UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended March 31, 2010
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 ¨ Non-accelerated filer x (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: 62,004,181 shares outstanding as of May 5, 2010.
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 or requirements with respect to asset-backed securities that we may issue; |
| 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)
March 31, 2010 (Unaudited) |
December 31, 2009 | |||||||
Assets |
||||||||
Non-Recourse VIE Financing Structures |
||||||||
Real estate securities, available for sale |
$ | 1,762,830 | $ | 1,784,487 | ||||
Real estate related loans, held for sale, net |
578,166 | 554,367 | ||||||
Residential mortgage loans, held for sale, net |
404,474 | 380,123 | ||||||
Subprime mortgage loans subject to call option |
403,190 | 403,006 | ||||||
Restricted cash |
233,979 | 200,251 | ||||||
Receivables from brokers, dealers and clearing organizations |
843 | | ||||||
Receivables and other assets |
33,271 | 36,643 | ||||||
3,416,753 | 3,358,877 | |||||||
Recourse Financing Structures and Unlevered Assets |
||||||||
Real estate securities, available for sale |
1,597 | 46,308 | ||||||
Real estate related loans, held for sale, net |
9,722 | 19,495 | ||||||
Residential mortgage loans, held for sale, net |
3,516 | 3,524 | ||||||
Investments in equity method investees |
41 | 193 | ||||||
Operating real estate, held for sale |
9,966 | 9,966 | ||||||
Cash and cash equivalents |
11,838 | 68,300 | ||||||
Restricted cash |
54 | 5,127 | ||||||
Receivables from brokers, dealers and clearing organizations |
16,116 | | ||||||
Receivables and other assets |
1,640 | 2,838 | ||||||
54,490 | 155,751 | |||||||
$ | 3,471,243 | $ | 3,514,628 | |||||
Liabilities and Stockholders Equity (Deficit) |
||||||||
Liabilities |
||||||||
Non-Recourse VIE Financing Structures |
||||||||
CDO bonds payable |
$ | 3,623,503 | $ | 4,058,928 | ||||
Other bonds payable |
292,486 | 303,697 | ||||||
Notes payable |
4,681 | | ||||||
Financing of subprime mortgage loans subject to call option |
403,190 | 403,006 | ||||||
Derivative liabilities |
184,798 | 203,054 | ||||||
Accrued expenses and other liabilities |
2,444 | 2,992 | ||||||
4,511,102 | 4,971,677 | |||||||
Recourse Financing Structures and Other Liabilities |
||||||||
Repurchase agreements |
12,889 | 71,309 | ||||||
Junior subordinated notes payable |
51,257 | 103,264 | ||||||
Derivative liabilities |
| 4,100 | ||||||
Dividends payable |
78 | | ||||||
Due to affiliates |
1,482 | 1,497 | ||||||
Payables to brokers, dealers and clearing organizations |
7,407 | | ||||||
Accrued expenses and other liabilities |
4,806 | 3,433 | ||||||
77,919 | 183,603 | |||||||
4,589,021 | 5,155,280 | |||||||
Stockholders Equity (Deficit) |
||||||||
Preferred stock, $0.01 par value, 100,000,000 shares authorized, 1,347,321 and 2,500,000 shares of 9.75% Series B Cumulative Redeemable Preferred Stock, 496,000 and 1,600,000 shares of 8.05% Series C Cumulative Redeemable Preferred Stock, and 620,000 and 2,000,000 shares of 8.375% Series D Cumulative Redeemable Preferred Stock, liquidation preference $25.00 per share, issued and outstanding as of March 31, 2010 and December 31, 2009, respectively |
61,583 | 152,500 | ||||||
Common stock, $0.01 par value, 500,000,000 shares authorized, 62,004,181 and 52,912,513 shares issued and outstanding at March 31, 2010 and December 31, 2009, respectively |
620 | 529 | ||||||
Additional paid-in capital |
1,065,302 | 1,033,520 | ||||||
Accumulated deficit |
(1,809,759 | ) | (2,193,383 | ) | ||||
Accumulated other comprehensive income (loss) |
(435,524 | ) | (633,818 | ) | ||||
(1,117,778 | ) | (1,640,652 | ) | |||||
$ | 3,471,243 | $ | 3,514,628 | |||||
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 March 31, | ||||||||
2010 | 2009 | |||||||
Interest income |
$ | 70,092 | $ | 124,473 | ||||
Interest expense |
45,589 | 60,544 | ||||||
Net interest income |
24,503 | 63,929 | ||||||
Impairment |
||||||||
Valuation allowance (reversal) on loans |
(95,774 | ) | 120,888 | |||||
Other-than-temporary impairment on securities |
64,856 | 186,582 | ||||||
Portion of other-than-temporary impairment on securities recognized in other comprehensive income |
(37,114 | ) | | |||||
(68,032 | ) | 307,470 | ||||||
Net interest income (loss) after impairment |
92,535 | (243,541 | ) | |||||
Other Income (Loss) |
||||||||
Gain (loss) on settlement of investments, net |
9,677 | (8,047 | ) | |||||
Gain (loss) on extinguishment of debt |
48,346 | 26,845 | ||||||
Other income (loss), net |
(1,565 | ) | (6,494 | ) | ||||
Equity in earnings (losses) of equity method investees |
85 | 13 | ||||||
56,543 | 12,317 | |||||||
Expenses |
||||||||
Loan and security servicing expense |
1,035 | 1,402 | ||||||
General and administrative expense |
3,038 | 1,626 | ||||||
Management fee to affiliate |
4,477 | 4,491 | ||||||
Depreciation and amortization |
63 | 72 | ||||||
8,613 | 7,591 | |||||||
Income (loss) from continuing operations |
140,465 | (238,815 | ) | |||||
Income (loss) from discontinued operations |
(40 | ) | (33 | ) | ||||
Net Income (Loss) |
140,425 | (238,848 | ) | |||||
Preferred dividends |
(3,268 | ) | (3,375 | ) | ||||
Excess of carrying amount of exchanged preferred stock over fair value of consideration paid - Note 9 |
43,043 | | ||||||
Income (Loss) Applicable to Common Stockholders |
$ | 180,200 | $ | (242,223 | ) | |||
Income (Loss) Per Share of Common Stock |
||||||||
Basic |
$ | 3.36 | $ | (4.59 | ) | |||
Diluted |
$ | 3.36 | $ | (4.59 | ) | |||
Income (loss) from continuing operations per share of common stock, after preferred dividends and excess of carrying amount of exchanged preferred stock over fair value of consideration paid |
||||||||
Basic |
$ | 3.36 | $ | (4.59 | ) | |||
Diluted |
$ | 3.36 | $ | (4.59 | ) | |||
Income (loss) from discontinued operations per share of common stock |
||||||||
Basic |
$ | | $ | 0.00 | ||||
Diluted |
$ | | $ | 0.00 | ||||
Weighted Average Number of Shares of Common Stock Outstanding |
||||||||
Basic |
53,619,643 | 52,807,232 | ||||||
Diluted |
53,619,643 | 52,807,232 | ||||||
Dividends Declared per Share of Common Stock |
$ | | $ | | ||||
See notes to consolidated financial statements
2
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT) (Unaudited)
FOR THE THREE MONTHS ENDED MARCH 31, 2010
(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, 2009 |
6,100,000 | $ | 152,500 | 52,912,513 | $ | 529 | $ | 1,033,520 | $ | (2,193,383 | ) | $ | (633,818 | ) | $ | (1,640,652 | ) | ||||||||||
Preferred dividends declared |
| | | | | (19,019 | ) | | (19,019 | ) | |||||||||||||||||
Exchange of preferred stock for common stock and cash |
(3,636,679 | ) | (90,917 | ) | 9,091,668 | 91 | 31,782 | 43,043 | | (16,001 | ) | ||||||||||||||||
Deconsolidation of CDO VII: |
|||||||||||||||||||||||||||
Cumulative net loss |
| | | | | 219,175 | | 219,175 | |||||||||||||||||||
Deconsolidation of unrealized loss on securities |
| | | | | | 40,715 | 40,715 | |||||||||||||||||||
Deconsolidation of unrealized loss on derivatives designated as cash flow hedges |
| | | | | | 28,514 | 28,514 | |||||||||||||||||||
Comprehensive income: |
|||||||||||||||||||||||||||
Net income (loss) |
| | | | | 140,425 | | 140,425 | |||||||||||||||||||
Net unrealized gain on securities |
| | | | | | 117,928 | 117,928 | |||||||||||||||||||
Reclassification of net realized loss on securities into earnings |
| | | | | | 14,786 | 14,786 | |||||||||||||||||||
Net unrealized gain on derivatives designated as cash flow hedges |
| | | | | | (8,528 | ) | (8,528 | ) | |||||||||||||||||
Reclassification of net realized loss on derivatives designated as cash flow hedges into earnings |
| | | | | | 4,879 | 4,879 | |||||||||||||||||||
Total comprehensive income (loss) |
269,490 | ||||||||||||||||||||||||||
Stockholders equity (deficit) - March 31. 2010 |
2,463,321 | $ | 61,583 | 62,004,181 | $ | 620 | $ | 1,065,302 | $ | (1,809,759 | ) | $ | (435,524 | ) | $ | (1,117,778 | ) | ||||||||||
See notes to consolidated financial statements
3
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(dollars in thousands)
Three Months Ended March 31, | ||||||||
2010 | 2009 | |||||||
Cash Flows From Operating Activities |
||||||||
Net income (loss) |
$ | 140,425 | $ | (238,848 | ) | |||
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 |
63 | 78 | ||||||
Accretion of discount and other amortization |
(1,181 | ) | (39,308 | ) | ||||
Interest income in CDOs redirected for reinvestment or CDO bonds paydown |
(4,639 | ) | (3,232 | ) | ||||
Valuation allowance on loans |
(95,774 | ) | 120,888 | |||||
Non-cash directors compensation |
| 15 | ||||||
(Gain) on sale of investments |
(9,677 | ) | 8,051 | |||||
Unrealized (gain) loss on non-hedge derivatives and hedge ineffectiveness |
1,749 | 6,505 | ||||||
Other-than-temporary impairment on securities |
27,742 | 186,582 | ||||||
(Gain) loss on extinguishment of debt |
(48,346 | ) | (26,845 | ) | ||||
Equity in (earnings) losses of equity method investees |
(85 | ) | (13 | ) | ||||
Distributions of earnings from equity method investees |
85 | 13 | ||||||
Change in: |
||||||||
Restricted cash |
(122 | ) | 4,053 | |||||
Receivables and other assets |
2,346 | 8,791 | ||||||
Due to affiliates |
(15 | ) | (35 | ) | ||||
Accrued expenses and other liabilities |
744 | (621 | ) | |||||
Net cash provided by (used in) operating activities |
13,315 | 26,074 | ||||||
Cash Flows From Investing Activities |
||||||||
Purchase of real estate securities |
(3 | ) | (1,800 | ) | ||||
Proceeds from sale of real estate securities |
26,022 | 131,120 | ||||||
Purchase of and advances on loans |
| (13,130 | ) | |||||
Repayments of loan and security principal |
22,901 | 17,339 | ||||||
Margin received on derivative instruments |
5,073 | 2,760 | ||||||
Return of margin deposits on total rate of return swaps (treated as derivative instruments) |
| 37 | ||||||
Payments on settlement of derivative instruments |
(3,668 | ) | (9,487 | ) | ||||
Proceeds from sale of real estate held for sale |
| 1,350 | ||||||
Distributions of capital from equity method investees |
152 | 35 | ||||||
Net cash provided by (used in) in investing activities |
50,477 | 128,224 | ||||||
Cash Flows From Financing Activities |
||||||||
Repayments and repurchases of CDO bonds payable |
(11,355 | ) | (638 | ) | ||||
Repayments of other bonds payable |
(11,346 | ) | (39,516 | ) | ||||
Repayments of repurchase agreements |
(58,420 | ) | (145,629 | ) | ||||
Margin deposits under repurchase agreements |
| (3,422 | ) | |||||
Return of margin deposits under repurchase agreements |
| 3,705 | ||||||
Cash consideration paid in exchange for junior subordinated notes |
(9,715 | ) | | |||||
Cash consideration paid to redeem preferred stock |
(16,001 | ) | | |||||
Dividends paid |
(18,942 | ) | | |||||
Payment of deferred financing costs |
| (200 | ) | |||||
Restricted cash returned from refinancing activities |
5,525 | 38,386 | ||||||
Net cash provided by (used in) financing activities |
(120,254 | ) | (147,314 | ) | ||||
Net Increase (Decrease) in Cash and Cash Equivalents |
(56,462 | ) | 6,984 | |||||
Cash and Cash Equivalents, Beginning of Period |
68,300 | 49,746 | ||||||
Cash and Cash Equivalents, End of Period |
$ | 11,838 | $ | 56,730 | ||||
Supplemental Disclosure of Cash Flow Information |
||||||||
Cash paid during the period for interest expense |
$ | 32,506 | $ | 44,305 | ||||
Supplemental Schedule of Non-Cash Investing and Financing Activities |
||||||||
Preferred stock dividends declared but not paid |
$ | 78 | $ | | ||||
Common stock issued to redeem preferred stock |
$ | 28,457 | $ | | ||||
Face amount of CDO bonds issued in exchange for previously issued junior subordinated notes of $52,094 |
$ | 37,625 | $ | |
See notes to consolidated financial statements
4
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(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 3.8 million shares of Newcastles common stock were held by the Manager, through its affiliates, and the principals of an affiliate of the Manager at March 31, 2010. In addition, the Manager, through its affiliates, held options to purchase approximately 1.7 million shares of Newcastles common stock at March 31, 2010.
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, 2009 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, 2009.
Change in Presentation
Newcastle has changed the format of its consolidated balance sheets for all periods presented to reflect the requirements of new guidance which became effective January 1, 2010. This change in format did not have any effect on any of the reported line items within the balance sheets, other than breaking them out by financing type, or on the statement of consolidated equity (deficit).
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.
5
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(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 | |||||||||||||||||||
Three Months Ended March 31, 2010 |
||||||||||||||||||||||||
Interest income |
$ | 50,943 | $ | 18,046 | $ | 859 | $ | 223 | $ | 21 | $ | 70,092 | ||||||||||||
Interest expense |
28,866 | 15,039 | 627 | | 1,057 | 45,589 | ||||||||||||||||||
Net interest income (expense) |
22,077 | 3,007 | 232 | 223 | (1,036 | ) | 24,503 | |||||||||||||||||
Impairment |
(30,846 | ) | (37,292 | ) | (60 | ) | 166 | | (68,032 | ) | ||||||||||||||
Other income (loss) |
59,722 | (1,398 | ) | (663 | ) | (1,118 | ) | | 56,543 | |||||||||||||||
Depreciation and amortization |
| | | | 63 | 63 | ||||||||||||||||||
Other operating expenses |
352 | 678 | 4 | 1 | 7,515 | 8,550 | ||||||||||||||||||
Income (loss) from continuing operations |
112,293 | 38,223 | (375 | ) | (1,062 | ) | (8,614 | ) | 140,465 | |||||||||||||||
Income (loss) from discontinued operations |
| | | (40 | ) | | (40 | ) | ||||||||||||||||
Net income (loss) |
112,293 | 38,223 | (375 | ) | (1,102 | ) | (8,614 | ) | 140,425 | |||||||||||||||
Preferred dividends |
| | | | (3,268 | ) | (3,268 | ) | ||||||||||||||||
Excess of carrying amount of exchanged preferred stock over fair value of consideration paid - Note 9 |
| | | | 43,043 | 43,043 | ||||||||||||||||||
Income (loss) applicable to common stockholders |
$ | 112,293 | $ | 38,223 | $ | (375 | ) | $ | (1,102 | ) | $ | 31,161 | $ | 180,200 | ||||||||||
March 31, 2010 |
||||||||||||||||||||||||
Investments (C) (D) |
$ | 2,388,797 | $ | 759,863 | $ | 18,994 | $ | 5,848 | $ | | $ | 3,173,502 | ||||||||||||
Cash and restricted cash |
233,979 | | 200 | 260 | 11,432 | 245,871 | ||||||||||||||||||
Other assets |
34,114 | | 143 | 16,133 | 1,480 | 51,870 | ||||||||||||||||||
Total assets |
2,656,890 | 759,863 | 19,337 | 22,241 | 12,912 | 3,471,243 | ||||||||||||||||||
Debt (D) |
(3,628,184 | ) | (695,676 | ) | (12,889 | ) | | (51,257 | ) | (4,388,006 | ) | |||||||||||||
Derivative liabilities |
(160,736 | ) | (24,062 | ) | | | | (184,798 | ) | |||||||||||||||
Other liabilities |
(1,772 | ) | (672 | ) | (611 | ) | (137 | ) | (13,025 | ) | (16,217 | ) | ||||||||||||
Total liabilities |
(3,790,692 | ) | (720,410 | ) | (13,500 | ) | (137 | ) | (64,282 | ) | (4,589,021 | ) | ||||||||||||
Preferred stock |
| | | | (61,583 | ) | (61,583 | ) | ||||||||||||||||
GAAP book value (E) |
$ | (1,133,802 | ) | $ | 39,453 | $ | 5,837 | $ | 22,104 | $ | (112,953 | ) | $ | (1,179,361 | ) | |||||||||
Three Months Ended March 31, 2009 |
||||||||||||||||||||||||
Interest income |
$ | 100,763 | $ | 20,342 | $ | 2,518 | $ | 829 | $ | 21 | $ | 124,473 | ||||||||||||
Interest expense |
38,314 | 19,156 | 1,197 | | 1,877 | 60,544 | ||||||||||||||||||
Net interest income (expense) |
62,449 | 1,186 | 1,321 | 829 | (1,856 | ) | 63,929 | |||||||||||||||||
Impairment |
279,941 | 3,596 | 21,294 | 2,639 | | 307,470 | ||||||||||||||||||
Other income (loss) |
13,800 | (5,681 | ) | 4,233 | (37 | ) | 2 | 12,317 | ||||||||||||||||
Depreciation and amortization |
| | | | 72 | 72 | ||||||||||||||||||
Other operating expenses |
440 | 941 | 22 | 1 | 6,115 | 7,519 | ||||||||||||||||||
Income (loss) from continuing operations |
(204,132 | ) | (9,032 | ) | (15,762 | ) | (1,848 | ) | (8,041 | ) | (238,815 | ) | ||||||||||||
Income (loss) from discontinued operations |
| | | (33 | ) | | (33 | ) | ||||||||||||||||
Net income (loss) |
(204,132 | ) | (9,032 | ) | (15,762 | ) | (1,881 | ) | (8,041 | ) | (238,848 | ) | ||||||||||||
Preferred dividends |
| | | | (3,375 | ) | (3,375 | ) | ||||||||||||||||
Income (loss) applicable to common stockholders |
$ | (204,132 | ) | $ | (9,032 | ) | $ | (15,762 | ) | $ | (1,881 | ) | $ | (11,416 | ) | $ | (242,223 | ) | ||||||
(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 $7.0 million (carrying value) was recourse as of March 31, 2010. |
(C) | At March 31, 2010, carrying values of investments in the unlevered segment include $1.6 million of real estate securities, $4.2 million of real estate related loans and $0.04 million of interests in a joint venture. |
6
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
(D) | Included in the other non-recourse segment were $403.2 million of Investments and Debt at March 31, 2010, representing the loans subject to call option of the two subprime securitizations and the corresponding financing. |
(E) | 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 an increase to GAAP book value is $706.8 million as of March 31, 2010. |
Equity Method Investees
The following table summarizes the activity for significant equity method investees:
Real Estate Loan | ||||
Balance at December 31, 2009 |
$ | 193 | ||
Distributions from equity method investees |
(237 | ) | ||
Equity in earnings of equity method investees |
85 | |||
Balance at March 31, 2010 |
$ | 41 | ||
Variable Interest Entities (VIEs)
In June 2009, the FASB issued new guidance which changes the definition of a 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. This guidance is effective for fiscal years beginning after November 15, 2009. As a result, on January 1, 2010, Newcastle deconsolidated a non-recourse financing structure, CDO VII. Newcastle determined that it does not have the current power to direct the relevant activities of CDO VII as an event of default had occurred and we may be removed as the collateral manager by a single party. The deconsolidation has reduced Newcastles gross assets by $149.4 million, reduced liabilities by $437.8 million and increased equity by $288.4 million. The deconsolidation also reduced revenues and expenses, but its impact was not material to the net income applicable to common stockholders. As a result of this new guidance, Newcastle has interests in the following unconsolidated VIE at March 31, 2010, in which it has a significant interest, in addition to the subprime securitizations which are described in Note 4:
Entity |
Gross Assets (A) | Debt (B) | Carrying Value of Newcastles Investment (C) | ||||||
CDO VII |
$ | 493,449 | $ | 516,521 | $ | |
(A) | Face amount. |
(B) | Includes $60.0 million face amount of debt owned by Newcastle with a carrying value of zero at March 31, 2010. |
(C) | Represents Newcastles maximum exposure to loss from these entities. |
Gain (Loss) on Settlement of Investments, Net and Other Income (Loss), Net
These items are comprised of the following:
Three Months Ended March 31, | ||||||||
2010 | 2009 | |||||||
Gain (loss) on settlement of investments, net |
||||||||
Gain on settlement of real estate securities |
$ | 13,817 | $ | 7,388 | ||||
Loss on settlement of real estate securities |
(861 | ) | (15,619 | ) | ||||
Gain on disposition of loans held for sale |
| 180 | ||||||
Realized gain (loss) on termination of derivative instruments |
(3,279 | ) | 4 | |||||
$ | 9,677 | $ | (8,047 | ) | ||||
Other income (loss), net |
||||||||
Gain (loss) on non-hedge derivative instruments |
$ | (1,748 | )$ | 3,116 | ||||
Unrealized (loss) recognized at de-designation of hedges |
| (8,797 | ) | |||||
Hedge ineffectiveness |
(1 | ) | (828 | ) | ||||
Other income (loss) |
184 | 15 | ||||||
$ | (1,565 | ) | $ | (6,494 | ) | |||
7
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
3. REAL ESTATE SECURITIES
The following is a summary of Newcastles real estate securities at March 31, 2010, 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) (D) |
Principal Subordination (E) |
||||||||||||||||||||||||||||
Asset Type |
Gains | Losses | |||||||||||||||||||||||||||||||||||||
CMBS-Conduit |
$ | 1,416,362 | $ | 1,228,967 | $ | (446,387 | ) | $ | 782,580 | $ | 64,511 | $ | (185,075 | ) | $ | 662,016 | 190 | BBB- | 5.77 | % | 9.78 | % | 3.7 | 10.4 | % | ||||||||||||||
CMBS- Single Borrower |
625,928 | 609,647 | (47,088 | ) | 562,559 | 9,204 | (130,577 | ) | 441,186 | 70 | BB- | 4.24 | % | 5.85 | % | 2.1 | 8.6 | % | |||||||||||||||||||||
CMBS-Large Loan |
85,305 | 87,032 | (17,514 | ) | 69,518 | | (24,369 | ) | 45,149 | 11 | B+ | 1.78 | % | 2.04 | % | 1.0 | 11.3 | % | |||||||||||||||||||||
REIT Debt |
394,550 | 394,396 | | 394,396 | 13,128 | (15,551 | ) | 391,973 | 46 | BB+ | 6.14 | % | 5.87 | % | 3.8 | N/A | |||||||||||||||||||||||
ABS-Subprime (F) |
418,268 | 415,103 | (248,246 | ) | 166,857 | 6,543 | (15,730 | ) | 157,670 | 94 | B | 1.67 | % | 13.37 | % | 4.2 | 18.7 | % | |||||||||||||||||||||
ABS-Manufactured Housing |
50,534 | 49,108 | | 49,108 | 736 | (3,503 | ) | 46,341 | 9 | BBB+ | 6.69 | % | 7.25 | % | 5.5 | 37.2 | % | ||||||||||||||||||||||
ABS-Franchise |
32,780 | 33,170 | (20,650 | ) | 12,520 | 42 | (2,994 | ) | 9,568 | 15 | B | 3.84 | % | 5.05 | % | 2.4 | 18.3 | % | |||||||||||||||||||||
FNMA/FHLMC (G) |
4,164 | 5,271 | | 5,271 | 58 | | 5,329 | 1 | AAA | 5.73 | % | 3.98 | % | 3.6 | N/A | ||||||||||||||||||||||||
CDO (H) |
78,852 | 14,734 | (14,734 | ) | | | | | 4 | C | 4.14 | % | 0.00 | % | | N/A | |||||||||||||||||||||||
Debt Security Total /Average (I) |
3,106,743 | 2,837,428 | (794,619 | ) | 2,042,809 | 94,222 | (377,799 | ) | 1,759,232 | 440 | BB | 4.80 | % | 7.87 | % | 3.3 | |||||||||||||||||||||||
Equity Securities |
1,388 | (276 | ) | 1,112 | 4,083 | | 5,195 | 2 | |||||||||||||||||||||||||||||||
Total |
$ | 2,838,816 | $ | (794,895 | ) | $ | 2,043,921 | $ | 98,305 | $ | (377,799 | ) | $ | 1,764,427 | $ | 442 | |||||||||||||||||||||||
(A) | Represents the cumulative impairment against amortized cost basis recorded through earnings, net of the effect of the cumulative adjustment as a result of the adoption of new accounting guidance on impairment in 2009. |
(B) | See Note 6 regarding the estimation of fair value, which is equal to carrying value for all securities. |
(C) | Represents the weighted average of the ratings of all securities in each asset type, expressed as an S&P equivalent rating. For each security rated by multiple rating agencies, the lowest rating is used. 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) | The weighted average maturity is based on the timing of expected principal reduction on the assets. |
(E) | Percentage of the outstanding face amount of securities that is subordinate to Newcastles investments. |
(F) | Includes the retained bonds with face amount of $52.5 million and carrying value of $1.6 million from Securitization Trust 2006 and Securitization Trust 2007 (Note 4). The residual interests were fully written off as of March 31, 2010. |
(G) | Amortized cost basis and carrying value include principal receivable of $0.9 million. |
(H) | Includes one CDO bond issued by a third party and three CDO bonds issued by CDO VII, which has been deconsolidated, and held as investments by Newcastle. |
(I) | The total outstanding face amount of fixed rate securities was $2.2 billion, and of floating rate securities was $0.9 billion. |
8
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
Unrealized losses that are considered other-than-temporary are recognized currently in income. During the three months ended March 31, 2010, Newcastle recorded other-than-temporary impairment charges (OTTI) of $64.9 million (gross of $37.1 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. Any remaining unrealized losses on Newcastles securities were primarily the result of changes in market factors, rather than issue-specific credit impairment. The following table summarizes Newcastles securities in an unrealized loss position as of March 31, 2010.
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 | Coupon | Yield | Maturity (Years) | |||||||||||||||||||||||
Less Than Twelve Months |
$ | 191,811 | $ | 156,835 | $ | (65,805 | ) | $ | 91,030 | $ | | $ | (4,979 | ) | 86,051 | 25 | BB+ | 5.11 | % | 11.46 | % | 4.7 | |||||||||||||
Twelve or More Months |
1,437,391 | 1,429,357 | (220,955 | ) | 1,208,402 | | (372,820 | ) | 835,582 | 232 | BB- | 4.61 | % | 5.15 | % | 3.2 | |||||||||||||||||||
Total |
$ | 1,629,202 | $ | 1,586,192 | $ | (286,760 | ) | $ | 1,299,432 | $ | | $ | (377,799 | ) | $ | 921,633 | 257 | BB | 4.67 | % | 5.59 | % | 3.4 | ||||||||||||
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 OTTI, exceeds its fair value) and determined the following:
March 31, 2010 | |||||||||||||
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 |
80,288 | 127,790 | (283,219 | ) | (47,502 | ) | |||||||
Non credit impaired securities |
841,345 | 1,171,642 | | (330,297 | ) | ||||||||
Total debt securities in an unrealized loss position |
921,633 | 1,299,432 | (283,219 | ) | (377,799 | ) | |||||||
(A) | Newcastle may, at times, be more likely than not to be required to sell certain securities for liquidity purposes. While the amount of the securities to be sold may be an estimate, and the securities to be sold have not yet been identified, Newcastle must make its best estimate, which is subject to significant judgment regarding future events, and may differ materially from actual future sales. |
(B) | Excluding the effect of previously recorded OTTI. This amount is required to be recorded as other-than-temporary impairment through earnings. 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. |
The following table summarizes the activity related to credit losses on debt securities for the three months ended March 31, 2010:
Beginning balance of credit losses on debt securities for which a portion of an OTTI was recognized in other comprehensive income |
$ | (408,782 | ) | |
Additions for credit losses on securities for which an OTTI was not previously recognized |
(1,113 | ) | ||
Increases to credit losses on securities for which an OTTI was previously recognized and a portion of an OTTI was recognized in other comprehensive income |
(37,426 | ) | ||
Additions for credit losses on securities for which an OTTI was previously recognized without any portion of OTTI recognized in other comprehensive income |
(65,330 | ) | ||
Reduction for credit losses on securities for which no OTTI was recognized in other comprehensive income at March 31, 2010 |
115,400 | |||
Reduction for securities sold during the period |
7,412 | |||
Reduction for securities deconsolidated during the period |
105,356 | |||
Reduction for increases in cash flows expected to be collected that are recognized over the remaining life of the security |
1,264 | |||
Ending balance of credit losses on debt securities for which a portion of an OTTI was recognized in other comprehensive income |
$ | (283,219 | ) | |
9
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
The table below summarizes the geographic distribution of the collateral securing our CMBS and ABS at March 31, 2010 (in thousands):
CMBS | ABS | |||||||||||
Geographic Location |
Outstanding Face Amount | Percentage | Outstanding Face Amount | Percentage | ||||||||
Western U.S. |
$ | 532,005 | 25.0 | % | $ | 144,851 | 28.9 | % | ||||
Northeastern U.S. |
484,626 | 22.8 | % | 93,823 | 18.7 | % | ||||||
Southeastern U.S. |
412,327 | 19.4 | % | 121,259 | 24.2 | % | ||||||
Midwestern U.S. |
284,932 | 13.4 | % | 68,972 | 13.8 | % | ||||||
Southwestern U.S. |
236,096 | 11.1 | % | 55,788 | 11.1 | % | ||||||
Other |
155,406 | 7.3 | % | 16,881 | 3.3 | % | ||||||
Foreign |
22,203 | 1.0 | % | 8 | 0.0 | % | ||||||
$ | 2,127,595 | 100.0 | % | $ | 501,582 | 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.
4. REAL ESTATE RELATED LOANS, RESIDENTIAL MORTGAGE LOANS AND SUBPRIME MORTGAGE LOANS
All of Newcastles loan investments were classified as held for sale as of March 31, 2010 and December 31, 2009 and marked to the lower of carrying value or fair value.
The following is a summary of real estate related loans, residential mortgage loans and subprime mortgage loans at March 31, 2010. 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 Coupon |
Weighted Average Maturity (Years) (A) |
Floating Rate Loans as a % of Face Amount |
Delinquent Face Amount (B) | ||||||||||||||
Mezzanine Loans |
$ | 717,134 | $ | 250,066 | 21 | 36.52 | % | 4.76 | % | 1.9 | 85.5 | % | $ | 130,258 | ||||||||
Corporate Bank Loans |
291,598 | 207,246 | 9 | 11.11 | % | 7.95 | % | 3.7 | 100.0 | % | 37,081 | |||||||||||
B-Notes |
308,006 | 101,452 | 11 | 26.58 | % | 4.43 | % | 2.0 | 84.2 | % | 131,589 | |||||||||||
Whole Loans |
56,085 | 29,124 | 3 | 19.09 | % | 2.91 | % | 4.7 | 96.2 | % | | |||||||||||
Total Real Estate Related Loans Held for Sale, Net (C) |
$ | 1,372,823 | $ | 587,888 | 44 | 24.98 | % | 5.29 | % | 2.4 | 88.7 | % | $ | 298,928 | ||||||||
Residential Loans |
$ | 67,694 | $ | 51,316 | 236 | 5.12 | % | 2.53 | % | 5.7 | 100.0 | % | $ | 6,570 | ||||||||
Manufactured Housing Loans Portfolio I |
166,684 | 135,609 | 4,288 | 8.48 | % | 8.76 | % | 7.4 | 1.3 | % | 2,629 | |||||||||||
Manufactured Housing Loans Portfolio II |
236,065 | 221,065 | 7,790 | 8.45 | % | 9.75 | % | 6.6 | 17.3 | % | 4,101 | |||||||||||
Total Residential Mortgage Loans Held for Sale, Net (C) |
$ | 470,443 | $ | 407,990 | 12,314 | 8.04 | % | 8.36 | % | 6.8 | 23.5 | % | $ | 13,300 | ||||||||
Subprime Mortgage Loans Subject to Call Option |
$ | 406,217 | $ | 403,190 | ||||||||||||||||||
(A) | The weighted average maturity is based on the timing of expected principal reduction on the assets. |
(B) | Includes loans that are non-performing, in foreclosure, under bankruptcy, or considered real estate owned. |
(C) | Carrying value includes interest receivable of $0.1 million for the residential housing loans and principal and interest receivable of $6.6 million for the manufactured housing loans. |
10
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
The following is a reconciliation of the related loss allowance.
Real Estate Related Loans |
Residential Mortgage Loans |
|||||||
Balance at December 31, 2009 |
$ | (822,409 | ) | $ | (96,409 | ) | ||
Charge-offs |
13,199 | 2,620 | ||||||
Deconsolidation of CDO VII |
5,263 | | ||||||
Recoveries |
| | ||||||
Valuation (allowance) reversal on loans |
59,092 | 36,682 | ||||||
Balance at March 31, 2010 |
$ | (744,855 | ) | $ | (57,107 | ) | ||
The charge-offs of $13.2 million for the three months ended March 31, 2010 represent two loans which were either sold or paid off at a discounted price during the period.
Securitization of Subprime Mortgage Loans
The following table presents information on the retained interests in Newcastles securitizations of subprime mortgage loans at March 31, 2010:
Subprime Portfolio | ||||||
I | II | |||||
Total securitized loans (unpaid principal balance) (A) |
$ | 571,635 | $ | 754,874 | ||
Loans subject to call option (carrying value) |
$ | 299,176 | $ | 104,014 | ||
Retained interests (fair value) (B) |
$ | 1,377 | $ | 192 |
(A) | Average loan seasoning of 56 months and 38 months for Subprime Portfolios I and II, respectively, at March 31, 2010. |
(B) | The retained interests include retained bonds of the securitizations. As of March 31, 2010, Newcastles residual interests have been written off. Fair value is estimated based on pricing models. |
The following table summarizes certain characteristics of the underlying subprime mortgage loans, and related financing, in the securitizations as of March 31, 2010:
Subprime Portfolio | ||||||||
I | II | |||||||
Loan unpaid principal balance (UPB) |
$ | 571,635 | $ | 754,874 | ||||
Weighted average coupon rate of loans |
6.83 | % | 6.55 | % | ||||
Delinquencies of 60 or more days (UPB) (A) |
$ | 159,833 | $ | 279,077 | ||||
Net credit losses for the three months ended March 31, 2010 |
$ | 9,462 | $ | 21,145 | ||||
Cumulative net credit losses |
$ | 134,989 | $ | 124,392 | ||||
Cumulative net credit losses as a % of original UPB |
8.99 | % | 11.43 | % | ||||
Percentage of ARM loans (B) |
53.5 | % | 66.1 | % | ||||
Percentage of loans with loan-to-value ratio >90% |
10.50 | % | 17.20 | % | ||||
Percentage of interest-only loans |
23.2 | % | 3.9 | % | ||||
Face amount of debt (C) |
$ | 551,270 | $ | 722,057 | ||||
Weighted average funding cost of debt (D) |
1.57 | % | 2.02 | % |
(A) | Delinquencies include loans 60 or more days past due, in foreclosure, under bankruptcy filing or real estate owned. |
(B) | ARM loans are adjustable-rate mortgage loans. An option ARM is an adjustable-rate mortgage that provides the borrower with an option to choose from several payment amounts each month for a specified period of the loan term. None of the loans in the subprime portfolios are an option ARM. |
(C) | Excludes face amount of $19.7 million and $32.8 million of retained notes for Subprime Portfolios I and II, respectively, at March 31, 2010. |
(D) | Includes the effect of applicable hedges. |
Newcastle received net cash inflows of $0.1 million and $0.2 million from the retained interests of Subprime Portfolios I and II, respectively, during the three months ended March 31, 2010.
The weighted average yield of the retained notes of Subprime Portfolios I and II was 18.38%, as of March 31, 2010. 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.
11
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(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 March 31, 2010:
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 | $ | 365,447 | $ | 364,347 | 1.21% | Mar 2039 | 2.89 | % | 2.9 | $ | 341,411 | $ | 416,783 | $ | 353,067 | $ | 261,887 | 3.2 | $ | 165,566 | $ | 165,300 | ||||||||||||||||
CDO V (D) |
Sep 2004 | 440,773 | 439,219 | 0.99% | Sep 2039 | 2.73 | % | 3.1 | 428,395 | 502,232 | 375,718 | 285,052 | 3.3 | 205,773 | 188,367 | ||||||||||||||||||||||||
CDO VI (D) |
Apr 2005 | 435,043 | 433,585 | 0.75% | Apr 2040 | 3.13 | % | 3.9 | 427,150 | 482,713 | 261,387 | 222,943 | 2.9 | 171,613 | 224,702 | ||||||||||||||||||||||||
CDO VIII |
Nov 2006 | 675,563 | 675,149 | 0.94% | Nov 2052 | 2.08 | % | 3.8 | 667,963 | 814,914 | 458,787 | 465,321 | 3.6 | 571,584 | 161,655 | ||||||||||||||||||||||||
CDO IX |
May 2007 | 532,125 | 537,249 | 0.78% | May 2052 | 1.59 | % | 4.7 | 532,125 | 828,094 | 452,632 | 465,089 | 2.4 | 628,042 | 91,694 | ||||||||||||||||||||||||
CDO X |
Jul 2007 | 1,175,000 | 1,173,954 | 0.37% | Jul 2052 | 4.49 | % | 5.3 | 1,175,000 | 1,336,375 | 1,003,997 | 925,559 | 3.7 | 297,300 | 943,764 | ||||||||||||||||||||||||
3,623,951 | 3,623,503 | 3.08 | % | 4.3 | 3,572,044 | 4,381,111 | 2,905,588 | 2,625,851 | 3.3 | 2,039,878 | 1,775,482 | ||||||||||||||||||||||||||||
Other Bonds Payable |
|||||||||||||||||||||||||||||||||||||||
MH loans Portfolio I (E) |
Jan 2006 | 101,719 | 101,718 | LIBOR+0.75% | (E | ) | 5.21 | % | | 101,719 | 166,684 | 135,609 | 135,609 | 7.4 | 2,123 | | |||||||||||||||||||||||
MH loans Portfolio II (F) |
Aug 2006 | 191,336 | 190,768 | LIBOR+1.00% | Aug 2011 | 6.25 | % | 1.2 | 191,336 | 236,065 | 221,065 | 221,065 | 6.6 | 40,852 | | ||||||||||||||||||||||||
293,055 | 292,486 | 5.89 | % | 0.8 | 293,055 | 402,749 | 356,674 | 356,674 | 6.9 | 42,975 | | ||||||||||||||||||||||||||||
Notes Payable (J) |
|||||||||||||||||||||||||||||||||||||||
Residential Mortgage Loans |
Aug 2004 | 4,681 | 4,681 | LIBOR+0.90% | Dec 2034 | 1.15 | % | 5.8 | 4,681 | 4,681 | 4,681 | 4,681 | 5.8 | 4,681 | | ||||||||||||||||||||||||
4,681 | 4,681 | 1.15 | % | 5.8 | 4,681 | 4,681 | 4,681 | 4,681 | 5.8 | 4,681 | | ||||||||||||||||||||||||||||
Repurchase Agreements (G) |
|||||||||||||||||||||||||||||||||||||||
RE securities, loans and properties |
Various | 12,889 | 12,889 | LIBOR+2.43% | (G | ) | 2.68 | % | | 12,889 | 153,285 | 18,994 | 18,994 | 0.3 | 141,332 | | |||||||||||||||||||||||
12,889 | 12,889 | 2.68 | % | | 12,889 | 153,285 | 18,994 | 18,994 | 0.3 | 141,332 | | ||||||||||||||||||||||||||||
Corporate |
|||||||||||||||||||||||||||||||||||||||
Junior subordinated notes payable (H) |
Mar 2006 | 51,004 | 51,257 | 7.574%(H) | Apr 2035 | 7.42 | % | 25.1 | | | | | | | | ||||||||||||||||||||||||
51,004 | 51,257 | 7.42 | % | 25.1 | | | | | | | | ||||||||||||||||||||||||||||
Subtotal debt obligations |
3,985,580 | 3,984,816 | 3.33 | % | 4.3 | $ | 3,882,669 | $ | 4,941,826 | $ | 3,285,937 | $ | 3,006,200 | 3.5 | $ | 2,228,866 | $ | 1,775,482 | |||||||||||||||||||||
Financing on subprime mortgage loans subject to call option |
(I | ) | 406,217 | 403,190 | |||||||||||||||||||||||||||||||||||
Total debt obligations |
$ | 4,391,797 | $ | 4,388,006 | |||||||||||||||||||||||||||||||||||
(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 reinvestment in CDOs. The face amount and carrying value of Newcastles unlevered investments (real estate loans and securities) were $179.0 million and $5.8 million, respectively, as of March 31, 2010. |
(D) | CDOs IV, V and VI were not in compliance with their applicable over collateralization tests as of March 31, 2010. 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 $7.1 million face amount is recourse financing. |
(G) | The counterparties on these repurchase agreements are Deutsche Bank ($4.9 million) and Citigroup ($8.0 million). These non-FNMA/FHLMC financings were repaid in full in April 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. In connection with the preferred stock exchange (Note 9), the interest rate reverted to 7.574% on February 1, 2010. |
(I) | Issued in April 2006 and July 2007. See Note 4 regarding the securitizations of Subprime Portfolios I and II. |
(J) | Notes payable issued to CDO VII, which was previously eliminated in consolidation. |
12
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
See Note 2 regarding the deconsolidation of CDO VII.
In the first quarter of 2010, Newcastle repurchased $56.3 million face amount of CDO bonds for $7.6 million. As a result, Newcastle extinguished $56.3 million face amount of CDO debt and recorded a gain on extinguishment of debt of 48.3 million in the first quarter of 2010.
On January 29, 2010, Newcastle entered into an Exchange Agreement, dated as of January 29, 2010 (the Exchange Agreement), with Taberna Capital Management, LLC and certain of its affiliates (collectively, Taberna), pursuant to which Newcastle and Taberna agreed to exchange (the Exchange) approximately $52.1 million aggregate principal amount of junior subordinated notes due 2035 for approximately $37.6 million face amount of previously issued CDO securities and approximately $9.7 million of cash held by Newcastle. In other words, $51.9 million face amount of Newcastles debt, in the form of junior subordinated notes payable, was repurchased and extinguished for GAAP purposes in exchange for (i) the payment of $9.7 million of cash and (ii) the reissuance of $37.6 million face amount of CDO bonds payable (which had previously been repurchased by Newcastle). In connection with the Exchange, Newcastle paid or reimbursed $0.6 million of expenses incurred by Taberna, various indenture trustees and their respective advisors in accordance with the terms of the Exchange Agreement. Newacastle accounted for this exchange as a troubled debt restructuring involving the partial repayment of debt. As a result, Newcastle recorded no gain or loss. The following table presents certain information regarding the exchange:
Consideration | ||||||||||||||
Repurchased junior subordinated notes |
Cash | Reissued CDO bonds | Total | |||||||||||
Outstanding face amount |
$ | 51,891 | $ | 9,715 | $ | 37,625 | $ | 47,340 | ||||||
Weighted average coupon |
7.574 | % (A) | N/A | LIBOR + 0.66 | % (B) | |||||||||
Weighted average contractual maturity |
April 2035 | June 2052 | ||||||||||||
Collateral |
|
General credit of Newcastle |
|
|
Assets within the respective CDOs |
|
(A) | LIBOR + 2.25% after April 2016 |
(B) | Weighted average effective interest rate of approximately LIBOR+0.35% after the Exchange. |
The fair value of the consideration paid approximated the fair value of the repurchased junior subordinated notes of $16.7 million.
On April 15, 2010, Newcastle completed a securitization transaction to refinance its Manufactured Housing Loans Portfolio I (the Portfolio). Newcastle sold approximately $164.1 million outstanding principal balance of manufactured housing loans to Newcastle MH I LLC (the Issuer), an indirect wholly-owned subsidiary of Newcastle. The Issuer issued approximately $134.5 million aggregate principal amount of asset-backed notes (the Notes), of which $97.6 million was sold to third parties and $36.9 million was sold to certain CDOs managed and consolidated by Newcastle. Beginning in January 2009, the previously existing financing on this portfolio ($101.7 million as of March 31, 2010) became callable at the option of the lender, and the principal and interest payments from the Portfolio (net of expenses and payments related to related interest rate swap contracts) were used to repay the previously existing debt. At the closing of the securitization transaction, Newcastle used the gross proceeds received from the issuance of the Notes to repay the previously existing debt in full, terminate the related interest rate swap contracts, pay the related transaction costs and increase its unrestricted cash by approximately $14 million. Newcastle is currently evaluating the impact of this transaction on its financial results, which will be recorded in the second quarter of 2010.
In April 2010, Newcastle repaid in full its outstanding repurchase agreements of $12.9 million as of March 31, 2010.
13
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(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 March 31, 2010:
Principal Balance or Notional Amount |
Carrying Value |
Fair Value | Fair Value Method (A) |
Weighted Average Yield/Funding Cost |
Weighted Average Maturity (Years) |
||||||||||||
Assets |
|||||||||||||||||
Non-Recourse VIE Financing Structures (F) |
|||||||||||||||||
Financial instruments: |
|||||||||||||||||
Real estate securities, available for sale* |
$ | 2,913,513 | $ | 1,762,830 | $ | 1,762,830 | Broker quotations, counterparty quotations, pricing services, pricing models | 7.83 | % | 3.5 | |||||||
Real estate related loans, held for sale |
1,187,579 | 578,166 | 578,181 | Broker quotations, counterparty quotations, pricing services, pricing models | 24.93 | % | 2.5 | ||||||||||
Residential mortgage loans, held for sale |
466,648 | 404,474 | 404,474 | Pricing models | 8.07 | % | 7.0 | ||||||||||
Subprime mortgage loans subject to call option (B) |
406,217 | 403,190 | 403,190 | (B) | 9.09 | % | (B | ) | |||||||||
Restricted cash* |
233,979 | 233,979 | 233,979 | ||||||||||||||
Receivables and other assets |
34,114 | 34,114 | |||||||||||||||
$ | 3,416,753 | $ | 3,416,768 | ||||||||||||||
Recourse Financing Structures and Unlevered Assets |
|||||||||||||||||
Financial instruments: |
|||||||||||||||||
Real estate securities, available for sale* |
$ | 193,230 | $ | 1,597 | $ | 1,597 | Broker quotations, counterparty quotations, pricing services, pricing models | 71.50 | % | 0.4 | |||||||
Real estate related loans, held for sale |
185,244 | 9,722 | 9,722 | Broker quotations, counterparty quotations, pricing services, pricing models | 28.26 | % | 1.6 | ||||||||||
Residential mortgage loans, held for sale |
3,795 | 3,516 | 3,516 | Pricing models | 4.98 | % | 2.8 | ||||||||||
Restricted cash* |
54 | 54 | 54 | ||||||||||||||
Cash and cash equivalents* |
11,838 | 11,838 | 11,838 | ||||||||||||||
Investments in equity method investees |
41 | 41 | |||||||||||||||
Operating real estate, held for sale |
9,966 | 9,966 | |||||||||||||||
Receivables and other assets |
17,756 | 17,756 | |||||||||||||||
$ | 54,490 | $ | 54,490 | ||||||||||||||
Liabilities |
|||||||||||||||||
Non-Recourse VIE Financing Structures (F) (G) |
|||||||||||||||||
Financial instruments: |
|||||||||||||||||
CDO bonds payable |
$ | 3,623,951 | $ | 3,623,503 | $ | 1,546,623 | Pricing models | 3.08 | % | 4.3 | |||||||
Other bonds payable ($7.1 million face amount is recourse) |
293,055 | 292,486 | 269,578 | Pricing models | 5.89 | % | 0.8 | ||||||||||
Notes payable |
4,681 | 4,681 | 3,803 | Broker quotation | 1.15 | % | 5.8 | ||||||||||
Financing of subprime mortgage loans subject to call option (B) |
406,217 | 403,190 | 403,190 | (B) | 9.09 | % | (B | ) | |||||||||
Interest rate swaps, treated as hedges (C )(E)* |
1,775,482 | 160,736 | 160,736 | Counterparty quotations | N/A | (C | ) | ||||||||||
Non-hedge derivatives (D)(E)* |
239,957 | 24,062 | 24,062 | Counterparty quotations | N/A | (D | ) | ||||||||||
Accrued expenses and other liabilities |
2,444 | 2,444 | |||||||||||||||
$ | 4,511,102 | $ | 2,410,436 | ||||||||||||||
Recourse Financing Structures and Other Liabilities (G) |
|||||||||||||||||
Financial instruments: |
|||||||||||||||||
Repurchase agreements |
$ | 12,889 | $ | 12,889 | $ | 12,889 | Market comparables | 2.68 | % | 0.0 | |||||||
Junior subordinated notes payable |
51,004 | 51,257 | 16,423 | Pricing models | 7.42 | % | 25.1 | ||||||||||
Due to affiliates |
1,482 | 1,482 | |||||||||||||||
Accrued expenses and other liabilities |
12,291 | 12,291 | |||||||||||||||
$ | 77,919 | $ | 43,085 | ||||||||||||||
* | Measured at fair value on a recurring basis. |
14
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
(A) | Methods are listed in order of priority. In the case of real estate securities and real estate related loans, broker quotations are obtained if available and practicable, otherwise counterparty quotations or pricing service valuations are obtained or, finally, internal pricing models are used. Internal pricing models are only used for (i) securities and loans that are not traded in an active market, and, therefore, have little or no price transparency, and for which significant unobservable inputs must be used in estimating fair value, or (ii) loans or debt obligations which are private and untraded. |
(B) | These two items result from an option, not an obligation, to repurchase loans from 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: |
Year of Maturity |
Weighted Average Month of Maturity |
Aggregate Notional Amount |
Weighted Average Fixed Pay Rate |
Aggregate Fair Value Liability, Net | |||||||
Agreements which receive 1-Month LIBOR: |
|||||||||||
2011 |
Dec | $ | 91,694 | 5.00 | % | $ | 6,266 | ||||
2014 |
Oct | 16,235 | 5.09 | % | 1,776 | ||||||
2015 |
Sep | 959,697 | 5.31 | % | 85,576 | ||||||
2016 |
May | 180,155 | 5.04 | % | 19,818 | ||||||
2017 |
Aug | 174,034 | 5.24 | % | 22,680 | ||||||
Agreements which receive 3-Month LIBOR: |
|||||||||||
2014 |
Jun | 353,667 | 4.20 | % | 24,620 | ||||||
$ | 1,775,482 | $ | 160,736 | ||||||||
(D) | These include three interest rate swaps with a total notional balance of $240.0 million. The maturity dates of the $89.7 million, $4.8 million and $145.4 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. |
(E) | Newcastles derivatives fall into two categories. Derivatives held within Newcastles nonrecourse debt structures (primarily CDOs), 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 CDO. 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. |
(F) | Assets held within CDOs and other non-recourse structures are not available to satisfy obligations outside of such financings, except to the extent Newcastle receives net cash flow distributions from such structures. Furthermore, our economic losses from such structures cannot exceed Newcastles invested equity in them. Therefore, economically, their net book value cannot be less than zero and as a result, the fair value of Newcastles net investments in these non-recourse financing structures is equal to the present value of their expected future net cash flows. |
(G) | Newcastle notes that the unrealized gain on the liabilities within such structures cannot be fully realized. |
Valuation Hierarchy
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 measured at fair value on a recurring basis at March 31, 2010:
Principal Balance or Notional Amount |
Carrying Value | Fair Value | ||||||||||||||||
Level 2 | Level 3A (1) | Level 3B (2) | Total | |||||||||||||||
Assets: |
||||||||||||||||||
Real estate securities, available for sale: |
||||||||||||||||||
CMBS |
$ | 2,127,595 | $ | 1,148,351 | $ | | $ | 1,044,072 | $ | 104,279 | $ | 1,148,351 | ||||||
ABS - subprime |
418,268 | 157,670 | | 80,622 | 77,048 | 157,670 | ||||||||||||
ABS - other real estate |
83,314 | 55,909 | | 47,819 | 8,090 | 55,909 | ||||||||||||
CDO |
78,852 | | | | | | ||||||||||||
FNMA / FHLMC |
4,164 | 5,329 | 5,329 | | | 5,329 | ||||||||||||
REIT debt |
394,550 | 391,973 | 391,973 | | | 391,973 | ||||||||||||
Debt security total |
3,106,743 | 1,759,232 | 397,302 | 1,172,513 | 189,417 | 1,759,232 | ||||||||||||
Equity securities |
1,112 | | | 5,195 | 5,195 | |||||||||||||
Total |
$ | 1,760,344 | $ | 397,302 | $ | 1,172,513 | $ | 194,612 | $ | 1,764,427 | ||||||||
Liabilities: |
||||||||||||||||||
Interest rate swaps, treated as hedges |
1,775,482 | 160,736 | 160,736 | | | 160,736 | ||||||||||||
Non-hedge derivatives |
239,957 | 24,062 | 24,062 | | | 24,062 |
(1) | Third party pricing sources with significant unobservable inputs. |
(2) | Internal models with significant unobservable inputs. |
15
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
Newcastles investments in instruments measured at fair value on a recurring basis using Level 3 inputs changed during the three months ended March 31, 2010 as follows:
Level 3A | ||||||||||||||||||||||||
CMBS | ABS | Equity/Other Securities |
Total | |||||||||||||||||||||
Conduit | Other | Subprime | Other | |||||||||||||||||||||
Balance at December 31, 2009 |
$ | 536,092 | $ | 397,407 | $ | 87,883 | $ | 46,059 | $ | | $ | 1,067,441 | ||||||||||||
Transfers (C) |
||||||||||||||||||||||||
Transfers from Level 3B |
| | | | | | ||||||||||||||||||
Transfers into Level 3B |
(7,954 | ) | (1,206 | ) | (10,538 | ) | | | (19,698 | ) | ||||||||||||||
CDO VII Deconsolidation |
(32,858 | ) | (3,379 | ) | (10,685 | ) | | | (46,922 | ) | ||||||||||||||
Total gains (losses) (A) |
||||||||||||||||||||||||
Included in net income (loss) (B) |
5,614 | | 121 | | | 5,735 | ||||||||||||||||||
Included in other comprehensive income (loss) |
58,180 | 41,007 | (165 | ) | 2,624 | | 101,646 | |||||||||||||||||
Amortization included in interest income |
2,867 | 1,701 | 2,710 | 50 | | 7,328 | ||||||||||||||||||
Purchases, sales and settlements |
||||||||||||||||||||||||
Purchases |
65,855 | 10,000 | 23,361 | | | 99,216 | ||||||||||||||||||
Proceeds from sales |
(25,679 | ) | (634 | ) | (6,478 | ) | | | (32,791 | ) | ||||||||||||||
Proceeds from repayments |
(2,022 | ) | (919 | ) | (5,587 | ) | (914 | ) | | (9,442 | ) | |||||||||||||
Balance at March 31, 2010 |
$ | 600,095 | $ | 443,977 | $ | 80,622 | $ | 47,819 | $ | | $ | 1,172,513 | ||||||||||||
Level 3B | ||||||||||||||||||||||||
CMBS | ABS | Equity/Other Securities |
Total | |||||||||||||||||||||
Conduit | Other | Subprime | Other | |||||||||||||||||||||
Balance at December 31, 2009 |
$ | 95,376 | $ | 32,744 | $ | 85,377 | $ | 10,719 | $ | 2,620 | $ | 226,836 | ||||||||||||
Transfers (C) |
||||||||||||||||||||||||
Transfers from Level 3A |
7,954 | 1,206 | 10,538 | | | 19,698 | ||||||||||||||||||
Transfers into Level 3A |
| | | | | | ||||||||||||||||||
CDO VII Deconsolidation |
(48,665 | ) | | (17,890 | ) | (457 | ) | | (67,012 | ) | ||||||||||||||
Total gains (losses) (A) |
||||||||||||||||||||||||
Included in net income (loss) (B) |
(20,128 | ) | (6 | ) | (4,651 | ) | (2,090 | ) | (279 | ) | (27,154 | ) | ||||||||||||
Included in other comprehensive income (loss) |
31,325 | 8,447 | 7,360 | 472 | 2,851 | 50,455 | ||||||||||||||||||
Amortization included in interest income |
3,477 | 95 | 2,247 | 181 | | 6,000 | ||||||||||||||||||
Purchases, sales and settlements |
||||||||||||||||||||||||
Purchases |
| | | | 3 | 3 | ||||||||||||||||||
Proceeds from sales |
(170 | ) | | | | | (170 | ) | ||||||||||||||||
Proceeds from repayments |
(7,249 | ) | (127 | ) | (5,933 | ) | (735 | ) | | (14,044 | ) | |||||||||||||
Balance at March 31, 2010 |
$ | 61,920 | $ | 42,359 | $ | 77,048 | $ | 8,090 | $ | 5,195 | $ | 194,612 | ||||||||||||
(A) | None of the gains (losses) recorded in earnings during the period is attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates. |
(B) |
Three Months Ended March 31, 2010 |
||||||||
Level 3A | Level 3B | |||||||
Gain (loss) on settlement of investments, net |
$ | 6,405 | $ | (82 | ) | |||
Other income (loss), net |
| | ||||||
OTTI |
(670 | ) | (27,072 | ) | ||||
Total |
$ | 5,735 | $ | (27,154 | ) | |||
Gain (loss) on settlement of investments, net, from investments transferred into Level 3 during the period |
$ | | $ | |
(C) | Transfers are assumed to occur at the beginning of the quarter. |
16
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
Securities Valuation
As of March 31, 2010, Newcastles securities valuation methodology and results are further detailed as follows:
Outstanding Face Amount (A) |
Amortized Cost Basis (B) |
Fair Value | ||||||||||||||||
Asset Type |
Multiple Quotes (C) |
Single Quote (D) |
Internal Pricing Models (E) |
Total | ||||||||||||||
CMBS |
$ | 2,127,595 | $ | 1,414,657 | $ | 830,630 | $ | 213,442 | $ | 104,279 | $ | 1,148,351 | ||||||
ABS subprime |
418,268 | 166,857 | 63,345 | 17,277 | 77,048 | 157,670 | ||||||||||||
ABS other real estate |
83,314 | 61,628 | 4,365 | 43,454 | 8,090 | 55,909 | ||||||||||||
FNMA / FHLMC |
4,164 | 5,271 | | 5,329 | | 5,329 | ||||||||||||
REIT debt |
394,550 | 394,396 | 374,012 | 17,961 | | 391,973 | ||||||||||||
CDO |
78,852 | | | | | | ||||||||||||
Debt security total |
$ | 3,106,743 | 2,042,809 | 1,272,352 | 297,463 | 189,417 | 1,759,232 | |||||||||||
Equity securities |
1,112 | | | 5,195 | 5,195 | |||||||||||||
Total |
$ | 2,043,921 | $ | 1,272,352 | $ | 297,463 | $ | 194,612 | 1,764,427 | |||||||||
(A) | Net of incurred losses. |
(B) | Net of discounts (or gross of premiums) and after OTTI, including impairment taken during the period ended March 31, 2010. |
(C) | Management generally obtained pricing service quotations or broker quotations from two sources, one of which was generally the seller (the party that sold us the security). Management selected one of the quotes received as being most representative of fair value and did not use an average of the quotes. 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) or a pricing service. |
(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 Severity | ||||||||||||||||||
CMBS Conduit |
$ | 80,495 | $ | 61,920 | $ | 19,691 | $ | (18,575 | ) | 20% | N/A | 7% - 35% | 3% - 27% | ||||||||
CMBS Large loan / Single borrower |
71,479 | 42,359 | 6 | (29,120 | ) | 20% -48% | N/A | 0% -100% | 0% - 100% | ||||||||||||
ABS subprime |
88,345 | 77,048 | 5,006 | (11,297 | ) | 15% | 1% - 10% | 26% - 92% | 60% - 100% | ||||||||||||
ABS other RE |
9,542 | 8,090 | 2,090 | (1,452 | ) | 15% | 0% - 8% | 36% -73% | 55% - 90% | ||||||||||||
CDO |
| | 3 | | N/A | N/A | 100% | 100% | |||||||||||||
Debt security total |
$ | 249,861 | $ | 189,417 | $ | 26,796 | $ | (60,444 | ) | ||||||||||||
Equity securities |
1,112 | 5,195 | 276 | 4,083 | |||||||||||||||||
Total |
$ | 250,973 | $ | 194,612 | $ | 27,072 | $ | (56,361 | ) | ||||||||||||
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. Newcastle uses assumptions that generate its best estimate of future cash flows of each respective security.
The prepayment vector specifies the percentage of the collateral balance that is expected to voluntarily pay off at each point in the future. The prepayment vector is based on projections from a widely published investment bank model which considers factors such as collateral FICO score, loan-to-value ratio, debt-to-income ratio, and vintage on a loan level basis. This vector is scaled up or down to match recent collateral-specific prepayment experience, as obtained from remittance reports and market data services.
Loss severities are based on recent collateral-specific experience with additional consideration given to collateral characteristics. Collateral age is taken into consideration because severities tend to initially increase with collateral age before eventually stabilizing. Newcastle typically uses projected severities that are higher than the historic experience for collateral that is relatively new (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. Newcastle considers whether a collateral pool has experienced a significant change in its composition with respect to these factors when assigning severity projections.
17
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
Default rates are determined from the current pipeline of loans that are more than 90 days delinquent, in foreclosure, or are real estate owned (REO). These significantly delinquent loans determine the first 24 months of the default vector. Beyond month 24, the default vector transitions to a steady-state value that is generally equal to or greater than that given by the widely published investment bank model.
The discount rates Newcastle uses are derived from a range of observable pricing on securities backed by similar collateral and offered in a live market. As the markets in which Newcastle transacts have become less liquid, Newcastle has had to rely on fewer data points in this analysis.
(F) | Projected annualized average prepayment rate. |
Loan Valuation
Loans which Newcastle does not have the ability to hold into the foreseeable future are classified as held-for-sale. As a result, these held-for-sale loans are carried at the lower of amortized cost or fair value and are therefore recorded at fair value on a non-recurring basis. During the three months ended March 31, 2010, Newcastle recorded ($59.1) million and ($36.7) 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.
The following tables summarize the fair value information of real estate related loans and residential mortgage loans:
Outstanding Face Amount |
Carrying Value |
Fair Value |
Valuation Allowance/ (Reversal) In Current Year |
Significant Input Ranges | |||||||||||||||||
Loan Type |
Discount Rate | Loss Severity | |||||||||||||||||||
Mezzanine |
$ | 717,134 | $ | 250,066 | $ | 250,066 | $ | (13,605 | ) | 17.5% - 87.1% | 0.0% - 100.0% | ||||||||||
Bank Loan |
291,598 | 207,246 | 207,262 | (23,602 | ) | 8.2% - 29.8% | 0.0% - 51.0% | ||||||||||||||
B-Note |
308,006 | 101,452 | 101,452 | (22,101 | ) | 10.1% - 61.6% | 0.0% - 100.0% | ||||||||||||||
Whole Loan |
56,085 | 29,124 | 29,124 | 216 | 7.5% - 20.0% | 0.0% - 0.0% | |||||||||||||||
Loans |
$ | 1,372,823 | $ | 587,888 | $ | 587,904 | $ | (59,092 | ) | ||||||||||||
Outstanding Face Amount |
Carrying Value |
Fair Value |
Valuation Allowance/ (Reversal) In Current Year |
Significant Input Ranges | |||||||||||||||||
Loan Type |
Discount Rate | Prepayment Speed |
Cumulative Default Rate |
Loss Severity | |||||||||||||||||
Residential Loans |
$ | 67,694 | $ | 51,316 | $ | 51,316 | $ | 609 | 4.98% - 9.66% | 7% - 30% | 0.31% - 5.5% | 25% - 30% | |||||||||
Manufactured Housing Loans I |
166,684 | 135,609 | 135,609 | (17,420 | ) | 8.40% | 3.00% | 4.00% | 75.0% | ||||||||||||
Manufactured Housing Loans II |
236,065 | 221,065 | 221,065 | (19,871 | ) | 8.40% | 4.00% | 3.50% | 75.0% | ||||||||||||
Loans |
$ | 470,443 | $ | 407,990 | $ | 407,990 | $ | (36,682 | ) | ||||||||||||
Derivatives
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. 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 is recognized in current earnings during the period of change.
18
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
Newcastles derivative instruments are valued using counterparty quotations. These quotations are generally based on valuation models with model inputs that can generally be verified and which do not involve significant judgment. The significant observable inputs used in determining the fair value of our Level 2 derivative contracts are contractual cash flows and market based interest rate curves. Newcastles derivatives are recorded on its balance sheet as follows:
Fair Value | ||||||||
Balance sheet location | March 31, 2010 |
December 31, 2009 | ||||||
Interest rate swaps, designated as hedges |
Derivative liabilities | $ | 160,736 | $ | 178,037 | |||
Interest rate swaps, not designated as hedges |
Derivative liabilities | 24,062 | 29,117 | |||||
$ | 184,798 | $ | 207,154 | |||||
The following table summarizes information related to derivatives:
March 31, 2010 |
December 31, 2009 |
|||||||
Cash flow hedges |
||||||||
Notional amount of interest rate swap agreements |
$ | 1,775,482 | $ | 2,099,435 | ||||
Amount of (loss) recognized in OCI on effective portion |
(150,416 | ) | (173,683 | ) | ||||
Deferred hedge gain (loss) related to anticipated financings, which have subsequently occurred, net of amortization |
397 | 832 | ||||||
Deferred hedge gain (loss) related to dedesignation, net of amortization |
(6,011 | ) | (8,045 | ) | ||||
Expected reclassification of deferred hedges from AOCI into earnings over the next 12 months |
(3,969 | ) | (4,234 | ) | ||||
Expected reclassification of current hedges from AOCI into earnings over the next 12 months |
(75,816 | ) | (90,666 | ) | ||||
Non-hedge Derivatives |
||||||||
Notional amount of interest rate swap agreements |
239,957 | 296,243 |
The following table summarizes gains (losses) recorded in relation to derivatives:
Three Months Ended March 31, |
||||||||||
Income statement location | 2010 | 2009 | ||||||||
Cash flow hedges |
||||||||||
Gain (loss) on the ineffective portion |
Other income (loss) | $ | (1 | ) | $ | (828 | ) | |||
Gain (loss) immediately recognized at dedesignation |
Other income (loss) | (3,279 | ) | (8,797 | ) | |||||
Amount of gain (loss) reclassified from AOCI into income, related to effective portion |
Interest expense | (25,320 | ) | (23,922 | ) | |||||
Deferred hedge gain reclassified from AOCI into income, related to anticipated financings |
Interest expense | 434 | 25 | |||||||
Deferred hedge gain (loss) reclassified from AOCI into income, related to effective portion of dedesignated hedges |
Interest expense | (2,033 | ) | (5,466 | ) | |||||
Non-hedge derivatives gain (loss) |
Other income (loss) | (1,748 | ) | 3,116 |
19
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
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 (loss) applicable to 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 months ended March 31, 2010 and 2009, Newcastle had no dilutive common stock equivalents. Net income (loss) applicable to common stockholders is equal to net income (loss) less preferred dividends plus excess of carrying amount of exchanged preferred stock over fair value of consideration paid.
As of March 31, 2010, 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 | |
8. COMMITMENTS AND CONTINGENCIES
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 March 31, 2010, if any, will not materially affect Newcastles consolidated results of operations or financial position.
Contingent Gain in CDOs As of March 31, 2010, Newcastle has recorded $706.8 million of losses in its CDOs in excess of its economic exposure which must eventually be reversed through amortization, sales at gains, or as reductions to accumulated deficit 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 March 31, 2010 (referred to as subsequent events) through the issuance of these consolidated financial statements. Events subsequent to that date have not been considered in these financial statements.
In March 2010, Newcastle sold $22.8 million face amount of FHLMC securities and repaid the corresponding repurchase agreements in the amount of $22.6 million. Concurrent with the sales, Newcastle terminated the related interest rate swap agreements. As a result, the gain on sale recorded from these assets was offset by the loss on the termination of the derivatives.
On March 23, 2010, Newcastle announced the final results of its offer to exchange (the Exchange Offer) shares of its common stock and cash for up to (i) 1,725,000 shares of its outstanding 9.75% Series B Cumulative Redeemable Preferred Stock (Series B Preferred Stock), (ii) 1,104,000 shares of its outstanding 8.05% Series C Cumulative Redeemable Preferred Stock (Series C Preferred Stock), and (iii) 1,380,000 shares of its outstanding 8.375% Series D Cumulative Redeemable Preferred Stock (Series D Preferred Stock, and, together with Series B Preferred Stock and Series C Preferred Stock, the Preferred Stock).
On March 25, 2010, Newcastle settled the Exchange Offer. In the aggregate, Newcastle issued 9,091,668 shares of its common stock (approximately 17.2% of Newcastles outstanding shares of common stock prior to the issuance of shares in the Exchange Offer). A total of 2,881,694 shares of common stock were issued in exchange for 1,152,679 shares of Series B Preferred Stock, a total of 2,759,989 shares of common stock were issued in exchange for 1,104,000 shares of Series C Preferred Stock, and a total of 3,449,985 shares of common stock were issued in exchange for 1,380,000 shares of Series D Preferred Stock. The shares of Preferred Stock acquired by Newcastle in the Exchange Offer were retired upon receipt. After settlement of the Exchange Offer, 1,347,321 shares of Series B Preferred Stock, 496,000 shares of Series C Preferred Stock and 620,000 shares of Series D Preferred Stock remain outstanding for trading on the New York Stock Exchange.
The shares of common stock were issued in the Exchange Offer in reliance on the exemption set forth in Section 3(a)(9) of the Securities Act of 1933, as amended, for securities exchanged by an issuer with its existing security holders exclusively where no commission or other remuneration is paid or given directly or indirectly for soliciting such exchange.
20
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2010
(dollars in tables in thousands, except share data)
In connection with the Exchange Offer, all of Newcastles preferred stock dividends in arrears were paid, and all cumulative preferred stock dividends accrued through April 30, 2010 have been paid. The $43.0 million excess of the $87.5 million carrying value of the exchanged preferred stock over the $44.5 million fair value of consideration paid (which included $28.5 million of common stock and $16.0 million of cash) was recorded as an increase to Net Income (Loss) Applicable to Common Stockholders.
See note 5 regarding the securitization transaction in April 2010 to refinance Newcastles Manufactured Housing Loans Portfolio I.
In April 2010, Newcastle repaid in full its outstanding repurchase agreements of $12.9 million as of March 31, 2010.
In April 2010, Newcastle, through two of its CDOs, made a cash investment of $75.0 million in a new real estate related loan to a portfolio company of a private equity fund managed by an affiliate of Newcastles manager. Newcastles chairman is an officer of the borrower. This investment improves the applicable CDOs results under some of their respective tests, and is expected to yield approximately 22%. The loan will initially mature in April 2013, with two one-year extensions, and is secured by subordinated interests in the properties of the borrower. Interest on the loan will be accrued and deferred until maturity.
21
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, and with Part II, Item 1A, Risk Factors.
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, liquidity, 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 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 March 31, 2010. 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 March 31, 2010, our debt to equity ratio, as computed under this method, was approximately 4.0 to 1.0. We utilize leverage for the sole purpose of financing our portfolio and not for the purpose of speculating on changes in interest rates.
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 seek to 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 continued challenging credit and liquidity conditions have 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 onset of challenging conditions. However, credit and liquidity conditions have continued to improve during 2010, and, as a result, we have recently been able to access more types of capital and on better terms than we had been able to access during 2008 and 2009.
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. Revenues attributable to each segment are disclosed below (in thousands).
For the Three Months Ended March 31, |
CDOs | Other Non-Recourse |
Recourse | Unlevered | Unallocated | Total | ||||||||||||
2010 |
$ | 50,943 | $ | 18,046 | $ | 859 | $ | 223 | $ | 21 | $ | 70,092 | ||||||
2009 |
$ | 100,763 | $ | 20,342 | $ | 2,518 | $ | 829 | $ | 21 | $ | 124,473 |
Market Considerations
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.
22
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 three months of 2010, credit spreads tightened. This tightening of credit spreads caused the net unrealized losses on our securities to decrease.
Despite signs of improvement, market conditions remain significantly challenging, and we do not know how recent changes in market conditions will affect our business.
Liquidity
Credit and liquidity conditions have continued to improve in 2010, but such conditions are still less favorable than those we experienced prior to 2007. The continued challenging credit and liquidity conditions have adversely affected us and the markets in which we operate in a number of other ways. For example, they have 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 made at prices significantly below face amount while the related debt is being repaid at its full face amount, as well as the retention of cash, 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 not to declare any common dividends since the third quarter of 2008. 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.
In addition, we note that the recent reduction in the number of financial institutions has impacted our liquidity options and sources of capital. 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 II, Item 1A, Risk Factors Risks Related to the Financial Services Industry and Financial Markets We are subject to counterparty default and concentration risk.
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. 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.
23
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
Variable interest entities (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. The guidance for consolidating a VIE was changed effective January 1, 2010. A VIE is now required to be consolidated by its primary beneficiary, and only by its primary beneficiary, which is defined as the party who has the power to direct the activities of a VIE that most significantly impact its economic performance and who has the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE.
The VIEs in which we have a significant interest include (i) our CDOs, (ii) our subprime securitizations, and (iii) our manufactured housing loan financing structures. Our CDOs were all consolidated under prior guidance; however, under current guidance we do not have the power to direct the relevant activities of CDO VII, as a result of the event of default which allows us to be removed as collateral manager of CDO VII and prevents us from purchasing or selling collateral within CDO VII, and therefore we have deconsolidated CDO VII as of January 1, 2010. Similar events of default in the future, if they occur, could cause us to deconsolidate additional financing structures. Our subprime securitizations were not consolidated under prior guidance and are still not consolidated under current guidance since we do not have the power to direct the relevant activities of these entities. Our manufactured housing loan financing structures were both consolidated under prior guidance and continue to be consolidated under the new guidance. However, as discussed in - Liquidity and Capital Resources Debt Obligations, we completed a securitization transaction to refinance our Manufactured Housing Loans Portfolio I. We are currently evaluating whether we will consolidate the new securitization financing structure.
In addition, our investments in securities may be deemed to be variable interests in VIEs, depending on their structure. We monitor these investments and, to the extent we determine we potentially control the current controlling class of securities, analyze them for potential consolidation. As of March 31, 2010, we did not control the current controlling class of any of these securitizations.
We will continue to analyze future investments, as well as reconsideration events in existing entities, pursuant to the VIE requirements. These analyses require considerable judgment in determining the primary beneficiary of a VIE since they involve subjective determinations of significance, with respect to both power and economics. 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 the sources described above, 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 the sources described above. The determination of estimated cash flows used in pricing models is inherently subjective and imprecise. Changes in market conditions, as well as changes in the assumptions or methodology used to determine fair value, could result in a significant and immediate increase or decrease in our book 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 March 31, 2010.
24
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 book equity. 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 slight improvement in liquidity currently in the markets. In the first quarter of 2010, the inputs to our models for the overall portfolio have generally remained consistent with the assumptions used at year-end, other than certain modifications we have made to the assumptions to reflect conditions relevant to specific assets.
For debt securities valued with internal models, which have an aggregate fair value of $189.4 million as of March 31, 2010, a 10% unfavorable change in our assumptions would result in the following decreases in such aggregate fair value:
CMBS | ABS | |||||||
Outstanding face amount |
$ | 708,949 | $ | 355,646 | ||||
Fair value |
$ | 104,279 | $ | 85,138 | ||||
Effect on fair value with 10% unfavorable change in: |
||||||||
Discount rate |
$ | (3,655 | ) | $ | (3,543 | ) | ||
Prepayment rate |
N/A | $ | (1,090 | ) | ||||
Default rate |
$ | (18,863 | ) | $ | (5,811 | ) | ||
Loss severity |
$ | (14,888 | ) | $ | (11,485 | ) |
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.
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 GAAP 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 and pricing service 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 GAAP. For the $1.5 billion carrying value of securities valued using quotations, a 100 basis point change in credit spreads would impact estimated fair value at period and by approximately $43.0 million.
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 certain securities which represent 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. These securities 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 definition of beneficial interests in securitized financial assets.
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
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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 three months ended March 31, 2010, we had 48, or $141.7 million carrying amount of, securities that were downgraded and recorded a net other-than-temporary impairment charge of $21.8 million on these securities in 2010. 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 on Loan Pools. 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. 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 fair value is reflected on a net by counterparty basis when Newcastle believes a legal right of offset exists under an enforceable netting agreement. To the extent they qualify as cash flow hedges, 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 credit risk. The results of such variability could be a significant increase or decrease in our GAAP equity and/or earnings.
Impairment of Loans
We own, 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.
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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.
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 June 2009, the FASB issued new guidance on transfers of financial assets which 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. This guidance is effective for fiscal years beginning after November 15, 2009. The adoption of this guidance did not have a material impact on our financial position, liquidity or results of operations.
In June 2009, the FASB issued new guidance which 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. This guidance is effective for fiscal years 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. As discussed under Variable Interest Entities above, this guidance resulted in changes in our consolidated entities. Changes to consolidation conclusions impact our gross assets, liabilities, equity, revenues and expenses but are not material to the net income applicable to our common stockholders.
RESULTS OF OPERATIONS
The following table summarizes the changes in our results of operations from the three months ended March 31, 2009 to the three months ended March 31, 2010 (dollars in thousands):
Three Months | Explanations of Changes |
|||||||||
Amount Change | Percent Change | |||||||||
Interest income |
$ | (54,381 | ) | (43.7 | %) | (1 | ) | |||
Interest expense |
(14,955 | ) | (24.7 | %) | (1 | ) | ||||
Valuation allowance (reversal) on loans |
(216,662 | ) | N.M. | (2 | ) | |||||
Other-than-temporary impairment on securities, net |
(158,840 | ) | N.M. | (3 | ) | |||||
Gain (loss) on settlement of investments, net |
17,724 | N.M. | (4 | ) | ||||||
Gain (loss) on extinguishment of debt |
21,501 | N.M. | (5 | ) | ||||||
Other income (loss), net |
4,929 | N.M. | (6 | ) | ||||||
Equity in earnings of equity method investees |
72 | 553.8 | % | (7 | ) | |||||
Loan and security servicing expense |
(367 | ) | (26.2 | %) | (8 | ) | ||||
General and administrative expense |
1,412 | 86.8 | % | (9 | ) | |||||
Management fee to affiliate |
(14 | ) | (0.3 | %) | (10 | ) | ||||
Depreciation and amortization |
(9 | ) | (12.5 | %) | N/A | |||||
Income (loss) from continuing operations |
$ | 379,280 | 158.8 | % | ||||||
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 | ||||||||
Period to Period
Increase (Decrease) |
||||||||
Interest Income | Interest Expense | |||||||
Disposition of securities and loans |
$ | (426 | ) | $ | (261 | ) | ||
Deconsolidation of VIE |
(7,995 | ) | (4,936 | ) | ||||
Paydowns |
(2,767 | ) | (766 | ) | ||||
Amortization of deferred hedge loss |
| (3,842 | ) | |||||
Other (see below) |
(43,193 | ) | (5,150 | ) | ||||
$ | (54,381 | ) | $ | (14,955 | ) | |||
The change in the amortization of deferred hedge loss is the result of the dedesignation of certain interest rate swaps in one of the manufactured housing loan pools in early 2009.
The change in Other Interest Income is primarily due to interest income recorded in 2009 as a result of the accretion of discounts on the impaired securities. Changes in the remaining Other are primarily due to changes in interest rates.
(2) | The change is primarily the result of increase in fair values of the real estate related loans and the manufactured housing loan pools for the quarter ended March 31, 2010. |
(3) | The change is due to the impairment charges recorded to write down a significant portion of our securities portfolio in the first quarter of 2009 as we were not able to express the intent and ability to hold our investments through maturity or recovery. |
(4) | The change is a result of the net gain or loss on the sale of securities, loans and termination of derivatives. The increase in net gain recorded in the first quarter of 2010 is predominantly the result of the sale of securities at a gain, partially offset by the loss on sales of certain securities and termination of certain interest rate swap agreements at a loss. |
(5) | The change is a result of the increased gain on the repurchase of our own debt. |
(6) | The change is primarily due to an unrealized loss recorded through earnings upon the de-designation of certain interest rate swaps as accounting hedges in the first quarter of 2009. |
(7) | The change is due to an increase in earnings for the quarter ended March 31, 2010 from our operating real estate joint venture which owns a pool of franchise loans. |
(8) | Changes in loan and security servicing expense are primarily due to dispositions and paydowns. |
(9) | The change is primarily due to an increase in legal and professional fees incurred in connection with (i) the exchange offer on our preferred stocks, as described in Liquidity and Capital Resources Preferred Stock below, and (ii) the exchange of $52.1 million of our junior subordinated notes in the first quarter of 2010, as described in Liquidity and Capital Resources Debt Obligations below. |
(10) | The change is due to a decrease in management fee paying equity as a result of the exchange of preferred stock. 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 feasible. Our debt obligations are generally secured directly by our investment assets, except for the junior subordinated notes payable.
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 junior subordinated notes payable, 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
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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 recourse 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.
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 or 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.