Drive Shack Inc. Annual report pursuant to Section 13 and 15(d)

Annual report pursuant to Section 13 and 15(d)

FAIR VALUE OF FINANCIAL INSTRUMENTS

FAIR VALUE OF FINANCIAL INSTRUMENTS

12 Months Ended

Dec. 31, 2011

7.	FAIR VALUE OF FINANCIAL INSTRUMENTS

Fair value may be based upon broker quotations, counterparty quotations or pricing services quotations, which provide valuation estimates based upon reasonable market order indications or a good faith estimate thereof and are subject to significant variability based on market conditions, such as interest rates, credit spreads and market liquidity. A significant portion of Newcastles loans, securities and debt obligations are currently not traded in active markets and therefore have little or no price transparency. As a result, Newcastle has estimated the fair value of these illiquid instruments based on internal pricing models rather than quotations. 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 change to estimated fair values. It should be noted that minor changes in assumptions or estimation methodologies can have a material effect on these derived or estimated fair values, and that the fair values reflected below are indicative of the interest rate and credit spread environments as of December 31, 2011 and do not take into consideration the effects of subsequent changes in market or other factors.

Fair Value Summary Table

The carrying values and estimated fair values of Newcastles financial instruments at December 31, 2011 and 2010 were as follows:


	December 31, 2011									December 31, 2010
	Principal Balance or Notional Amount		Carrying Value		Estimated Fair Value		Fair Value Method (A)	Weighted Average Yield/Funding Cost	Weighted Average Maturity (Years)	Carrying Value		Estimated Fair Value
Assets
Non-Recourse VIE Financing Structures (F)
Financial instruments:
Real estate securities, available-for-sale*	$	2,005,275	$	1,479,214	$	1,479,214	Broker quotations, counterparty quotations, pricing services, pricing models	9.60%	4.4	$	1,859,984	$	1,859,984
Real estate related loans, held-for-sale, net		1,072,071		807,214		812,883	Broker quotations, counterparty quotations, pricing services, pricing models	12.72%	2.6		750,130		754,589
Residential mortgage loans, held-for-investment, net		373,968		331,236		330,277	Pricing models	8.26%	6.6		124,974		128,369
Residential mortgage loans, held-for-sale, net		-		-		-	Pricing models	N/A	N/A		252,915		252,915
Subprime mortgage loans subject to call option (B)		406,217		404,723		404,723	(B)	9.09%	(B)		403,793		403,793
Restricted cash*		105,040		105,040		105,040					157,005		157,005
Derivative assets, treated as hedges (C)(E)*		104,205		1,092		1,092	Counterparty quotations	N/A	(C)		4,537		4,537
Non-hedge derivative assets (D)(E)*		36,428		862		862	Counterparty quotations	N/A	(D)		2,530		2,530
Operating real estate, held-for-sale				7,741		7,741					8,776		8,776
Other investments				18,883		18,883					18,883		18,883
Receivables and other assets				23,319		23,319					29,206		29,206

			$	3,179,324	$	3,184,034				$	3,612,733	$	3,620,587

Recourse Financing Structures and Unlevered Assets
Financial instruments:
Real estate securities, available-for-sale*	$	415,861	$	252,530	$	252,530	Broker quotations, counterparty quotations, pricing services, pricing models	2.28%	2.9	$	600	$	600
Real estate related loans, held-for-sale, net		24,543		6,366		6,366	Broker quotations, counterparty quotations, pricing services, pricing models	20.00%	2.4		32,475		32,475
Residential mortgage loans, held-for-sale, net		5,227		2,687		2,687	Pricing models	17.34%	4.5		298		298
Investments in excess mortgage servicing rights at fair value* (H)		9,705,512		43,971		43,971	Pricing models	20.00%	6.0		-		-
Cash and cash equivalents*		157,356		157,356		157,356					33,524		33,524
Other investments				6,024		6,024					6,024		6,024
Receivables and other assets				3,541		3,541					1,457		1,457

			$	472,475	$	472,475				$	74,378	$	74,378

*Measured at fair value on a recurring basis.


	December 31, 2011									December 31, 2010
	Principal Balance or Notional Amount		Carrying Value		Estimated Fair Value		Fair Value Method (A)	Weighted Average Yield/Funding Cost	Weighted Average Maturity (Years)	Carrying Value		Estimated Fair Value
Liabilities
Non-Recourse VIE Financing Structures (F) (G)
Financial instruments:
CDO bonds payable	$	2,405,044	$	2,403,605	$	1,500,307	Pricing models	2.76%	3.7	$	3,010,868	$	1,845,419
Other bonds and notes payable		202,456		200,377		203,136	Broker quotations, pricing models	4.31%	3.5		261,165		248,416
Repurchase agreements		6,546		6,546		6,546	Market comparables	2.05%	0.5		14,049		14,049
Financing of subprime mortgage loans subject to call option (B)		406,217		404,723		404,723	(B)	9.09%	(B)		403,793		403,793
Interest rate swaps, treated as hedges (C)(E)*		848,434		90,025		90,025	Counterparty quotations	N/A	(C)		136,575		136,575
Non-hedge derivatives (D)(E)*		316,600		29,295		29,295	Counterparty quotations	N/A	(D)		40,286		40,286
Accrued expenses and other liabilities				16,112		16,112					8,445		8,445

			$	3,150,683	$	2,250,144				$	3,875,181	$	2,696,983

Recourse Financing Structures and Other Liabilities (G)
Financial instruments:
Repurchase agreements	$	233,194	$	233,194	$	233,194	Market comparables	0.45%	0.2	$	4,683	$	4,683
Junior subordinated notes payable		51,004		51,248		30,145	Pricing models	7.41%	23.3		51,253		34,817
Due to affiliates				1,659		1,659					1,419		1,419
Dividends payable, accrued expenses and other liabilities				22,926		22,926					2,160		2,160

			$	309,027	$	287,924				$	59,515	$	43,079

(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 results from an option, not an obligation, to repurchase loans from Newcastles subprime mortgage loan securitizations (Note 5), are noneconomic until such option is exercised, and are equal and offsetting.

Notes continued on next page.

(C)

Represents derivative agreements as follows:


Year of Maturity	Weighted Average Month of Maturity	Aggregate Notional Amount		Weighted Average Fixed Pay Rate / Cap Rate	Aggregate Fair Value Asset / (Liability)
Interest rate cap agreements which receive 1-Month LIBOR above the cap rates:
2015	Sep	$	21,000	2.26%	$	149
2016	Jul		77,905	2.66%		858
2017	Jan		5,300	1.86%		85

		$	104,205		$	1,092

Interest rate swap agreements which receive 1-Month LIBOR:
2014	Nov	$	15,172	5.08%		(1,849)
2015	May		484,932	5.43%		(29,404)
2016	May		174,296	5.04%		(21,102)
2017	Aug		174,034	5.24%		(37,670)

		$	848,434		$	(90,025)

(D)

This represents two interest rate swap agreements with a notional balance of $127.7 million and $188.9 million, maturing in March 2014 and March 2015, respectively, and three interest rate cap agreements with a total notional balance of $36.4 million, maturing in August 2017 and January 2019. Newcastle entered into these hedge agreements to reduce its exposure to interest rate changes on the floating rate financings of its CDO IV, CDO VI and CDO X. These derivative agreements were not designated as hedges for accounting purposes as of December 31, 2011.

(E)

Newcastles derivatives fall into two categories. As of December 31, 2011, all derivatives were held within Newcastles nonrecourse CDO structures. An aggregate notional balance of $1.2 billion, which were liabilities at period end, are only subject to the credit risks of the respective CDO structures. As they are senior to all the debt obligations of the respective CDOs and the fair value of each of the CDOs total investments exceeded the fair value of each of the CDOs derivative liabilities, no credit valuation adjustments were recorded. An aggregate notional balance of $140.6 million were assets at period end and therefore are subject to the counterpartys credit risk. No adjustments have been made to the fair value quotations received related to credit risk as a result of the counterpartys AA credit rating. Newcastles significant derivative counterparties include Bank of America, Credit Suisse, and Wells Fargo.

(F)

Assets held within CDOs and other non-recourse structures are not available to satisfy obligations outside of such financings, except to the extent Newcastle receives net cash flow distributions from such structures. Furthermore, creditors or beneficial interest holders of these structures have no recourse to the general credit of Newcastle. Therefore, Newcastles exposure to the economic losses from such structures is limited to its invested equity in them and economically their book value cannot be less than zero. As a result, the fair value of 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.

(H)

The notional amount represents the total unpaid principal balance of the mortgage loans on which Newcastle is entitled to receive 65% of the excess MSRs on performing loans.

Valuation Hierarchy

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

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

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

Quoted prices in active markets for similar instruments,

Quoted prices in less active or inactive markets for identical or similar instruments,

Other observable inputs (such as interest rates, yield curves, volatilities, prepayment speeds, loss severities, credit risks and default rates), and

Market corroborated inputs (derived principally from or corroborated by observable market data).

Level 3 - Valuations based significantly on unobservable inputs.

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

Level 3B - Valuations based on internal models with significant unobservable inputs.

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

The following table summarizes financial assets and liabilities measured at fair value on a recurring basis at December 31, 2011:


	Principal Balance or Notional				Fair Value
	Amount		Carrying Value		Level 2		Level 3A (1)		Level 3B (2)		Total
Assets:
Real estate securities, available for sale:
CMBS	$	1,545,877	$	1,128,818	$	-	$	948,718	$	180,100	$	1,128,818
REIT debt		137,393		135,296		135,296		-		-		135,296
ABS - subprime		246,014		128,622		-		66,141		62,481		128,622
ABS - other real estate		53,347		38,107		-		31,188		6,919		38,107
FNMA / FHLMC		232,355		244,915		244,915		-		-		244,915
CDO		206,150		55,986		-		52,047		3,939		55,986

Real estate securities total	$	2,421,136		1,731,744		380,211		1,098,094		253,439		1,731,744

Investments in excess MSRs (3)	$	9,705,512	$	43,971	$	-	$	-	$	43,971	$	43,971

Derivative assets:
Interest rate caps, treated as hedges	$	104,205	$	1,092	$	1,092	$	-	$	-	$	1,092
Interest rate caps, not treated as hedges		36,428		862		862		-		-		862

Derivative assets total	$	140,633	$	1,954	$	1,954	$	-	$	-	$	1,954


Liabilities:
Derivative Liabilities:
Interest rate swaps, treated as hedges	$	848,434	$	90,025	$	90,025	$	-	$	-	$	90,025
Interest rate swaps, not treated as hedges		316,600		29,295		29,295		-		-		29,295

Derivative liabilities total	$	1,165,034	$	119,320	$	119,320	$	-	$	-	$	119,320

(1)

Third party pricing sources with significant unobservable inputs.

(2)

Internal models with significant unobservable inputs.

(3)

The notional amount represents the total unpaid principal balance of the mortgage loans on which Newcastle is entitled to receive 65% of the excess MSRs on performing loans.

Newcastles investments in instruments (excluding the excess MSRs investments, see below) measured at fair value on a recurring basis using Level 3 inputs changed as follows:


	Level 3A Assets
	CMBS				ABS				Equity/Other
	Conduit		Other		Subprime		Other		Securities		Total
Balance at January 1, 2010	$	536,092	$	397,407	$	87,883	$	46,059	$	-	$	1,067,441
Transfers (A)
Transfers from Level 3B		5,528		20,511		-		-		-		26,039
Transfers into Level 3B		(54,816)		(22,177)		(16,015)		-		-		(93,008)
CDO VII Deconsolidation		(32,858)		(3,379)		(10,685)		-		-		(46,922)
Total gains (losses) (B)
Included in net income (loss) (C)		17,645		3,508		59		(345)		-		20,867
Included in other comprehensive income (loss)		198,146		79,436		1,455		7,354		-		286,391
Amortization included in interest income		16,663		7,131		7,515		179		-		31,488
Purchases, sales and settlements
Purchases		279,095		34,478		44,894		-		-		358,467
Proceeds from sales		(88,645)		(49,260)		(6,478)		(11,525)		-		(155,908)
Proceeds from repayments		(36,623)		(135,751)		(25,046)		(5,529)		-		(202,949)

Balance at December 31, 2010	$	840,227	$	331,904	$	83,582	$	36,193	$	-	$	1,291,906


	Level 3B Assets
	CMBS				ABS				Equity/Other
	Conduit		Other		Subprime		Other		Securities		Total
Balance at January 1, 2010	$	95,376	$	32,744	$	85,377	$	10,719	$	2,620	$	226,836
Transfers (A)
Transfers from Level 3A		54,816		22,177		16,015		-		-		93,008
Transfers into Level 3A		(5,528)		(20,511)		-		-		-		(26,039)
CDO VII Deconsolidation		(48,665)		-		(17,890)		(457)		-		(67,012)
Total gains (losses) (B)
Included in net income (loss) (C)		(83,128)		26,959		(9,374)		(3,488)		(422)		(69,453)
Included in other comprehensive income (loss)		107,272		55,781		31,469		4,163		1,938		200,623
Amortization included in interest income		17,204		1,207		11,843		483		-		30,737
Purchases, sales and settlements
Purchases		-		14,414		-		-		146		14,560
Proceeds from sales		(2,066)		(21,646)		(1,063)		-		-		(24,775)
Proceeds from repayments		(27,824)		(89,979)		(21,953)		(2,435)		-		(142,191)

Balance at December 31, 2010	$	107,457	$	21,146	$	94,424	$	8,985	$	4,282	$	236,294


	Level 3A Assets
	CMBS				ABS				Equity/Other
	Conduit		Other		Subprime		Other		Securities		Total
Balance at January 1, 2011	$	840,227	$	331,904	$	83,582	$	36,193	$	-	$	1,291,906
Transfers (A)
Transfers from Level 3B		41,158		25,000		19,950		718		2,641		89,467
Transfers into Level 3B		(88,464)		(24,826)		(15,031)		(7,548)		(2,475)		(138,344)
CDO V Deconsolidation		(59,970)		(55,838)		(5,107)		-		-		(120,915)
Total gains (losses) (B)
Included in net income (loss) (C)		42,597		579		(23)		(113)		-		43,040
Included in other comprehensive income (loss)		(106,500)		38,583		(9,158)		(716)		(11,461)		(89,252)
Amortization included in interest income		23,878		5,883		5,210		338		3,376		38,685
Purchases, sales and settlements
Purchases		313,857		27,262		29,359		7,548		69,308		447,334
Proceeds from sales		(139,387)		(54,885)		(6,573)		-		-		(200,845)
Proceeds from repayments		(51,113)		(161,227)		(36,068)		(5,232)		(9,342)		(262,982)

Balance at December 31, 2011	$	816,283	$	132,435	$	66,141	$	31,188	$	52,047	$	1,098,094


	Level 3B Assets
	CMBS				ABS				Equity/Other
	Conduit		Other		Subprime		Other		Securities		Total
Balance at January 1, 2011	$	107,457	$	21,146	$	94,424	$	8,985	$	4,282	$	236,294
Transfers (A)
Transfers from Level 3A		88,464		24,826		15,031		7,548		2,475		138,344
Transfers into Level 3A		(41,158)		(25,000)		(19,950)		(718)		(2,641)		(89,467)
CDO V Deconsolidation		(32,289)		(1,908)		(14,568)		(3,833)		-		(52,598)
Total gains (losses) (B)
Included in net income (loss) (C)		7,972		722		(1,332)		(287)		2,273		9,348
Included in other comprehensive income (loss)		32,374		1,743		3,766		(3,200)		(3,346)		31,337
Amortization included in interest income		17,055		163		8,796		911		617		27,542
Purchases, sales and settlements
Purchases		13,634		25,000		25		-		10,192		48,851
Proceeds from sales		(27,400)		(721)		(8,624)		(348)		(3,884)		(40,977)
Proceeds from repayments		(25,487)		(6,493)		(15,087)		(2,139)		(6,029)		(55,235)

Balance at December 31, 2011	$	140,622	$	39,478	$	62,481	$	6,919	$	3,939	$	253,439

(A)

Transfers are assumed to occur at the beginning of the quarter. CDO V was deconsolidated on June 17, 2011 and CDO VII was deconsolidated on January 1, 2010.

(B)

None of the gains (losses) recorded in earnings during the periods is attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates.

(C)

These gains (losses) are recorded in the following line items in the consolidated statements of operations:


	Year Ended December 31,
	2011				2010
	Level 3A		Level 3B		Level 3A		Level 3B
Gain (loss) on settlement of investments, net	$	44,560	$	22,895	$	23,775	$	26,668
Other income (loss), net		-		-		-		-
OTTI		(1,520)		(13,547)		(2,908)		(96,121)

Total	$	43,040	$	9,348	$	20,867	$	(69,453)

Gain (loss) on sale of investments, net, from investments transferred into Level 3 during the period	$	-	$	-	$	-	$	-

Securities Valuation

As of December 31, 2011, Newcastles securities valuation methodology and results are further detailed as follows:


					Fair Value
Asset Type	Outstanding Face Amount (A)		Amortized Cost Basis (B)		Multiple Quotes (C)		Single Quote (D)		Internal Pricing Models (E)		Total
CMBS	$	1,545,877	$	1,124,447	$	745,189	$	203,529	$	180,100	$	1,128,818
REIT debt		137,393		135,931		34,029		101,267		-		135,296
ABS - subprime		246,014		123,022		46,715		19,426		62,481		128,622
ABS - other real estate		53,347		39,919		30,553		635		6,919		38,107
FNMA / FHLMC		232,355		243,385		153,062		91,853		-		244,915
CDO		206,150		67,625		2,750		49,297		3,939		55,986

Total	$	2,421,136	$	1,734,329	$	1,012,298	$	466,007	$	253,439	$	1,731,744

(A)

Net of incurred losses.

(B)

Net of discounts (or gross premiums) and after OTTI, including impairment taken during the period ended December 31, 2011.

(C)

Management generally obtained pricing service quotations or broker quotations from two sources, one of which was generally the seller (the party that sold us the security). Management selected one of the quotes received as being most representative of fair value and did not use an average of the quotes. Even if Newcastle receives two or more quotes on a particular security that come from non-selling brokers or pricing services, it does not use an average because management believes using an actual quote more closely represents a transactable price for the security than an average level. Furthermore, in some cases there is a wide disparity between the quotes Newcastle receives. Management believes using an average of the quotes in these cases would generally not represent the fair value of the asset. Based on 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. These quotations are generally received via email and contain disclaimers which state that they are indicative and not actionable meaning that the party giving the quotation is not bound to actually purchase the security at the quoted price.

(D)

Management was unable to obtain quotations from more than one source on these securities. The one source was generally the seller (the party that sold us the security) or a pricing service.

(E)

Securities whose fair value was estimated based on internal pricing models are further detailed as follows:


							Unrealized			Assumption Ranges
Asset Type	Amortized Cost Basis (B)		Fair Value		Impairment Recorded in Current Year		Gains (Losses) in Accumulated OCI			Discount Rate	Prepayment Speed (F)	Cumulative Default Rate	Loss Severity
CMBS - conduit	$	114,493	$	140,622	$	5,709	$	26,129		12.0%	N/A	0% - 100%	0% - 100%
CMBS - Large loan / single borrower		40,246		39,478		-		(768	)	3% - 9%	N/A	0% - 100%	0% - 100%
ABS - subprime		49,859		62,481		2,624		12,622		8.0%	0% - 8%	25% - 87%	60% - 100%
ABS - other real estate		8,709		6,919		275		(1,790	)	8.0%	1% - 5%	33% - 63%	85% - 95%
CDO		4,224		3,939		-		(285	)	14.0%	4%	18%	83%

Total	$	217,531	$	253,439	$	8,608	$	35,908

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 to account for this effect. Collateral characteristics such as loan size, lien position, and location (state) also effect loss severity. Newcastle considers whether a collateral pool has experienced a significant change in its composition with respect to these factors when assigning severity projections.

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

The discount rates 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 or intent to hold into the foreseeable future are classified as held-for-sale. As a result, these held-for-sale loans are carried at the lower of amortized cost or fair value and are therefore recorded at fair value on a non-recurring basis. During the year ended December 31, 2011, Newcastle recorded ($19.1) million and $6.5 million of valuation allowance (reversal) on real estate related loans and residential mortgage loans (Note 5), 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 certain information for real estate related loans and residential mortgage loans held-for-sale as of December 31, 2011:


							Valuation Allowance/ (Reversal) In Current Year
	Outstanding Face Amount									Significant Input Ranges
Loan Type	Outstanding Face Amount		Carrying Value		Fair Value					Discount Rate	Loss Severity
Mezzanine	$	609,117	$	469,326	$	474,980		$(31,236)		7.7% - 20.0%	0.0% - 100.0%
Bank Loan		282,778		161,153		161,153		21,276		14.4% - 24.9%	0.0% - 74.0%
B-Note		174,153		152,535		152,535		(11,669)		6.3% - 15.9%	0.0%
Whole Loan		30,566		30,566		30,581		-		5.2% - 7.1%	0.0% - 15.0%

Total Real Estate Related Loans Held for Sale, Net	$	1,096,614	$	813,580	$	819,249	$	(21,629	)


							Valuation Allowance/ (Reversal) In Current Year
	Outstanding Face Amount									Significant Input Ranges
Loan Type	Outstanding Face Amount		Carrying Value		Fair Value					Discount Rate	Prepayment Speed	Cumulative Default Rate	Loss Severity
Non-securitized Manufactured Housing Loans I	$	768	$	199	$	199	$	74		39.8%	0.0%	52.9%	75.0%
Non-securitized Manufactured Housing Loans II		4,459		2,488		2,488		(958	)	15.5%	5.0%	10.2%	80.0%

Total Residential Mortgage Loans Held for Sale, Net	$	5,227	$	2,687	$	2,687	$	(884	)

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

The following table summarizes certain information for residential mortgage loans held-for-investment as of December 31, 2011:


							Valuation Allowance/ (Reversal) In Current Year
	Outstanding Face Amount								Significant Input Ranges
Loan Type	Outstanding Face Amount		Carrying Value		Fair Value				Discount Rate	Prepayment Speed	Constant Default Rate	Loss Severity
Securitized Manufactured Housing Loans I	$	135,209	$	112,316	$	113,929	$	700	9.5%	3.0%	4.0%	75.0%
Securitized Manufactured Housing Loans II		178,603		175,120		172,561		3,132	7.6%	5.0%	3.5%	80.0%
Residential Loans		60,156		43,800		43,787		3,518	4.7% - 8.2%	0.0% - 5.0%	0.0% - 3.0%	0.0% - 50.0%

Total Residential Mortgage Loans, Held-for-Investment, Net	$	373,968	$	331,236	$	330,277	$	7,350

Excess MSRs Valuation

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

The following table summarizes certain information regarding the inputs used in valuing the excess MSRs investments as of December 31, 2011:


	Significant Input Ranges
	Prepayment Speed (A)		Delinquency (B)		Constant Default Rate (C)		Recapture Rate (D)		Excess Mortgage Servicing Fee (E)		Discount Rate
Portfolio I		20.0%		10.0%		5.0%		35.0%		29 bps		20.0%
Portfolio I - Recapture Agreement		8.0%		10.0%		5.0%		35.0%		21 bps		20.0%

(A)

Projected annualized weighted average lifetime prepayment rate using a prepayment vector.

(B)

Percentage of mortgage loans in the pool that were 30 or more days past due at period end.

(C)

Projected annualized average default rate.

(D)

Percentage of voluntarily prepaid loans that are expected to be refinanced by Nationstar.

(E)

Weighted average mortgage servicing fees in excess of the base mortgage servicing fee.

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. Prepayment and default projections are in the form of curves or vectors that vary over the expected life of the pool. Newcastle uses assumptions that generate its best estimate of future cash flows for each excess MSRs investment.

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 that consider factors such as the underlying borrowers FICO score, loan-to-value ratio, debt-to-income ratio, vintage on a loan level basis, as well as the potential effect on loans eligible for the Home Affordable Refinance Program 2.0 (HARP 2.0). This vector is scaled up or down to match recent collateral-specific prepayment experience, as obtained from remittance reports, market data services and other market factors.

Delinquency rates and default rates are based on recent pool-specific experience with additional consideration given to the current pipeline of loans that are more than 90 days delinquent, in foreclosure, or are real estate owned (REO).

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

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

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

Newcastles MSRs investments measured at fair value on a recurring basis using Level 3B inputs changed during the period ended December 31, 2011 as follows:


	Level 3B
	Portfolio I		Portfolio I - Recapture Agreement		Total
Balance at December 31, 2010	$	-	$	-	$	-
Transfers (A)
Transfers from Level 3		-		-		-
Transfers into Level 3		-		-		-
Total gains (losses)
Included in net income (B)		168		199		367
Amortization included in interest income		1,260		-		1,260
Purchases, sales and settlements
Purchases		37,607		6,135		43,742
Proceeds from sales		-		-		-
Proceeds from repayments		(1,398)		-		(1,398)

Balance at December 31, 2011	$	37,637	$	6,334	$	43,971

(A)

Transfers are assumed to occur at the beginning of the quarter.

(B)

The gains (losses) recorded in earnings during the period are attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates. These gains(losses) are recorded in Other Income (Loss) in the consolidated statement of income.

Derivatives

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
		December 31,
	Balance sheet location	2011		2010
Derivative Assets
Interest rate caps, designated as hedges	Derivative Assets	$	1,092	$	4,537
Interest rate caps, not designated as hedges	Derivative Assets		862		2,530

		$	1,954	$	7,067

Derivative Liabilities
Interest rate swaps, designated as hedges	Derivative Liabilities	$	90,025	$	136,575
Interest rate swaps, not designated as hedges	Derivative Liabilities		29,295		40,286

		$	119,320	$	176,861

The following table summarizes information related to derivatives:


	December 31,
	2011		2010
Cash flow hedges
Notional amount of interest rate swap agreements	$	848,434	$	1,473,669
Notional amount of interest rate cap agreements		104,205		104,205
Amount of (loss) recognized in OCI on effective portion		(69,908)		(118,608)
Deferred hedge gain (loss) related to anticipated financings, which have subsequently occurred, net of amortization		299		357
Deferred hedge gain (loss) related to dedesignation, net of amortization		(893)		1,343
Expected reclassification of deferred hedges from AOCI into earnings over the next 12 months		1,688		2,289
Expected reclassification of current hedges from AOCI into earnings over the next 12 months		(35,348)		(63,541)

Non-hedge Derivatives
Notional amount of interest rate swap agreements		316,600		343,570
Notional amount of interest rate cap agreements		36,428		36,428

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


	Income Statement	Year Ended December 31,
	Location	2011		2010		2009
Cash flow hedges
Gain (loss) on the ineffective portion	Other Income (Loss)	$	(917)	$	580	$	(278)
Gain (loss) immediately recognized at dedesignation	Gain (Loss) on Sale of Investments, Other Income (Loss)		(13,939)		(39,184)		(15,223)
Amount of gain (loss) reclassified from AOCI into income, related to effective portion	Interest Expense		(63,350)		(83,869)		(100,046)
Deferred hedge gain reclassified from AOCI into income, related to anticipated financings	Interest Expense		58		475		101
Deferred hedge gain (loss) reclassified from AOCI into income, related to effective portion of dedesignated hedges	Interest Expense		2,259		(5,471)		(9,547)

Non-hedge derivatives gain (loss)	Other Income (Loss)		3,284		(1,240)		15,446

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

+ References

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