Quarterly report pursuant to Section 13 or 15(d)

FAIR VALUE OF FINANCIAL INSTRUMENTS

v2.4.0.6
FAIR VALUE OF FINANCIAL INSTRUMENTS
 3 Months Ended
Mar. 31, 2012
Fair Value Of Financial Instruments  
FAIR VALUE OF FINANCIAL INSTRUMENTS

6. FAIR VALUE OF FINANCIAL INSTRUMENTS

 

Fair Value Summary Table

 

The carrying values and fair values of Newcastle’s financial instruments at March 31, 2012 were as follows:

  

    Principal Balance or Notional Amount     Carrying Value     Estimated 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*   $ 1,952,640     $ 1,536,251     $ 1,536,251   Broker quotations, counterparty quotations, pricing services, pricing models     9.47 %     4.4  
Real estate related loans, held-for-sale, net     1,097,349       838,818       845,329   Broker quotations, counterparty quotations, pricing services, pricing models     12.28 %     2.6  
Residential mortgage loans, held-for-investment, net     361,765       321,347       320,182   Pricing models     8.21 %     6.5  
Subprime mortgage loans subject to call option (B)     406,217       404,979       404,979   (B)     9.09 %   (B)  
Restricted cash*     107,875       107,875       107,875                    
Derivative assets, treated as hedges (C)(E)*     122,755       1,029       1,029   Counterparty quotations     N/A     (C)  
Non-hedge derivative assets (D)(E)*     42,428       803       803   Counterparty quotations     N/A     (D)  
Operating real estate, held-for-sale             7,739       7,739                    
Other investments             18,883       18,883                    
Receivables and other assets             22,147       22,147                    
            $ 3,259,871     $ 3,264,903                    
Recourse Financing Structures and Unlevered Assets                                          
Financial instruments:                                          
Real estate securities, available-for-sale*   $ 410,288     $ 248,638     $ 248,638   Broker quotations, counterparty quotations, pricing services, pricing models     2.56 %     3.0  
Residential mortgage loans, held-for-sale, net     4,696       2,775       2,775   Pricing models     17.14 %     4.8  
Investments in excess mortgage servicing rights at fair value *(H)     9,434,272       42,587       42,587   Pricing models     20.00 %     6.0  
Cash and cash equivalents*     156,425       156,425       156,425                    
Other investments             6,024       6,024                    
Receivables and other assets             3,226       3,226                    
            $ 459,675     $ 459,675                    

  

 

    Principal Balance or Notional Amount     Carrying Value     Estimated Fair Value     Fair Value Method (A)     Weighted Average Yield/Funding
Cost		     Weighted Average
Maturity
(Years) 		 
Liabilities                                    
Non-Recourse VIE Financing Structures (F) (G)                                    
Financial instruments:                                    
CDO bonds payable   $ 2,367,443     $ 2,365,537     $ 1,522,029     Pricing models     2.71 %    3.5  
Other bonds and notes payable     191,921       190,091       192,574     Broker quotations, pricing models       4.33 %     3.4  
Repurchase agreements     5,644       5,644       5,644     Market comparables       1.99 %     0.3  
Financing of subprime mortgage loans subject to call option (B)     406,217       404,979       404,979     (B)          9.09 %     (B)  
Interest rate swaps, treated as hedges (C)(E)*     832,767       81,618       81,618     Counterparty quotations       N/A       (C)  
Non-hedge derivatives (D)(E)*     306,077       27,156       27,156     Counterparty quotations       N/A       (D)  
Accrued expenses and other liabilities             15,723       15,723                          
            $ 3,090,748     $ 2,249,723                          
Recourse Financing Structures and Other Liabilities (G)                                                
Financial instruments:                                                
Repurchase agreements   $ 228,080     $ 228,080     $ 228,080     Market comparables       0.39 %     0.2  
Junior subordinated notes payable     51,004       51,247       33,638     Pricing models       7.41 %     23.1  
Due to affiliates             1,659       1,659                          
Dividends payable, accrued expenses and other liabilities             24,790       24,790                          
            $ 305,776     $ 288,167                          

 

*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 cap agreements which receive 1-Month LIBOR:            
2015     Nov     $ 39,550       2.10 %   $ 250  
2016     Jul       77,905       2.66 %     708  
2017     Jan       5,300       1.86 %     71  
            $ 122,755             $ 1,029  
Interest rate swap agreements which receive 1-Month LIBOR:
2014     Nov     $ 15,034       5.08 %   $ (1,726 )
2015     May       469,734       5.43 %     (24,123 )
2016     May       173,965       5.04 %     (19,665 )
2017     Aug       174,034       5.24 %     (36,104 )
            $ 832,767             $ (81,618 )

 

(D) This represents two interest rate swap agreements with a total notional balance of $306.1 million, maturing in March 2014 and March 2015, respectively, and four interest rate cap agreements with a total notional balance of $42.4 million, maturing in March 2013, August 2017 and January 2019. Newcastle entered, respectively, into these hedge agreements to reduce its exposure to interest rate changes on the floating rate financings of CDO IV, CDO VI and CDO X. These derivative agreements were not designated as hedges for accounting purposes as of March 31, 2012.
   
(E) Newcastle’s derivatives fall into two categories. As of March 31, 2012, all derivatives were held within Newcastle’s nonrecourse CDO structures. An aggregate notional balance of $1.1 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 $165.2 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 on which Newcastle is entitled to receive 65% of the excess mortgage servicing amount 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 such financial assets and liabilities measured at fair value on a recurring basis at March 31, 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   $ 1,502,244     $ 1,187,445     $ —     $ 1,008,497     $ 178,948     $ 1,187,445  
REIT debt     120,288       122,857       122,857       —       —       122,857  
ABS - subprime     255,524       132,033       —       62,231       69,802       132,033  
ABS - other real estate     51,741       37,051       —       30,950       6,101       37,051  
FNMA / FHLMC     226,808       240,624       240,624       —       —       240,624  
CDO     206,323       64,879       —       60,901       3,978       64,879  
Real estate securities total   $ 2,362,928     $ 1,784,889     $ 363,481     $ 1,162,579     $ 258,829     $ 1,784,889  
Investments in Excess MSRs (1)   $ 9,434,272     $ 42,587     $ —     $ —     $ 42,587     $ 42,587  
Derivative assets:                                                
Interest rate caps, treated as hedges   $ 122,755     $ 1,029     $ 1,029     $ —     $ —     $ 1,029  
Interest rate caps, not treated as hedges     42,428       803       803       —       —       803  
Derivative assets total   $ 165,183     $ 1,832     $ 1,832     $ —     $ —     $ 1,832  
                                                 
Liabilities:                                                
Derivative Liabilities:                                                
Interest rate swaps, treated as hedges   $ 832,767     $ 81,618     $ 81,618     $ —     $ —     $ 81,618  
Interest rate swaps, not treated as hedges     306,077       27,156       27,156       —       —       27,156  
Derivative liabilities total   $ 1,138,844     $ 108,774     $ 108,774     $ —     $ —     $ 108,774  

 

(1) The notional amount represents the total unpaid principal balance of the mortgage loans on which Newcastle is entitled to receive 65% of the excess mortgage servicing amount on performing 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 three months ended March 31, 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       —       —       —       —       6,056  
Transfers into Level 3B     —       (14,105 )     (11,057 )     —       —       (25,162 )
Total gains (losses) (B)                                                
Included in net income (C)     (1 )     —       —       —       —       (1 )
Included in other comprehensive income (loss)     62,865       3,324       870       1,087       8,173       76,319  
Amortization included in interest income     7,882       331       1,122       (83 )     1,194       10,446  
Purchases, sales and settlements                                                
Purchases     6,007       —       8,682       —       —       14,689  
Proceeds from sales     —       —       —       —       —       —  
Proceeds from repayments     (11,965 )     (615 )     (3,527 )     (1,242 )     (513 )     (17,862 )
Balance at March 31, 2012   $ 887,127     $ 121,370     $ 62,231     $ 30,950     $ 60,901     $ 1,162,579  

 

    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     —       14,105       11,057       —       —       25,162  
Transfers into Level 3A     (6,056 )     —       —       —       —       (6,056 )
Total gains (losses) (B)                                                
Included in net income (C)     3,634       (329 )     1,187       (5 )     —       4,487  
Included in other comprehensive income (loss)     (8,592 )     788       (1,265 )     (749 )     1       (9,817 )
Amortization included in interest income     3,030       157       1,854       79       103       5,223  
Purchases, sales and settlements                                                
Purchases     —       —       —       —       —       —  
Proceeds from sales     (5,418 )     —       (2,215 )     —       —       (7,633 )
Proceeds from repayments     (2,750 )     279       (3,297 )     (143 )     (65 )     (5,976 )
Balance at March 31, 2012   $ 124,470     $ 54,478     $ 69,802     $ 6,101     $ 3,978     $ 258,829  

 

  (A) Transfers are assumed to occur at the beginning of the quarter.
  (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:

 

    Three Months Ended March 31, 2012  
    Level 3 A     Level 3 B  
Gain (loss) on settlement of investments, net   $ —     $ 6,437  
Other income (loss), net     —       —  
OTTI     (1 )     (1,950 )
Total   $ (1 )   $ 4,487  
Gain (loss) on settlement of investments, net,
from investments transferred into Level 3 during the period		   $ —     $ —  

 

Securities Valuation

 

As of March 31, 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   $ 1,502,244     $ 1,124,688     $ 847,838     $ 160,659     $ 178,948     $ 1,187,445  
REIT debt     120,288       119,552       77,512       45,345       —       122,857  
ABS - subprime     255,524       126,828       44,878       17,353       69,802       132,033  
ABS - other real estate     51,741       38,526       30,329       621       6,101       37,051  
FNMA / FHLMC     226,808       237,607       153,103       87,521       —       240,624  
CDO     206,323       68,343       2,750       58,151       3,978       64,879  
Total   $ 2,362,928     $ 1,715,544     $ 1,156,410     $ 369,650     $ 258,829     $ 1,784,889  

 

(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, 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:

 

                            Assumption Ranges  
    Amortized Cost     Fair     Impairment Recorded In Current     Unrealized Gains (Losses) in Accumulated     Discount     Prepayment     Default     Loss  
    Basis (B)     Value     Period     OCI     Rate     Speed (F)     Rate     Severity  
CMBS - Conduit   $ 107,431     $ 124,470     $ 1,471     $ 17,039       12%       N/A       5%-100%       16%-100%  
CMBS - Large loan /
single borrower		     56,728       54,478       —       (2,250 )     1%-12%       N/A       0%-100%       0%-100%  
ABS - subprime     61,006       69,802       479       8,796       8%       0%-11%       24%-87%       60%-100%  
ABS - other RE     8,641       6,101       —       (2,540 )     8%       1%-4%       33%-63%       79%-95%  
CDO     4,261       3,978       —       (283 )     14%       4%       17%       83%  
Total   $ 238,067     $ 258,829     $ 1,950     $ 20,762                                  

 

  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 March 31, 2012:

 

 

                            Significant Input Ranges  
Loan Type   Outstanding Face Amount     Carrying Value     Fair Value     Valuation Allowance/ (Reversal) In Current Year     Discount Rate     Loss Severity  
Mezzanine   $ 584,234     $ 462,197     $ 468,556     $ (733 )     8.0% -15.0%       0.0% - 100.0%  
Bank Loan     295,638       183,526       183,660       (11,299 )     8.4% - 24.9%       0.0% - 70.0%  
B-Note     187,017       162,635       162,635       1,550       6.3% - 15.0%       0.0%  
Whole Loan     30,460       30,460       30,478       —       5.1% - 7.1%       0.0% - 15.0%  
Total Real Estate Related
Loans Held-for-Sale, Net		   $ 1,097,349     $ 838,818     $ 845,329     $ (10,482 )                

 

                            Significant Input Ranges  
Loan Type   Outstanding Face Amount     Carrying Value     Fair Value     Valuation Allowance/ (Reversal) In Current Year     Discount Rate     Prepayment Speed     Default Rate     Loss Severity  
Non-securitized Manufactured
Housing Loans Portfolio I		   $ 711     $ 193     $ 193     $ 5       39.1 %     0.0 %     52.9 %     75.0 %
Non-securitized Manufactured
Housing Loans Portfolio II		     3,985       2,582       2,582       (202 )     15.5 %     5.0 %     6.6 %     80.0 %
Total Residential Mortgage
Loans Held-for-Sale, Net		   $ 4,696     $ 2,775     $ 2,775     $ (197 )                                

 

 

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 March 31, 2012:

 

                            Significant Input Ranges  
Loan Type   Outstanding Face Amount     Carrying Value     Fair Value     Valuation Allowance/
(Reversal) In Current Year		     Discount Rate     Prepayment Speed     Constant Default Rate     Loss Severity  
Securitized Manufactured Housing
Loans Portoflio I		   $ 130,488     $ 108,839     $ 109,875     $ 680     9.5%     3.0%     4.0%     75.0%  
Securitized Manufactured Housing
 Loans Portfolio II		     171,858       168,837       165,691       1,069       7.6%       5.0%       3.5%       80.0%  
Residential Loans     59,419       43,671       44,616       (101 )     4.7%-7.8%       0.0%-5.0%       0.0%-3.0%       0.0%-50.0%  
Total Residential Mortgage Loans,
 Held-for-Investment, Net		   $ 361,765     $ 321,347     $ 320,182     $ 1,648                                  

 

 

Excess MSRs Valuation

 

Fair value estimates of Newcastle’s Excess MSRs were based on internal pricing models. Significant inputs used in the valuations included expectations of prepayment rates, 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, 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 March 31, 2012:

 

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

 

(A) Projected annualized weighted average lifetime voluntary and involuntary prepayment rate using a prepayment vector.
(B) Projected percentage of mortgage loans in the pool that will miss their mortgage payments.
(C) Percentage of voluntarily prepaid loans that are expected to be refinanced by Nationstar.
(D) Weighted average mortgage servicing amount in excess of the base mortgage servicing fee.

 

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 rates 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 MSR investment.

 

The prepayment vector specifies the percentage of the collateral balance that is expected to voluntarily and involuntarily (i.e. default) pay off at each point in the future. The prepayment vector is based on projections that consider factors such as the underlying borrower’s 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 are based on recent pool-specific experience of loans that misled their most recent mortgage payments, with additional consideration given to the current “pipeline” of loans that are 30 days or more delinquent, in foreclosure, or are real estate owned (REO).

 

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

 

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

 

Newcastle’s MSRs investments measured at fair value on a recurring basis using Level 3B inputs changed during the period ended March 31, 2012 as follows:

 

    Level 3B  
    Portfolio I     Portfolio I -
Recapture Agreement		     Total  
Balance at December 31, 2011   $ 37,637     $ 6,334     $ 43,971  
Transfers (A)                        
Transfers from Level 3     —       —       —  
Transfers into Level 3     —       —       —  
Total gains (losses)                        
Included in net income (B)     1,215       1       1,216  
Amortization included in interest income     2,037       —       2,037  
Purchases, sales and settlements                        
Purchase adjustments     (150 )     (28 )     (178 )
Proceeds from sales     —       —       —  
Proceeds from repayments     (4,459 )     —       (4,459 )
Balance at March 31, 2012   $ 36,280     $ 6,307     $ 42,587  

 

  (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.

 

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 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.

 

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, default rates, delinquency rates, recapture rates and excess mortgage servicing amount. Significant increases (decreases) in the discount rates, prepayments, default rates 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 default assumption is accompanied by directionally similar changes in the assumptions used for the loss severity and 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  
        March 31,     December 31,  
    Balance sheet location    2012     2011  
                 
Derivative Assets                    
Interest rate caps, designated as hedges   Derivative Assets   $ 1,029     $ 1,092  
Interest rate caps, not designated as hedges   Derivative Assets     803       862  
        $ 1,832     $ 1,954  
Derivative Liabilities                    
Interest rate swaps, designated as hedges   Derivative Liabilities   $ 81,618     $ 90,025  
Interest rate swaps, not designated as hedges   Derivative Liabilities     27,156       29,295  
        $ 108,774     $ 119,320  

 

The following table summarizes information related to derivatives: 

 

    March 31, 2012     December 31, 2011  
Cash flow hedges            
Notional amount of interest rate swap agreements   $ 832,767     $ 848,434  
Notional amount of interest rate cap agreements     122,755       104,205  
Amount of (loss) recognized in OCI on effective portion     (61,763 )     (69,908 )
Deferred hedge gain (loss) related to anticipated financings, which have subsequently occurred, net of amortization     284       299  
Deferred hedge gain (loss) related to dedesignation, net of amortization     (1,059 )     (893 )
Expected reclassification of deferred hedges from AOCI into earnings over the next 12 months     1,745       1,688  
                 
Expected reclassification of current hedges from AOCI into earnings over the next 12 months     (33,762 )     (35,348 )
                 
Non-hedge Derivatives                
Notional amount of interest rate swap agreements     306,077       316,600  
Notional amount of interest rate cap agreements     42,428       36,428  

 

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

 

      Three Months Ended
March 31,		    
    Income statement location    2012      2011     
Cash flow hedges                      
Gain (loss) on the ineffective portion   Other income (loss)   $ 30     $ 283    
Gain (loss) immediately recognized at dedesignation   Gain (loss) on sale of investments;
Other income (loss)		     (276 )     (5,315 )  
Amount of gain (loss) reclassified from AOCI into income, related to effective portion   Interest expense     (10,646 )     (21,191 )  
Deferred hedge gain reclassified from AOCI into income, related to anticipated financings   Interest expense     15       14    
Deferred hedge gain (loss) reclassified from AOCI into income, related to effective portion of dedesignated hedges   Interest expense     442       719    
Non-hedge derivatives gain (loss)   Other income (loss)     2,056       4,831    

 

 

 

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 quotation

• 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 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