in unrealized losses relating to Level 3 assets still held at September 30, 2009.
Nine Months Ended September 30, 2009 | |||
Gain (loss) on settlement of investments, net, from investments transferred into Level 3 during the period |
$ | |
(B) | Transfers are assumed to occur at the beginning of the quarter. |
During the nine months ended September 30, 2009, Newcastle recorded $85.8 million and ($2.7) million of valuation allowance (reversal) on real estate related loans and residential mortgage loans (Note 4), respectively. These loans were written down to fair value at the time of the impairment, based on broker quotations, pricing service quotations or internal pricing models. All the loans were within Level 3 of the fair value hierarchy. For real estate related loans, the most significant inputs used in the valuations are the amount and timing of expected future cash flows, market yields and the estimated collateral value of such loan investments. For residential mortgage loans, significant inputs include managements expectations of prepayment speeds, default rates, loss severities and discount rates that market participants would use in determining the fair values of similar pools of residential mortgage loans.
Derivatives
ASC 815, Derivatives and Hedging establishes the accounting and disclosures for derivative instruments. The disclosure below provides information relating to Newcastles uses and reporting of derivative instruments, as well as enhanced qualitative and quantitative disclosures pursuant to these accounting standards.
Newcastle is exposed to certain risks relating to its ongoing business operations. The primary risk managed by Newcastle using derivative instruments is interest rate risk. Newcastle enters into interest rate swap agreements to reduce the impact of fluctuating interest rates on its earnings. Pursuant to ASC 815, Newcastle designates certain interest rate swap agreements as cash flow hedges of its floating rate financings. For derivative instruments that are designated and qualify as a cash flow hedge (i.e. hedging the exposure to variability in expected future cash flows that is attributable to a particular risk), the effective portion of the gain or loss, and net payments received or made, on the derivative instrument are reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of future cash flows of the hedged item, if any, is recognized in current earnings during the period of change.
Newcastles derivatives are recorded on its balance sheet as follows:
Fair Value | ||||||||
Balance sheet location |
September 30, 2009 |
December 31, 2008 | ||||||
Interest rate swaps, designated as hedging instruments under ASC 815 |
Derivative liabilities | $ | 215,662 | $ | 317,757 | |||
Interest rate swaps, not designated as hedging instruments under ASC 815 |
Derivative liabilities | 26,916 | 16,220 | |||||
$ | 242,578 | $ | 333,977 | |||||
20
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
The following table summarizes information related to derivatives:
September 30, 2009 |
December 31, 2008 |
|||||||
Cash flow hedges |
||||||||
Notional amount of interest rate swap agreements |
$ | 2,164,114 | $ | 2,376,420 | ||||
Amount of (loss) recognized in OCI on effective portion |
(211,094 | ) | (312,431 | ) | ||||
Deferred hedge gain (loss) related to anticipated financings, which have subsequently occurred, net of amortization |
857 | 932 | ||||||
Deferred hedge gain (loss) related to dedesignation, net of amortization |
(9,571 | ) | (2,825 | ) | ||||
Expected reclassification of deferred hedges from AOCI into earnings over the next 12 months |
(4,536 | ) | 1,149 | |||||
Expected reclassification of current hedges from AOCI into earnings over the next 12 months |
(95,832 | ) | (19,570 | ) | ||||
Non-hedge Derivatives |
||||||||
Notional amount of interest rate swap agreements |
256,765 | 182,867 |
The following table summarizes gains (losses) recorded in relation to derivatives (excluding total rate of return swaps, which are reported separately):
Nine Months Ended September 30, |
||||||||||
Income statement location |
2009 | 2008 | ||||||||
Cash flow hedges |
||||||||||
Gain (loss) on the ineffective portion |
Other income (loss) | $ | (489 | ) | $ | 218 | ||||
Gain (loss) immediately recognized at dedesignation |
Other income (loss) | (8,797 | ) | (990 | ) | |||||
Amount of gain (loss) reclassified from AOCI into income, related to effective portion |
Interest expense | (74,180 | ) | (45,233 | ) | |||||
Deferred hedge gain reclassified from AOCI into income, related to anticipated financings |
Interest expense | 75 | 69 | |||||||
Deferred hedge gain (loss) reclassified from AOCI into income, related to effective portion of dedesignated hedges |
Interest expense | (8,021 | ) | (1,316 | ) | |||||
Non-hedge derivatives gain (loss) |
Other income (loss) | 11,232 | (38,261 | ) |
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. Newcastles common stock equivalents are its outstanding stock options. During the three and nine months ended September 30, 2009 and 2008, Newcastle had no dilutive common stock equivalents. Net loss applicable to common stockholders is equal to net loss less preferred dividends.
As of September 30, 2009, Newcastles outstanding options were summarized as follows:
Held by the Manager |
1,686,447 | |
Issued to the Manager and subsequently transferred to certain of the Managers employees |
798,162 | |
Held by the independent directors and former directors |
14,000 | |
Total |
2,498,609 | |
21
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2009
(dollars in tables in thousands, except share data)
8. COMMITMENTS AND CONTINGENCIES
Loan Commitment With respect to a commercial construction loan, Newcastle entered into an agreement effective June 30, 2009 with the other parties to the loan. As a result, as of September 30, 2009, Newcastle and its CDOs do not have any future funding commitment with respect to this loan.
Litigation Newcastle is, from time to time, a defendant in legal actions from transactions conducted in the ordinary course of business. Management, after consultation with legal counsel, believes the ultimate liability arising from such actions which existed at September 30, 2009, if any, will not materially affect Newcastles consolidated results of operations or financial position.
Preferred Dividends in Arrears As of September 30, 2009, $12.4 million of dividends on Newcastles cumulative preferred stock were unpaid and in arrears.
Contingent Gain in CDOs As of September 30, 2009, Newcastle has recorded $1.0 billion of losses in its CDOs in excess of its economic exposure which must eventually be reversed through amortization, sales at gains, or as gains at the deconsolidation or termination of the CDOs.
9. RECENT ACTIVITIES
These financial statements include a discussion of material events which have occurred subsequent to September 30, 2009 (referred to as subsequent events) through the issuance of these consolidated financial statements on November 9, 2009. Events subsequent to that date have not been considered in these financial statements.
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ITEM 2. | MANAGEMENTS 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, and actively manage, a portfolio of real estate securities, loans and other real estate related assets. 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 as part of our investment strategy. 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, 2009. 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, 2009, our debt to equity ratio, as computed under this method, was approximately 4.3 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 debt obligations (CDOs), other securitizations, term loans, and trust preferred securities, as well as short term financing in the form of loans and 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 relative to the terms we were able to obtain prior to the crisis. For example, we are currently contractually restricted from entering into new debt financings subject to margin calls other than to finance up to a specified amount of FNMA/FHLMC securities.
We seek to match fund our investments with respect to interest rates and maturities in order to reduce 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 CDO 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 debt obligations (CDOs), (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, |
CDOs | Other Non-Recourse |
Recourse | Unlevered | Unallocated | Total | ||||||||||||
2009 |
$ | 221,385 | $ | 58,043 | $ | 6,200 | $ | 1,333 | $ | 72 | $ | 287,033 | ||||||
2008 |
$ | 232,652 | $ | 67,700 | $ | 39,417 | $ | 19,861 | $ | 1,831 | $ | 361,461 |
23
Market Considerations
Financial Institutions
Many market participants remain 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 governments placing Fannie Mae, Freddie Mac and AIG under its supervision, the announced distressed sales of all or portions of Bear Stearns, Merrill Lynch, Wachovia and Washington Mutual and the governments increasing its equity investment in Citigroup. Although the United States and other governments have taken 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.
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. For a more detailed discussion of our counterparty default and concentration risk, see Part I, Item 1A, Risk Factors Risks Related to the Financial Services Industry and Financial Markets We are subject to counterparty default and concentration risk.
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.
During the first nine months of 2009, credit spreads widened initially and then tightened substantially in the third quarter of 2009. This net tightening of credit spreads caused the net unrealized losses on our securities to decrease. 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 fourth quarter of 2008 and the first portion of 2009 and caused credit spreads to widen further during this period. In the third quarter 2009, credit spreads tightened substantially. Despite signs of moderate improvement, market conditions remain significantly challenging, and we do not know how recent changes in market conditions will affect our business.
Liquidity
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 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 and the collateral underlying them. 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; |
| prompting us to negotiate the removal of certain financial covenants from our non-CDO financings; |
| reducing the amount, which we refer to as cushion, by which we satisfy the over collateralization and interest coverage tests of our CDOs (sometimes referred to as CDO triggers) or contributing to several of our CDOs failing their over collateralization tests (see Liquidity and Capital Resources and Debt Obligations below); and |
| requiring us to pay additional amounts under certain financing arrangements. |
In some cases, we have sold, and may continue to sell, assets at prices below what we believed to be their value in order to meet liquidity requirements under certain financing arrangements. Failed CDO triggers, impairments resulting from incurred losses, and asset sales at prices significantly below face amount, while the related debt is being repaid at its full face amount, further contribute to reductions in future earnings, cash flow and liquidity. As a result, we expect that our future cash flow from operations will be significantly reduced relative to previous periods.
In order to maintain 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, or to buy back stock or debt, and elected not to declare any common or preferred dividends during the fourth quarter of 2008 or the first three quarters of 2009. This approach has
24
increased our liquidity while reducing our operating earnings. We may elect to adjust or not to pay any future dividend payments to reflect our current and expected cash from operations or to satisfy future liquidity needs.
Extent of Market Disruption
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, particularly with respect to commercial real estate, we will likely experience additional impairment charges, potential reductions in cash flows from our investments and additional challenges in raising capital and obtaining investment financing on attractive terms. Moreover, we will likely need to continue to place a high priority on managing our liquidity. If we raised capital or issued unsecured debt in the current market, it could be significantly dilutive to our current shareholders.
Future cash flows and our liquidity may be materially impacted if conditions do not continue to 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.
Certain aspects of these effects are more fully described in Part I, Item 2, Managements Discussion and Analysis of Financial Condition and Results of Operations Interest Rate, Credit and Spread Risk and Liquidity and Capital Resources as well as in Part I, Item 3, Quantitative and Qualitative Disclosures About Market Risk.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Managements 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 managements estimates and judgments used in applying each of the accounting policies described below, as modified periodically to reflect current market conditions. The following is a summary of our accounting policies that are most effected by judgments, estimates and assumptions.
Variable Interest Entities
Financial Accounting Standards Board Accounting Standards Codification (ASC) Topic 810 Consolidation 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 VIEs expected losses or receive a majority of the expected residual returns as a result of holding variable interests.
The VIEs in which we have a significant interest include (i) our subprime securitizations, which are held in qualifying special purpose entities under ASC 860-40, Transfers to Qualifying Special Purpose Entities, and are therefore exempt from consolidation as VIEs, and (ii) our CDOs, in which we have been determined to be the primary beneficiary and therefore consolidate them, since we would absorb a majority of their expected losses and receive a majority of their expended residual returns, as determined on the date of formation and on any applicable reconsideration dates. Our CDOs are held in special purpose entities whose debt is treated as a non-recourse secured borrowing of Newcastle.
We will continue to analyze future investments, as well as reconsideration events in existing entities, pursuant to the requirements of ASC 810. These analyses require considerable judgment in determining the primary beneficiary of a VIE since they involve estimated probability weighting of subjectively determined possible cash flow scenarios. The result could be the consolidation of an entity that would otherwise not have been consolidated or the non-consolidation of an entity that would otherwise have been consolidated.
Valuation and Impairment of Securities
We have classified all 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 may be based upon broker quotations, counterparty quotations or pricing services quotations, which provide valuation estimates based upon reasonable market order indications or a good faith estimate thereof and 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 of this trend, see Market Considerations above. As a result, we have estimated the fair value of these illiquid securities based on internal pricing models rather than broker quotations. The determination of estimated cash flows used in pricing models is inherently subjective and imprecise. Changes in market conditions, as well as
25
changes in the assumptions or methodology used to determine fair value, could result in a significant and immediate increase or decrease in our GAAP equity. For securities valued with pricing models, these inputs include the discount rate, assumptions relating to prepayments, default rates and loss severities, as well as other variables.
See Note 6 to our consolidated financial statements in Part I, Item 1, Financial Statements and Supplementary Data for information regarding the fair value of our investments, and its estimation methodology, as of September 30, 2009.
Our estimation of the fair value of level 3B assets (as described below) involves significant judgment. 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 GAAP equity. 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. In the first three quarters of 2009, Newcastle generally lowered the prepayment assumptions based on observed reductions in actual prepayment speeds and slower expected future prepayments consistent with market projections. The slower prepayments were the result of increasing difficulties for borrowers to refinance, caused by a tightening of underwriting standards, decline in home prices, contraction of available lenders due to bank failures and a distressed securitization market. Default assumptions were increased due to higher levels of delinquent underlying loans. Loss severity assumptions were increased based on observed increases in recent loss severities that have been driven by falling home prices and the increasing number of foreclosures or distressed home sales in the residential sector and higher losses as a result of the increasing number of foreclosures and bankruptcies of borrowers experienced in the commercial sector.
For debt securities valued with internal models, which have an aggregate fair value of $227.0 million as of September 30, 2009, a 10% unfavorable change in our assumptions would result in the following decreases in such aggregate fair value:
CMBS | ABS | |||||||
Outstanding face amount |
$ | 969,323 | $ | 462,687 | ||||
Fair value |
$ | 126,789 | $ | 100,218 | ||||
Effect on fair value with 10% unfavorable change in: |
||||||||
Discount rate |
$ | (2,503 | ) | $ | (4,531 | ) | ||
Prepayment rate |
N/A | $ | (1,528 | ) | ||||
Default rate |
$ | (20,233 | ) | $ | (7,831 | ) | ||
Loss severity |
$ | (15,338 | ) | $ | (14,506 | ) |
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% 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.
Pursuant to ASC 820 Fair Value Measurements and Disclosures, 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. Fair value under ASC 820 represents an exit price in the normal course of business, not a forced liquidation price. If we were forced to sell assets in a short period to meet liquidity needs, the prices we receive could be substantially less than the recorded fair values.
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 indicative and not actionable meaning that the party giving the quotation is not bound to actually purchase the security at the quoted price. These quotations are generally based on models prepared by the brokers and we have little visibility into the inputs they use. Based on procedures we have performed with respect to prior quotations received from these brokers in comparison to the outputs generated from our internal pricing models and 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 performs its own quarterly analysis of fair value, based on internal pricing models, to confirm that each of the quotations received represented a reasonable estimate of fair value as defined under ASC 820. For securities valued using quotations, a 100 basis point change in credit spreads would impact estimated fair value at period and by approximately $49.1 million.
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We must also assess whether unrealized losses on securities, if any, reflect a decline in value which is other-than-temporary and, if so, write the impaired security down to its fair value through earnings. A decline in value is deemed to be other-than-temporary if (i) 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 (there is an expected credit loss), or (ii) if we have the intent to sell a security in an unrealized loss position or it is more likely than not we will be required to sell a security in an unrealized loss position prior to its anticipated recovery (if any). For the purposes of performing this analysis, we assume the anticipated recovery period is until the respective securitys expected maturity. Also, for those securities within the scope of ASC 325-40, Beneficial Interests in Securitized Financial Assets, whenever there is a probable adverse change in the timing or amounts of estimated cash flows of a security from the cash flows previously projected, an other-than-temporary impairment is considered to have occurred. Securities within the scope of ASC 325-40 are also analyzed for other-than-temporary impairment under the guidelines applicable to all securities as described herein. We note that primarily all of our securities, except our FNMA/FHLMC securities, fall within the scope of ASC 325-40.
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 securitys credit support, as well as prepayment rates. These factors are also analyzed in relation to the amount of the unrealized loss and the period elapsed since it was incurred. The result of this evaluation is considered when determining managements estimate of cash flows, particularly with respect to developing the necessary inputs and assumptions. Each security is impacted by different factors and in different ways; generally the more negative factors which are identified with respect to a given security, the more likely we are to determine that we do not expect to receive all contractual payments when due with respect to that security. Significant judgment is required in this analysis.
During the nine months ended September 30, 2009, we had 209, or $514.7 million carrying amount of, securities that were downgraded and recorded a net other-than-temporary impairment charge of $292.5 million on these securities in 2009. However, we do not depend on credit ratings in underwriting our securities, either at acquisition or on an ongoing basis. As mentioned above, a credit rating downgrade is one factor that we monitor and consider in our analysis regarding other-than-temporary impairment, however it is not determinative. Our securities generally benefit from the support of one or more subordinate classes of securities or equity or other forms of credit support. Therefore, credit rating downgrades, even to the extent they relate to an expectation that a securitization we have invested in, on an overall basis, has credit issues, may not ultimately impact cash flow estimates for the class of securities in which we are invested.
Furthermore, the analysis of whether it is more likely than not that we will be required to sell securities in an unrealized loss position prior to an expected recovery in value (if any), the amount of such expected required sales, and the projected identification of which securities would be sold is also be subject to significant judgment, particularly in times of market illiquidity such as we are currently experiencing.
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 ASC 815 Derivatives and Hedging, as amended. Fair value is based on counterparty quotations. Newcastle reports the fair value of derivative instruments gross of cash paid or received pursuant to credit support agreements and is reflected on a net by counterparty basis when Newcastle believes a legal right of setoff exists under an enforceable netting agreement. To the extent they qualify as cash flow hedges under ASC 815, 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, including counterparty risk. The results of such variability could be a significant increase or decrease in our GAAP equity and/or earnings.
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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. 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 borrowers 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 historical and anticipated 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. As of September 30, 2009, we determined that we could not express the intent and ability to hold all of our loans which are in an unrealized loss position for the foreseeable future or until their expected pay off.
Revenue Recognition on Loans Held for Investment
Income on these loans is recognized similarly to that on our securities and is subject to similar uncertainties and contingencies, which are also analyzed on at least a quarterly basis. For loan pools acquired at a discount for credit losses, the net income recognized is based on a loss adjusted yield whereby a gross interest yield is recorded to Interest Income, offset by a provision for probable, incurred credit losses which is accrued on a periodic basis to Provision for Credit Losses. The provision is determined based on an evaluation of the loans as described under Impairment of Loans above. A rollforward of the provision is included in Note 4 to our consolidated financial statements included herein.
Revenue Recognition on Loans Held for Sale
Real estate related, commercial mortgage and residential mortgage loans that are considered held for sale are carried at the lower of amortized cost or market value determined on either an individual method basis, or in the aggregate for pools of similar loans. Interest income is recognized to the extent cash is received whereas a change in the market value of loans, to the extent that the value is not above the cost basis, is recorded in Valuation Allowance.
Recent Accounting Pronouncements
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, codified in ASC 860-10, 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 November 15, 2008 and is only applied prospectively to transactions that occur on or after the adoption date. The adoption of FSP FAS 140-3 did not have a material impact on our financial condition, liquidity or results of operations as we have not entered into any such transactions since January 2009.
In March 2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments and Hedging Activities. SFAS 161, codified in ASC 815-10-65 applies to reporting periods beginning after November 15, 2008. ASC 815-10-65 requires enhanced disclosures about an entitys derivative and hedging activities. It does not change the accounting for such activities. As a result, while the adoption of ASC 815-10-65 has changed our disclosures, it did not have a material impact on our financial condition, liquidity or results of operations.
In January 2009, the FASB issued FSP EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20. This FSP, codified in ASC 325-40-65 Beneficial Interests in Securitized Financial Assets, amends previous guidance to achieve more consistent determination of whether an other-than-temporary impairment has occurred, with the same objective as ASC 320. In particular, it changed a requirement to analyze a securitys estimated cash flows from a market participants perspective to an analysis from the perspective of the holder. It is effective for periods ending after December 15, 2008 and is applied prospectively. Due to the prospective nature of its adoption, the adoption of ASC 325-40-65 did not have a material impact on our financial condition, liquidity or results of operations. It did not have a material impact on our impairment analyses subsequent to adoption because we generally analyze cash flows of securities in a manner consistent with market practice.
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In April 2009, the FASB issued three FSPs related to fair value and impairment, FSP FAS 107-1 and APB 28-1 Interim Disclosures about Fair Value of Financial Instruments (codified in ASC 825-10-65), FSP FAS 115-2 and FAS 124-2 Recognition and Presentation of Other-Than-Temporary Impairments (codified in ASC 320-10-65), and FSP FAS 157-4 Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (codified in ASC 820-10-65). These FSPs (i) require disclosures about the fair value of financial instruments on an interim basis, (ii) change the guidance for determining, recording and disclosing other-than-temporary impairment, and (iii) provide additional guidance for estimating fair value when the volume or level of activity for an asset or liability have significantly decreased. These FSPs were effective for Newcastle as of April 1, 2009. They had a significant impact on our disclosures, but no material impact on our financial condition, liquidity, or results of operations upon adoption. A reclassification adjustment of $1.3 billion of loss from Accumulated Deficit to Accumulated Other Comprehensive Income (Loss) was recorded at adoption of FSP FAS 115-2 and 124-2 (as codified in ASC 320-10-65) but had no net effect on equity. Post-adoption impairment determinations, including the analysis performed at September 30, 2009, are performed using this new guidance and may result in materially different conclusions than would have been reached under prior guidance.
In June 2009, the FASB issued SFAS No. 166 Accounting for Transfers of Financial Assets-an amendment of FASB Statement No. 140. As of the date of this filing, FASB ASC did not integrate SFAS 166 into the codification. SFAS 166 eliminates the concept of qualified special purpose entities (QSPEs), changes the requirements for reporting a transfer of a portion of financial assets as a sale, clarifies other sale accounting criteria and changes the initial measurement of a transferors interest in transferred financial assets. Furthermore, it requires additional disclosures. SFAS 166 is effective for fiscal year beginning after November 15, 2009. We are currently evaluating the potential impact of SFAS 166 will have on us. At this time, we do not expect that the adoption of SFAS 166 will have a material impact on our financial position, liquidity or results of operations.
In June 2009, the FASB issued SFAS No. 167 Amendment to FASB Interpretation No. 46(R). As of the date of this filing, FASB ASC did not integrate SFAS 167 into the codification. SFAS 167 changes the definition of a variable interest entity (VIE) and changes the methodology to determine who is the primary beneficiary of, or in other words who consolidates, a VIE. Furthermore, it eliminates the scope exception for qualified special purpose entities (QSPEs), which are now subject to the VIE consolidation rules. SFAS 167 is effective for fiscal year beginning after November 15, 2009. Generally, the changes are expected to cause more entities to be defined as VIEs and to require consolidation by the entity that exercises day-to-day control over a VIE, such as servicers and collateral managers. We are currently evaluating the potential impact of SFAS 167 on us. If the adoption of this standard caused us to deconsolidate any of our CDOs or other non-recourse financing structures, we would record a gain to the extent that we have taken impairments on assets within a given VIE in excess of our investment in such VIE. This gain could be material. To the extent the adoption resulted in the consolidation of VIEs that are currently not consolidated, the impact could be material to our gross assets, liabilities, revenues and expenses but would not be material to the net income or equity applicable to our common stockholders.
RESULTS OF OPERATIONS
The following table summarizes the changes in our results of operations from the three and nine months ended September 30, 2008 to the three and nine months ended September 30, 2009 (dollars in thousands):
Three Months | Nine Months | Explanations of Material Changes |
|||||||||||||||
Amount Change | Percent Change | Amount Change | Percent Change | ||||||||||||||
Interest income |
$ | (38,327 | ) | (33.8 | )% | $ | (74,428 | ) | (20.6 | )% | (1 | ) | |||||
Interest expense |
(21,213 | ) | (28.8 | )% | (69,585 | ) | (29.4 | )% | (1 | ) | |||||||
Provision for credit losses on loan pools |
(2,077 | ) | (100.0 | )% | (6,450 | ) | (100.0 | )% | (2 | ) | |||||||
Valuation allowance on loans (held for sale in 2009) |
(46,757 | ) | N.M. | 6,177 | N.M. | (2 | ) | ||||||||||
Other-than-temporary impairment on securities, net |
(23,319 | ) | N.M. | 169,370 | N.M. | (3 | ) | ||||||||||
Gain (loss) on settlement of investments, net |
860 | N.M. | 3,868 | 98.7 | % | (4 | ) | ||||||||||
Gain (loss) on extinguishment of debt |
127,219 | N.M. | 172,361 | N.M. | (5 | ) | |||||||||||
Other income (loss), net |
15,660 | N.M. | 37,986 | N.M. | (6 | ) | |||||||||||
Equity in earnings of unconsolidated subsidiaries |
(123 | ) | (29.4 | )% | (7,908 | ) | (96.6 | )% | (7 | ) | |||||||
Loan and security servicing expense |
(621 | ) | (36.1 | )% | (1,367 | ) | (26.1 | )% | (1 | ) | |||||||
General and administrative expense |
95 | 4.4 | % | 1,202 | 21.4 | % | (8 | ) | |||||||||
Management fee to affiliate |
(105 | ) | (2.3 | )% | (316 | ) | (2.3 | )% | (9 | ) | |||||||
Depreciation and amortization |
| 0.0 | % | | 0.0 | % | N/A | ||||||||||
Income (loss) from continuing operations |
$ | 199,286 | 136.2 | % | $ | 32,848 | (12.5 | )% | |||||||||
N.M.Not meaningful
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(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: |
Three Months | Nine Months | |||||||||||||||
Period to Period Increase (Decrease) |
Period to Period Increase (Decrease) |
|||||||||||||||
Interest Income | Interest Expense | Interest Income | Interest Expense | |||||||||||||
Disposition of securities and loans |
$ | (8,426 | ) | $ | (4,729 | ) | $ | (28,231 | ) | $ | (17,061 | ) | ||||
Prepayment penalty income |
704 | | 8,158 | | ||||||||||||
Repayment of debt obligations and related dispositions |
| (1,392 | ) | (4,004 | ) | (7,785 | ) | |||||||||
Paydowns |
(5,579 | ) | (2,987 | ) | (18,171 | ) | (10,459 | ) | ||||||||
Amortization of deferred hedge loss |
| 1,710 | | 6,699 | ||||||||||||
Other (see below) |
(25,026 | ) | (13,815 | ) | (32,180 | ) | (40,979 | ) | ||||||||
$ | (38,327 | ) | $ | (21,213 | ) | $ | (74,428 | ) | $ | (69,585 | ) | |||||
Changes in Other are primarily due to changes in interest rates and partially offset by the increased interest income recorded in 2009 as a result of the accretion of discounts on the impaired securities.
Changes in loan and security servicing expense are primarily due to dispositions and paydowns.
(2) | This change is primarily the result of the classification of loans as held for sale in the fourth quarter of 2008 as we could no longer express the intent and ability to hold our loan investments through maturity. For the nine months ended September 30, 2009, the actual losses incurred in our pools of residential mortgage loans were recorded against the Valuation Allowance on Loans Held for Sale whereas the change in fair value was recorded to Valuation Allowance on Loans Held for Sale. The change for the three months ended September 30, 2009 is a result of a net increase in the valuation of the loans. |
(3) | This change is due to the impairment charges recorded as a result of the continued credit market turmoil, which led us to record write downs to a significant portion of our securities portfolio. The change for the three months ended September 30, 2009 is a result of a tightening of credit spreads. |
(4) | This change is predominantly the result of the gains recorded on paydown at par of loans and securities previously written down, partially offset by the loss on sales of certain securities and loans. |
(5) | This change is primarily due to increased gains on the repurchase of our own debt. |
(6) | This change is primarily due to an increase in the fair value of our interest rate swaps not designated as accounting hedges in the three and nine months ended September 30, 2009 which we mark to market through the statement of operations, and the unrealized loss recorded on the total rate of return swaps held in 2008. |
(7) | This change is primarily due to the sale of our interests in the operating real estate joint venture in 2008. |
(8) | This change is primarily due to increases in insurance expense, legal and professional fees, partially offset by a refund of excise tax paid in 2008. |
(9) | Management fees have remained relatively stable as we did not raise capital through common or preferred stock offerings during these periods. As a result of impairment charges, we will not incur incentive compensation to our manager for an indefinite period of time. |
LIQUIDITY AND CAPITAL RESOURCES
Overview
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 Code, we must distribute annually at least 90% of our REIT taxable income. We note that up to 90% of this requirement may be met in future years through stock dividends, rather than cash, subject to limitations based on the value of our stock. Our primary sources of funds for liquidity consist of net cash provided by operating activities, sales or repayments of investments, potential refinancing of existing debt and the issuance of equity securities, when available. Our debt obligations are generally secured directly by our investment assets.
Sources of Liquidity and Uses of Capital
As of the date of this filing, we currently have sufficient cash on hand to satisfy all of our non-agency recourse liabilities (excluding our trust preferred securities, which are long-term obligations). With respect to the next twelve months, we expect that our cash on hand combined with our cash flow provided by operations will be sufficient to satisfy our anticipated liquidity needs with respect to our current investment portfolio, including related financings, hedges, potential margin calls and operating expenses. While it is inherently more difficult to forecast beyond the next twelve months, we currently expect to meet our long term liquidity requirements, specifically the repayment of our debt obligations, through our cash on hand and, if needed, additional borrowings, proceeds received from repurchase agreements and similar financings, and the liquidation or refinancing of our assets.
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These short-term and long-term expectations are forward-looking and subject to a number of uncertainties and assumptions, which are described below under Factors That Could Impact Our Liquidity as well as Part II, Item 1A, Risk Factors. If our assumptions about our liquidity prove to be incorrect, we could be subject to a shortfall in liquidity in the future, and this short-fall may occur rapidly and with little or no notice, which would limit our ability to address the shortfall on a timely basis.
Cash flow provided by operations constitutes a critical component of our liquidity. Essentially, our cash flow provided by operations is equal to (i) the net cash flow from our CDOs that have not failed their over collateralization and interest coverage tests, plus (ii) the net cash flow from our non-CDO investments that are not subject to mandatory debt repayment, including principal and sales proceeds, less (iii) operating expenses (primarily management fees, professional fees and insurance), and less (iv) interest on the junior subordinated notes payable.
Our cash flow provided by operations differs from our net income (loss) 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 CDOs, (iii) the provision for credit losses and valuation allowance recorded in connection with our loan assets, as well as other-than-temporary impairment on our securities, (iv) unrealized gains or losses on our non-hedge derivatives, (v) the non-cash charges associated with our early extinguishment of debt, and (vi) net income (loss) generated within CDOs that have failed their over collateralization tests and one of the manufactured housing loan portfolios that became callable in January 2009 and therefore do not remit cash to us. Proceeds from the sale of assets which serve as collateral for our CDO financings, including gains thereon, are required to be retained in the CDO structure until the related bonds are retired and are therefore not available to fund current cash needs outside of these structures.
Update on Liquidity, Capital Resources and Capital Obligations
Certain details regarding our liquidity, current financings and capital obligations as of November 4, 2009 are set forth below:
| Cash We had unrestricted cash of $74.0 million. In addition, we had $126.7 million of restricted cash for reinvestments in our CDOs; |
| Margin Exposure We have no financings subject to margin calls, other than one repurchase agreement with a face amount of $41.4 million which finances our FNMA/FHLMC investments and four interest rate swap agreements with an aggregate notional amount of $70.1 million; |
| Construction Loan Funding Commitment In June 2009, we entered into an agreement with the other lender parties to the commercial construction loan to terminate all future funding commitments. As a result, as of September 30, 2009, we no longer have any future funding commitments with respect to this loan; and |
| Recourse Financings Substantially all of our assets, other than our FNMA/FHLMC investments, are currently financed with term debt subject to amortization payments. The following table compares the face amount of our recourse financings, excluding the trust preferred securities: |
November 4, 2009 | September 30, 2009 | December 31, 2008 | |||||||
Recourse Financings |
|||||||||
Real Estate Securities, Loans and Properties |
$ | 36,171 | $ | 36,420 | $ | 102,977 | |||
Manufactured Housing Loans |
12,346 | 13,425 | 51,118 | ||||||
FNMA/FHLMC Securities |
41,438 | 41,619 | 173,495 | ||||||
Total Recourse Financings |
$ | 89,955 |