Quarterly report pursuant to Section 13 or 15(d)

FAIR VALUE

v2.4.0.6
FAIR VALUE
9 Months Ended
Sep. 30, 2012
Fair Value  
FAIR VALUE

7. FAIR VALUE

 

Fair Value Summary Table

 

The carrying values and fair values of Newcastle’s assets and liabilities at September 30, 2012 were as follows: 

 

    Principal                     Weighted     Weighted  
    Balance or           Estimated         Average     Average  
    Notional     Carrying     Fair         Yield/Funding     Maturity  
    Amount     Value     Value     Fair Value Method (A)   Cost     (Years)  
Assets                                            
Non-Recourse VIE Financing Structures (F)                                            
Financial instruments:                                            
Real estate securities, available-for-sale*   $ 731,415     $ 591,929     $ 591,929     Broker quotations, counterparty quotations, pricing services, pricing models     8.64 %     3.5  
Real estate related loans, held-for-sale, net     1,074,133       832,885       840,122     Broker quotations, counterparty quotations, pricing services, pricing models     12.63 %     2.2  
Residential mortgage loans, held-for-investment, net     338,158       301,370       302,073      Pricing models     8.19 %     6.2  
Subprime mortgage loans subject to call option (B)     406,217       405,525       405,525   (B)     9.09 %     (B)  
Restricted cash*     2,829       2,829       2,829                      
Operating real estate, held-for-sale             7,839       7,839                      
Other investments             18,883       18,883                      
Receivables and other assets             6,432       6,432                      
            $ 2,167,692     $ 2,175,632                      
Recourse Financing Structures, Mortgaged Real Estate and Unlevered Assets                                            
Financial instruments:                                            
Real estate securities, available-for-sale*   $ 1,027,954     $ 788,431     $ 788,431     Broker quotations, counterparty quotations, pricing services, pricing models     3.01 %     3.9  
Real estate related loans, held-for-sale, net     28,801       9,418       9,418     Broker quotations, counterparty quotations, pricing services, pricing models     6.51 %     1.8  
Residential mortgage loans, held-for-sale, net     3,735       2,566       2,566      Pricing models     16.85 %     4.7  
Investments in excess mortgage servicing rights at fair value *(H)     79,629,020       258,347       258,347      Pricing models     17.60 %     5.5  
Cash and cash equivalents*     229,036       229,036       229,036                      
Non-hedge derivative assets (D)(E)*     23,400       224       224      Counterparty quotations     N/A       (D)  
Investments in real estate and             141,553       143,300      Based on recent purchase price in July 2012            
resident lease intangibles, net                                    
Other investments             6,024       6,024                      
Receivables and other assets             33,571       33,571                      
            $ 1,469,170     $ 1,470,917                      

 

    Principal Balance                     Weighted     Weighted  
    or           Estimated         Average     Average  
    Notional     Carrying     Fair         Yield/Funding     Maturity  
    Amount     Value     Value     Fair Value Method (A)   Cost     (Years)  
Liabilities                                            
Non-Recourse VIE Financing Structures (F) (G)                                            
Financial instruments:                                            
CDO bonds payable   $ 1,154,745     $ 1,155,080     $ 802,107      Pricing models     2.02 %     2.7  
Other bonds and notes payable     202,409       197,583       204,991      Broker quotations, pricing models     4.92 %     4.2  
Repurchase agreements     5,368       5,368       5,368      Market comparables     2.21 %     0.0  
Financing of subprime mortgage loans subject to call option (B)     406,217       405,525       405,525   (B)     9.09 %     (B)  
Interest rate swaps, treated as hedges (C)(E)*     154,795       14,009       14,009      Counterparty quotations     N/A        (C)  
Non-hedge derivatives (D)(E)*     296,532       22,510       22,510      Counterparty quotations     N/A        (D)  
Accrued expenses and other liabilities             8,241       8,241                      
            $ 1,808,316     $ 1,462,751                      
Recourse Financing Structures, Mortgages and Other Liabilities (G)                                            
 Financial instruments:                                            
 Repurchase agreements   $ 599,959     $ 599,959     $ 599,959      Market comparables     0.60 %     0.1  
 Mortgage notes payable     88,400       88,400       88,400      Pricing models     3.45 %     6.5  
 Junior subordinated notes payable     51,004       51,245       31,588      Pricing models     7.41 %     22.6  
 Due to affiliates             3,351       3,351                      
 Dividends payable, accrued expenses and other liabilities             51,405       51,405                      
            $ 794,360     $ 774,703                      

 

*Measured at fair value on a recurring basis.

 

(A) Methods are listed in order of priority. In the case of real estate securities and real estate related loans, broker quotations are obtained if available and practicable, otherwise counterparty quotations or pricing service valuations are obtained or, finally, internal pricing models are used. Internal pricing models are only used for (i) securities and loans 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 Newcastle’s subprime mortgage loan securitizations (Note 4), are noneconomic until such option is exercised, and are equal and offsetting.
   
(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 swap agreements which receive 1-Month LIBOR:        
2016   Apr    $ 154,795   5.04%    $ (14,009)

 

(D) This represents two interest rate swap agreements with a total notional balance of $296.5 million, maturing in March 2014 and March 2015, respectively, and an interest rate cap agreement with a notional balance of $23.4 million, maturing in August 2019. Newcastle entered into these agreements to reduce its exposure to interest rate changes on the floating rate financings of CDO IV, CDO VI and the senior living assets. These derivative agreements were not designated as hedges for accounting purposes as of September 30, 2012.
   
(E) Newcastle’s derivatives fall into two categories. As of September 30, 2012, all derivatives were held within Newcastle’s nonrecourse structures. An aggregate notional balance of $451.3 million, 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 $23.4 million were assets at period end and therefore are subject to the counterparty’s credit risk. No adjustments have been made to the fair value quotations received related to credit risk as a result of the counterparty’s “AA” credit rating. Newcastle’s 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, Newcastle’s 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 Newcastle’s 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. Generally, Newcastle does not receive an excess mortgage servicing amount on nonperforming 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 such financial assets and liabilities measured at fair value on a recurring basis at September 30, 2012:

 

                Fair Value  
    Principal Balance or
Notional Amount
    Carrying Value     Level 2     Level 3A     Level 3B     Total  
Assets:                                                
Real estate securities, available-for-sale:                                                
CMBS   $ 484,684     $ 377,752     $ —     $ 329,088     $ 48,664     $ 377,752  
REIT debt     87,700       93,060       93,060       —       —       93,060  
ABS - subprime     438,269       260,439       —       220,816       39,623       260,439  
ABS - other real estate     10,208       1,576       —       854       722       1,576  
FNMA / FHLMC     534,801       577,132       577,132       —       —       577,132  
CDO     203,707       70,401       —       64,930       5,471       70,401  
Real estate securities total   $ 1,759,369     $ 1,380,360     $ 670,192     $ 615,688     $ 94,480     $ 1,380,360  
Investments in Excess MSRs (1)   $ 79,629,020     $ 258,347     $ —     $ —     $ 258,347     $ 258,347  
Derivative assets:                                                
Interest rate caps, not treated as hedges     23,400       224       224       —       —       224  
Derivative assets total   $ 23,400     $ 224     $ 224     $ —     $ —     $ 224  
                                                 
Liabilities:                                                
Derivative Liabilities:                                                
Interest rate swaps, treated as hedges   $ 154,795     $ 14,009     $ 14,009     $ —     $ —     $ 14,009  
Interest rate swaps, not treated as hedges     296,532       22,510       22,510       —       —       22,510  
Derivative liabilities total   $ 451,327     $ 36,519     $ 36,519     $ —     $ —     $ 36,519  

 

(1) The notional amount represents the total unpaid principal balance of the mortgage loans. Generally, Newcastle does not receive an excess mortgage servicing amount on nonperforming loans.

 

Newcastle’s investments in instruments (excluding the Excess MSRs, see below) measured at fair value on a recurring basis using Level 3 inputs changed during the nine months ended September 30, 2012 as follows:

 

    Level 3A  
    CMBS     ABS     Equity/Other        
    Conduit     Other     Subprime     Other     Securities     Total  
Balance at December 31, 2011   $ 816,283     $ 132,435     $ 66,141     $ 31,188     $ 52,047     $ 1,098,094  
Transfers (A)                                                
Transfers from Level 3B     6,056       4,057       10,178       —       —       20,291  
Transfers into Level 3B     (10,748 )     (14,105 )     (11,057 )     (5 )     —       (35,915 )
CDO X deconsolidation     (634,036 )     (40,172 )     (70,607 )     (25,883 )     —       (770,698 )
Total gains (losses) (B)                                                
Included in net income (C)     1,190       —       (8 )     —       —       1,182  
Included in other comprehensive income (loss)     28,071       9,596       14,913       (650 )     13,341       65,271  
Amortization included in interest income     22,608       1,164       6,457       (11 )     3,985       34,203  
Purchases, sales and repayments                                                
Purchases     71,968       —       228,832       —       —       300,800  
Proceeds from sales     (24,551 )     —       —       —       —       (24,551 )
Proceeds from repayments     (37,732 )     (2,996 )     (24,033 )     (3,785 )     (4,443 )     (72,989 )
Balance at September 30, 2012   $ 239,109     $ 89,979     $ 220,816     $ 854     $ 64,930     $ 615,688  

 

    Level 3B  
    CMBS     ABS     Equity/Other        
    Conduit     Other     Subprime     Other     Securities     Total  
Balance at December 31, 2011   $ 140,622     $ 39,478     $ 62,481     $ 6,919     $ 3,939     $ 253,439  
Transfers (A)                                                
Transfers from Level 3A     10,748       14,105       11,057       5       —       35,915  
Transfers into Level 3A     (6,056 )     (4,057 )     (10,178 )     —       —       (20,291 )
CDO X deconsolidation     (133,624 )     —       (16,097 )     (291 )     —       (150,012 )
Total gains (losses) (B)                                                
Included in net income (C)     (1,941 )     (396 )     836       (4,092 )     —       (5,593 )
Included in other comprehensive income (loss)     (12,004 )     980       (1,766 )     2,123       1,508       (9,159 )
Amortization included in interest income     8,016       339       5,651       164       304       14,474  
Purchases, sales and repayments                                                
Purchases     44,119       —       —       —       —       44,119  
Proceeds from sales     (18,708 )     —       (3,295 )     (3,743 )     —       (25,746 )
Proceeds from repayments     (17,372 )     (15,585 )     (9,066 )     (363 )     (280 )     (42,666 )
Balance at September 30, 2012   $ 13,800     $ 34,864     $ 39,623     $ 722     $ 5,471     $ 94,480  

 

  (A) Transfers are assumed to occur at the beginning of the quarter. CDO X was deconsolidated on September 12, 2012.
  (B) 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 date.
  (C) These gains (losses) are recorded in the following line items in the consolidated statements of income:

 

      Nine Months Ended September 30, 2012  
      Level 3A       Level 3B  
Gain (loss) on settlement of investments, net   $ 1,196     $ 8,986  
Other income (loss), net     —       —  
OTTI     (14 )     (14,579 )
Total   $ 1,182     $ (5,593 )
                 
Gain (loss) on settlement of investments, net, from investments transferred into Level 3 during the period   $ —     $ —  

 

Securities Valuation

 

As of September 30, 2012, Newcastle’s securities valuation methodology and results are further detailed as follows:

 

                Fair Value  
    Outstanding     Amortized                 Internal        
    Face     Cost     Multiple     Single     Pricing        
Asset Type   Amount (A)     Basis (B)     Quotes (C)     Quote (D)     Models (E)     Total  
                                     
CMBS   $ 484,684     $ 346,736     $ 296,337     $ 32,751     $ 48,664     $ 377,752  
REIT debt     87,700       86,916       22,747       70,313       —       93,060  
ABS - subprime     438,269       241,693       185,490       35,326       39,623       260,439  
ABS - other real estate     10,208       1,915       —       854       722       1,576  
FNMA / FHLMC     534,801       572,356       511,248       65,884       —       577,132  
CDO     203,707       67,190       3,960       60,970       5,471       70,401  
Total   $ 1,759,369     $ 1,316,806     $ 1,019,782     $ 266,098     $ 94,480     $ 1,380,360  

 

(A) Net of incurred losses
(B) Net of discounts (or gross of premiums) and after OTTI, including impairment taken during the period ended September 30, 2012.
(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 Newcastle’s 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:

  

                Impairment     Unrealized Gains     Assumption Ranges  
    Amortized           Recorded     (Losses) in                 Cumulative        
    Cost           In Current     Accumulated     Discount     Prepayment     Default     Loss  
    Basis (B)     Fair Value     Period     OCI     Rate     Speed (F)     Rate     Severity  
CMBS - Conduit   $ 7,083     $ 13,800     $ 208     $ 6,717       10%     N/A       13% - 100%       27% - 100%  
CMBS - Large loan / single borrower     36,115       34,864       —       (1,251 )     5% - 9%       N/A       0% - 100%       0% - 100%  
ABS - subprime     29,176       39,623       719       10,447       8%     0% - 13%       24% - 85%       60% - 100%  
ABS - other RE     745       722       64       (23 )     8%     1% - 4%       30% - 46%       95% - 100%  
CDO     4,246       5,471       —       1,225       10% - 35%       5%     13%     80%
Total     77,365       94,480       991       17,115                                  

 

All of the assumptions listed have some degree of market observability, based on Newcastle’s 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 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 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. 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 management’s 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 September 30, 2012:

 

                      Valuation            
    Outstanding                 Allowance/     Significant Input Ranges
    Face     Carrying     Fair     (Reversal) In     Discount   Loss  
Loan Type   Amount     Value     Value     Current Year     Rate   Severity  
Mezzanine   $ 530,343     $ 443,269     $ 449,847     $ 7,158     8.0% - 25.0%     0.0% - 100.0%  
Bank Loan     334,855       180,044       180,044       (13,969 )   6.2% - 31.7%     0.0% - 100.0%  
B-Note     207,494       188,748       189,393       (4,068 )   6.2% - 15.0%     0.0%
Whole Loan     30,242       30,242       30,256       —     5.1% - 7.1%     0.0% - 15.0%  
Total Real Estate Related Loans Held-for-Sale, Net   $ 1,102,934     $ 842,303     $ 849,540     $ (10,879 )            

 

                      Valuation                          
    Outstanding                 Allowance/ (Reversal)     Significant Input Ranges  
    Face     Carrying     Fair     In     Discount     Prepayment     Constant     Loss  
Loan Type   Amount     Value     Value     Current Year     Rate     Speed     Default Rate     Severity  
Non-securitized Manufactured Housing Loans Portfolio I   $ 591     $ 151     $ 151     $ 16       38.9 %     0.0 %     52.9 %     75.0 %
Non-securitized Manufactured Housing Loans Portfolio II     3,144       2,415       2,415       (498 )     15.5 %     5.0 %     3.5 %     80.0 %
Total Residential Mortgage Loans Held-for-Sale, Net   $ 3,735     $ 2,566     $ 2,566     $ (482 )                                

 

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 September 30, 2012:

 

                      Valuation                          
                      Allowance/                          
                    (Reversal)                          
    Outstanding             In     Significant Input Ranges  
Loan Type   Face
Amount
    Carrying
Value
    Fair
Value
    Current Year     Discount Rate     Prepayment Speed     Constant Default Rate     Loss Severity  
Securitized Manufactured Housing Loans Portoflio I   $ 122,453     $ 102,745     $ 102,844     $ 135       9.5%     4.0%     4.0%     75.0%
Securitized Manufactured Housing Loans Portfolio II     158,542       155,933       156,187       3,094       7.5%     5.0%     3.5%     80.0%
                                                                 
Residential Loans     57,163       42,692       43,042       (28 )     5.0% - 7.8%       0.0% - 5.0%       0.0% - 3.0%       0.0% - 50.0%  
Total Residential Mortgage Loans, Held-for-Investment, Net   $ 338,158     $ 301,370     $ 302,073     $ 3,201                                  

 

 

Excess MSRs Valuation

 

Fair value estimates of Newcastle’s Excess MSRs were based on internal pricing models. The valuation technique is based on discounted cash flows. Significant inputs used in the valuations included expectations of prepayment rates, delinquency rates, recapture rates, the excess mortgage servicing amount of the underlying mortgage loans, and discount rates that market participants would use in determining the fair values of mortgage servicing rights on similar pools of residential mortgage loans. In addition, in valuing the Excess MSRs, 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 as of September 30, 2012: 

 

    Significant Input Ranges  
    Prepayment Speed (A)     Delinquency (B)     Recapture Rate (C)     Excess Mortgage Servicing Amount (D)   Discount Rate  
MSR Pool 1     18.2 %     10.0 %     35.0 %   29 bps     18.0 %
MSR Pool 1 - Recapture Agreement     8.0 %     10.0 %     35.0 %   21 bps     18.0 %
MSR Pool 2     17.4 %     11.0 %     35.0 %   23 bps     17.3 %
MSR Pool 2 - Recapture Agreement     8.0 %     10.0 %     35.0 %   21 bps     17.3 %
MSR Pool 3     17.5 %     12.0 %     35.0 %   23 bps     17.6 %
MSR Pool 3 - Recapture Agreement     8.0 %     10.0 %     35.0 %   21 bps     17.6 %
MSR Pool 4     19.0 %     16.0 %     35.0 %   17 bps     17.9 %
MSR Pool 4 - Recapture Agreement     8.0 %     10.0 %     35.0 %   21 bps     17.9 %
MSR Pool 5     15.0 %     N/A (E)       35.0 %   13 bps     17.5 %
MSR Pool 5 - Recapture Agreement     8.0 %     N/A (E)       35.0 %   21 bps     17.5 %

 

(A) Projected annualized weighted average voluntary and involuntary prepayment rate using a prepayment vector.
(B) Projected percentage of mortgage loans in the pool that are expected to miss their mortgage payments.
(C) Percentage of voluntarily prepaid loans that are expected to be refinanced by Nationstar.
(D) Weighted average total mortgage servicing amount in excess of the basic fee.
(E) The Excess MSR will be paid on the total UPB of the mortgage portfolio (including both performing and delinquent loans until REO)

 

All of the assumptions listed have some degree of market observability, based on Newcastle’s knowledge of the market, relationships with market participants, and use of common market data sources.

 

Prepayment speed projections are in the form of a “vector” that varies over the expected life of the pool. The prepayment vector specifies the percentage of the collateral balance that is expected to prepay voluntarily (i.e., pay off) and involuntarily (i.e., default) at each point in the future. The prepayment vector is based on assumptions that reflect factors such as the borrower’s FICO score, loan-to-value ratio, debt-to-income ratio, vintage on a loan level basis, as well as the projected 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. For the Recapture Agreements and recaptured loans, Newcastle also considers industry research on the prepayment experience of similar loan pools. This data is obtained from remittance reports, market data services and other market sources.

 

Delinquency rates are based on the recent pool-specific experience of loans that missed their most recent mortgage payments. For the Recapture Agreements and recaptured loans, delinquency rates are based on the experience of similar loan pools recently originated by Nationstar and recent delinquency experience. Additional consideration is given to loans that are expected to become 30 or more days delinquent.

 

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

 

For existing mortgage pools, excess mortgage servicing amount projections are based on the actual total mortgage servicing amount in excess of a basic fee. For loans expected to be refinanced by Nationstar and subject to a Recapture Agreement, Newcastle considers the excess mortgage servicing amount on loans recently originated by Nationstar and other general market considerations.

 

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

 

Newcastle’s MSRs investments measured at fair value on a recurring basis using Level 3B inputs changed during the period ended September 30, 2012 as follows:

 

    Level 3B (A)  
    MSR Pool 1     MSR Pool 2     MSR Pool 3     MSR Pool 4     MSR Pool 5     Total  
Balance at December 31, 2011   $ 43,971     $ —     $ —     $ —     $ —     $ 43,971  
Transfers (B)                                                
Transfers from Level 3A     —       —       —       —       —       —  
Transfers into Level 3A     —       —       —       —       —       —  
Gains (losses) included in net income (C)     5,177       726       1,723       697       (1,810 )     6,513  
Interest income     5,832       1,929       1,807       747       6,104       16,419  
Purchases, sales and repayments                                                
Purchases     —       43,872       36,218       15,439       124,813       220,342  
Purchase adjustments     (178 )     (1,522 )     —       —       —       (1,700 )
Proceeds from sales     —       —       —       —       —       —  
Proceeds from repayments     (12,899 )     (3,730 )     (3,620 )     (1,359 )     (5,590 )     (27,198 )
Balance at September 30, 2012   $ 41,903     $ 41,275     $ 36,128     $ 15,524     $ 123,517     $ 258,347  

 

  (A) Includes the recapture agreement for each respective pool.
  (B) Transfers are assumed to occur at the beginning of the quarter.
  (C) 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.

 

Newcastle has various processes and controls in place to ensure that fair value is reasonably estimated. With respect to the broker and pricing service quotations, to ensure these quotes represent a reasonable estimate of fair value, Newcastle’s quarterly procedures include a comparison to the outputs generated from its internal pricing models and transactions Newcastle has completed with respect to these or similar securities, as well as on its knowledge and experience of these markets. With respect to fair value estimates generated based on Newcastle’s internal pricing models, Newcastle’s management validates the inputs and outputs of the internal pricing models by comparing them to available independent third party market parameters and models for reasonableness. Newcastle believes its valuation methods and the assumptions used are appropriate and consistent with other market participants.

 

For Excess MSRs acquired prior to the current quarter, we obtain a fairness opinion related to the valuation of our Excess MSRs on the existing mortgage pools from an independent valuation firm at the current quarter end date. For Excess MSRs acquired during the current quarter, we obtain a fairness opinion related to the valuation of our Excess MSRs on the existing mortgage pools at the time of acquisition. To date, we have not made any significant valuation adjustments as a result of these third party opinions.

 

Fair value measurements categorized within Level 3 are sensitive to changes in the assumptions or methodology used to determine fair value and such changes could result in a significant increase or decrease in the fair value. For Newcastle’s investments in real estate securities, real estate related loans and residential mortgage loans categorized within Level 3 of the fair value hierarchy, the significant unobservable inputs include the discount rates, assumptions relating to prepayments, default rates and loss severities. Significant increases (decreases) in any of the discount rates, default rates or loss severities in isolation would result in a significantly lower (higher) fair value measurement. The impact of changes in prepayment speeds would have differing impacts on fair value, depending on the seniority of the investment. Generally, a change in the default assumption is generally accompanied by directionally similar changes in the assumptions used for the loss severity and the prepayment speed. For Newcastle’s investments in Excess MSRs, significant unobservable inputs include the discount rate, assumptions relating to prepayments, delinquency rates, recapture rates and excess mortgage servicing amount. Significant increases (decreases) in the discount rates, prepayments or delinquency rates in isolation would result in a significantly lower (higher) fair value measurement, whereas significant increases (decreases) in the recapture rates or excess mortgage servicing amount in isolation would result in a significantly higher (lower) fair value measurement. Generally, a change in the delinquency rate assumption is accompanied by directionally similar changes in the assumptions used for the prepayment speed.

 

Derivatives

 

Newcastle’s 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. Newcastle’s derivatives are recorded on its balance sheet as follows:

 

        Fair Value  
        September 30,     December 31,  
    Balance sheet location   2012     2011  
Derivative Assets                    
Interest rate caps, designated as hedges   Derivative Assets   $ —     $ 1,092  
Interest rate caps, not designated as hedges   Derivative Assets     224       862  
        $ 224     $ 1,954  
Derivative Liabilities                    
Interest rate swaps, designated as hedges   Derivative Liabilities   $ 14,009     $ 90,025  
Interest rate swaps, not designated as hedges   Derivative Liabilities     22,510       29,295  
        $ 36,519     $ 119,320  

 

The following table summarizes information related to derivatives:

 

    September 30, 2012     December 31, 2011  
Cash flow hedges                
Notional amount of interest rate swap agreements   $ 154,795     $ 848,434  
Notional amount of interest rate cap agreements     —       104,205  
Amount of (loss) recognized in OCI on effective portion     (13,883 )     (69,908 )
Deferred hedge gain (loss) related to anticipated financings, which have subsequently occurred, net of amortization     253       299  
Deferred hedge gain (loss) related to dedesignation, net of amortization     (226 )     (893 )
Expected reclassification of deferred hedges from AOCI into earnings over the next 12 months     3       1,688  
                 
Expected reclassification of current hedges from AOCI into earnings over the next 12 months     (6,269 )     (35,348 )
                 
Non-hedge Derivatives                
Notional amount of interest rate swap agreements     296,532       316,600  
Notional amount of interest rate cap agreements     23,400       36,428  

 

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

 

        Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
    Income statement location   2012     2011     2012     2011  
Cash flow hedges                                    
Gain (loss) on the ineffective portion   Other income (loss)   $ —     $ (1,181 )   $ 483     $ (881 )
Gain (loss) immediately recognized at dedesignation   Gain (loss) on sale of investments;
Other income (loss)
    —       —       (7,036 )     (13,796 )
Amount of gain (loss) reclassified from AOCI into income, related to effective portion   Interest expense     (7,830 )     (12,824 )     (28,766 )     (51,532 )
Deferred hedge gain reclassified from AOCI into income, related to anticipated financings   Interest expense     15       15       45       (43 )
Deferred hedge gain (loss) reclassified from AOCI into income, related to effective portion of dedesignated hedges   Interest expense     307       497       1,205       1,799  
Non-hedge derivatives gain (loss)   Other income (loss)     1,975       (2,109 )     6,052       194  

 

Liabilities for Which Fair Value is Only Disclosed

 

The following table summarizes the level of the fair value hierarchy, valuation techniques and inputs used for estimating each class of liabilities not measured at fair value in the statement of financial position but for which fair value is disclosed:

 

Type of Liabilities Not Measured At Fair Value for Which Fair Value Is Disclosed Fair Value Hierarchy   Valuation Techniques and Significant Inputs
CDO bonds payable Level 3  

Valuation technique is based on discounted cash flow.

 

Significant inputs include:

      • Underlying security and loan prepayment, default and cumulative loss expectations
      • Amount and timing of expected future cash flows
      • Market yields and credit spreads implied by comparisons to transactions of similar tranches of CDO debt by the varying levels of subordination

Other bonds and notes payable

 

Level 3  

Valuation technique is based on discounted cash flow.

 

Significant inputs include:

      • Amount and timing of expected future cash flows
      • Interest rates
      • Broker quotations
      • Market yields and credit spreads implied by comparisons to transactions of similar tranches of securitized debt by the varying levels of subordination
Repurchase agreements Level 2  

Valuation technique is based on market comparables.

 

Significant variables include:

      • Amount and timing of expected future cash flows
      • Interest rates
      • Collateral funding spreads
Mortgage notes payable Level 3  

Valuation technique is based on discounted cash flows

 

Significant inputs include:

      • Amount and timing of expected future cash flows
      • Interest rates
      • Collateral funding spreads
Junior subordinated notes payable Level 3  

Valuation technique is based on discounted cash flow

 

Significant inputs include:

      • Amount and timing of expected future cash flows
      • Interest rates
      • Market yields and the credit spread of Newcastle