Quarterly report pursuant to Section 13 or 15(d)

FAIR VALUE

v2.4.0.6
FAIR VALUE
 3 Months Ended
Mar. 31, 2013
Fair Value  
FAIR VALUE
9.  FAIR VALUE
 
Fair Value Summary Table
 
The carrying values and fair values of Newcastle’s assets and liabilities at March 31, 2013 were as follows:
   
Principal
                  
Weighted
    
Weighted
  
   
Balance or
                  
Average
    
Average
  
   
Notional
    
Carrying
    
Estimated
      
Yield/Funding
    
Maturity
  
   
Amount
    
Value
    
Fair Value
  
Fair Value Method (A)
  
Cost
    
(Years)
  
Assets
                                
Financial instruments:
                                
Real estate securities, available-for-sale*
   $ 2,946,191     $ 2,495,473     $ 2,495,473  
Broker quotations, counterparty quotations,  pricing services,  pricing models
     3.92 %     4.7  
Real estate related loans, held-for-sale, net
     1,251,678       851,525       867,777  
 Broker quotations, counterparty quotations, pricing services,  pricing models
     11.56 %     1.6  
Residential mortgage loans, held-for-investment, net
     374,264       317,708       324,554  
 Pricing models
     8.58 %     5.6  
Residential mortgage loans, held-for-sale, net
     3,451       2,380       2,380  
 Pricing models
     18.86 %     4.7  
Investments in excess mortgage servicing rights at fair value* (B)
    73,322,892       236,555       236,555  
 Pricing models
     17.60 %     5.4  
Investments in equity method investees at fair value* (B)
     66,160,202       102,588       102,588  
 Pricing models
     15.56 %     6.3  
Investments in real estate and intangibles, net
             184,733       194,878  
 Broker quotations, recent purchase price
                
Subprime mortgage loans subject to call option (C)
     406,217       406,115       406,115  
 (C)
     9.09 %  
(C)
  
Restricted cash*
     11,494       11,494       11,494                    
Cash and cash equivalents*
     534,772       534,772       534,772                    
Non-hedge derivative assets (D)(E)*
     23,400       176       176  
 Counterparty quotations
     N/A    
(D)
  
Other investments
             24,907       13,165  
 Pricing models
                
Receivables and other assets
             27,577       27,577                    
            $ 5,196,003     $ 5,217,504                    
                                           
Liabilities
                                          
Financial instruments:
                                          
CDO bonds payable (G)
   $ 1,014,993     $ 1,015,560     $ 791,641  
 Pricing models
     2.17 %     1.8  
Other bonds and notes payable
     178,041       173,723       180,638  
 Broker quotations, pricing models
     5.13 %     4.0  
Repurchase agreements
     1,473,586       1,473,586       1,473,586  
 Market comparables
     0.63 %     0.1  
Mortgage notes payable
     120,525       120,525       120,525  
 Pricing models
     3.79 %     5.6  
Financing of subprime mortgage loans subject to call option (C)
    406,217       406,115       406,115  
 (C)
     9.09 %  
(C)
  
Junior subordinated notes payable
     51,004       51,242       32,840  
 Pricing models
     7.40 %     22.1  
Interest rate swaps, treated as hedges (E)(F)*
     154,100       10,331       10,331  
 Counterparty quotations
     N/A    
(F)
  
Non-hedge derivatives (D)(E)*
     281,869       16,281       16,281  
 Counterparty quotations
     N/A    
(D)
  
Due to affiliates
             4,611       4,611                    
Dividends payable, accrued expenses and other liabilities
             74,530       74,530                    
            $ 3,346,504     $ 3,111,098                    
 
*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)
The notional amount represents the total unpaid principal balance of the mortgage loans. Newcastle does not receive an excess mortgage servicing amount on nonperforming loans for Agency portfolios. The weighted average yield and maturity for the investments in equity method investees represents the yield and maturity of the underlying investments in Excess MSRs.
 
(C)
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.
 
(D)
This represents two interest rate swap agreements with a total notional balance of $281.9 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 March 31, 2013.
 
(E) 
Newcastle’s derivatives fall into two categories. As of March 31, 2013, all derivative liabilities were held within Newcastle’s nonrecourse structures. An aggregate notional balance of $436.0 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. A notional balance of $23.4 million was an asset at period end and therefore is 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) 
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
   $ 154,100       5.04 %   $ (10,331 )
 
(G)
Newcastle notes that the unrealized gain on the liabilities within such structures cannot be fully realized.
 
(H)
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 nonrecourse financing structures is equal to the present value of their expected future net cash flows.
 
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.
 
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.
 
The following table summarizes such financial assets and liabilities measured at fair value on a recurring basis at March 31, 2013:
 
               
Fair Value
  
   
Principal Balance or
Notional Amount
    
Carrying Value
    
Level 2
    
Level 3A
    
Level 3B
    
Total
  
Assets:
                                    
  Real estate securities, available-for-sale:
                                    
     CMBS
   $ 468,584     $ 384,017     $ —     $ 327,173     $ 56,844     $ 384,017  
     REIT debt
     50,700       54,119       54,119       —       —       54,119  
     Non-Agency RMBS
     904,784       583,900       —       559,703       24,197       583,900  
     ABS - other real estate
     10,036       1,384       —       746       638       1,384  
     FNMA / FHLMC
     1,309,855       1,400,428       1,400,428       —       —       1,400,428  
     CDO
     202,232       71,625       —       66,371       5,254       71,625  
     Real estate securities total
   $ 2,946,191     $ 2,495,473     $ 1,454,547     $ 953,993     $ 86,933     $ 2,495,473  
     Investments in Excess MSRs (1)
   $ 73,322,892     $ 236,555     $ —     $ —     $ 236,555     $ 236,555  
     Investments in equity method investees (1)
   $ 66,160,202     $ 102,588     $ —     $ —     $ 102,588     $ 102,588  
Derivative assets:
                                                
   Interest rate caps, not treated as hedges
     23,400       176       176       —       —       176  
          Derivative assets total
   $ 23,400     $ 176     $ 176     $ —     $ —     $ 176  
                                                 
Liabilities:
                                                
  Derivative Liabilities:
                                                
     Interest rate swaps, treated as hedges
   $ 154,100     $ 10,331     $ 10,331     $ —     $ —     $ 10,331  
     Interest rate swaps, not treated as hedges
     281,869       16,281       16,281       —       —       16,281  
          Derivative liabilities total
   $ 435,969     $ 26,612     $ 26,612     $ —     $ —     $ 26,612  
 
(1)
The notional amount represents the total unpaid principal balance of the mortgage loans.  Newcastle does not receive an excess mortgage servicing amount on nonperforming loans for Agency portfolios.
 

 

 
Newcastle’s investments in instruments (excluding the Excess MSRs and investment in equity method investees, see below) measured at fair value on a recurring basis using Level 3 inputs changed during the three months ended March 31, 2013 as follows:
 
   
Level 3A
  
   
CMBS
  
ABS
            
   
Conduit
    
Other
    
Non-Agency RMBS
  
Other
    
Equity/Other
Securities
  
Total
  
Balance at December 31, 2012
   $ 225,575     $ 104,451     $ 330,021     $ 798     $ 65,027     $ 725,872  
Transfers (A)
                                                
Transfers from Level 3B
     —       —       1,861       —       —       1,861  
Transfers into Level 3B
     —       (8,257 )     —       —       —       (8,257 )
Total gains (losses) (B)
                                                
Included in net income (C)
     —       —       —       —       —       —  
Included in other comprehensive income (loss)
     8,544       1,347       14,166       (25 )     1,334       25,366  
Amortization included in interest income
     2,055       161       5,622       —       998       8,836  
Purchases, sales and repayments
                                                
Purchases
     —       —       227,293       —       —       227,293  
Proceeds from sales
     —       —       —       —       —       —  
Proceeds from repayments
     (3,219 )     (3,484 )     (19,260 )     (27 )     (988 )     (26,978 )
Balance at March 31, 2013
   $ 232,955     $ 94,218     $ 559,703     $ 746     $ 66,371     $ 953,993  
                                                 
   
Level 3B
  
   
CMBS
  
ABS
                
   
Conduit
    
Other
    
Non-Agency RMBS
  
Other
    
Equity/Other
Securities
  
Total
  
Balance at December 31, 2012
   $ 29,194     $ 17,171     $ 25,954     $ 677     $ 5,998     $ 78,994  
Transfers (A)
                                                
Transfers from Level 3A
     —       8,257       —       —       —       8,257  
Transfers into Level 3A
     —       —       (1,861 )     —       —       (1,861 )
Total gains (losses) (B)
                                                
Included in net income (C)
     (539 )     —       —       —       —       (539 )
Included in other comprehensive income (loss)
     1,271       1,338       (349 )     (9 )     57       2,308  
Amortization included in interest income
     1,120       119       1,435       256       232       3,162  
Purchases, sales and repayments
                                                
Purchases
     —       —       —       —       —       —  
Proceeds from sales
     —       —       —       —       —       —  
Proceeds from repayments
     (1,087 )     —       (982 )     (286 )     (1,033 )     (3,388 )
Balance at March 31, 2013
   $ 29,959     $ 26,885     $ 24,197     $ 638     $ 5,254     $ 86,933  
 
(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, 2013
  
   
Level 3A
    
Level 3B
  
Gain (loss) on settlement of investments, net
   $ —     $ —  
Other income (loss), net
     —       —  
OTTI
     —       (539 )
Total
   $ —     $ (539 )
Gain (loss) on settlement of investments, net, from investments transferred into Level 3 during the period
   $ —     $ —  

 
 
Securities Valuation
 
As of March 31, 2013, 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
   $ 468,584     $ 332,092     $ 269,126     $ 58,047     $ 56,844     $ 384,017  
REIT debt
     50,700       50,055       28,321       25,798       —       54,119  
Non-Agency RMBS
     904,784       535,908       531,929       27,774       24,197       583,900  
ABS - other real estate
     10,036       1,490       —       746       638       1,384  
FNMA / FHLMC
     1,309,855       1,396,400       1,310,147       90,281       —       1,400,428  
CDO
     202,232       66,747       —       66,371       5,254       71,625  
Total
   $ 2,946,191     $ 2,382,692     $ 2,139,523     $ 269,017     $ 86,933     $ 2,495,473  
 
(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, 2013.
(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
    
Weighted Average Significant Input
  
   
Amortized
          
Recorded
    
Gains (Losses)
                
Cumulative
        
   
Cost
          
In Current
    
in Accumulated
    
Discount
    
Prepayment
    
Default
    
Loss
  
   
Basis (B)
    
Fair Value
    
Period
    
OCI
    
Rate
    
Speed (F)
    
Rate
    
Severity
  
CMBS - Conduit
   $ 23,143     $ 29,959     $ 539     $ 6,816       10.0 %     N/A       21.8 %     38.7 %
CMBS - Large loan /single borrower
    26,367       26,885       —       518       2.5 %     N/A       31.3 %     31.3 %
Non-Agency RMBS
     12,481       24,197       —       11,716       8.0 %     2.8 %     19.9 %     43.0 %
ABS - other RE
     424       638       —       214       8.0 %     0.5 %     44.1 %     99.7 %
CDO
     3,179       5,254       —       2,075       19.8 %     5.0 %     8.2 %     73.0 %
Total
     65,594       86,933       539       21,339                                  
 
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, 2013:

                     
Valuation
    
Significant Input
  
   
Outstanding
                
Allowance/
    
Range
    
Weighted Average
  
   
Face
    
Carrying
    
Fair
    
(Reversal) In
    
Discount
    
Loss
    
Discount
    
Loss
  
Loan Type
  
Amount
    
Value
    
Value
    
Current Year
    
Rate
    
Severity
    
Rate
    
Severity
  
Mezzanine
   $ 518,307     $ 432,432     $ 445,343     $ (838 )     3.5% - 25.0%       0.0% - 100.0%       9.1%       10.9%      
Bank Loan
     582,474       277,831       277,830       2,285       6.7% - 41.7%       0.0% - 100.0%       16.7%       45.6%  
B-Note
     120,872       111,237       114,437       (6 )     6.0% - 15.0%       0.0%       10.4%       0.0%  
Whole Loan
     30,025       30,025       30,167       —       4.8% - 6.9%       0.0% - 15.0%       4.8%       14.5%  
Total Real Estate Related
   Loans Held-for-Sale, Net
   $ 1,251,678     $ 851,525     $ 867,777     $ 1,441                                  
                                                                 
                           
Valuation
                                  
   
Outstanding
                    
Allowance/
    
Significant Input (Weighted Average)
  
   
Face
    
Carrying
    
Fair
    
(Reversal) In
    
Discount
    
Prepayment
    
Constant
    
Loss
  
Loan Type
  
Amount
    
Value
    
Value
    
Current Year
    
Rate
    
Speed
    
Default Rate
    
Severity
  
Non-securitized Manufactured
Housing Loans Portfolio I
  $ 569     $ 153     $ 153     $ (3 )     68.2 %      5.0 %      11.6 %      70.0 % 
Non-securitized Manufactured
Housing Loans Portfolio II
    2,882       2,227       2,227       (3 )     15.5 %      5.0 %      3.5 %      75.0 % 
Total Residential Mortgage
Loans Held-for-Sale, Net
  $ 3,451     $ 2,380     $ 2,380     $ (6 )                                
 
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, 2013:
 
                           
Significant Input (Weighted Average)
  
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 Portfolio I
   $ 114,355     $ 96,752     $ 97,192     $ 13       9.5 %     5.0 %     4.0 %     70.0 %
Securitized Manufactured Housing
   Loans Portfolio II
     146,865       144,274       143,048       835       7.5 %     5.0 %     3.5 %     75.0 %
Residential Loans
     54,458       41,198       47,134       (49 )     7.4 %     4.7 %     2.8 %     46.5 %
Reverse Mortgage Loans
     58,586       35,484       37,180       —       10.6 %     N/A       N/A       N/A  
Total Residential Mortgage Loans, Held-for-Investment, Net
  $ 374,264     $ 317,708     $ 324,554     $ 799                                  
 

 

 
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 owned directly and through equity method investees as of March 31, 2013:
 
   
Significant Input
  
Held Directly (Note 5)
  
Prepayment Speed (A)
    
Delinquency
(B)
    
Recapture Rate (C)
  
Excess Mortgage
Servicing Amount
(D)
  
Discount Rate
  
MSR Pool 1
     16.1 %     10.0 %     35.0 %
28 bps
     18.0 %
MSR Pool 1 - Recapture Agreement
     8.0 %     10.0 %     35.0 %
21 bps
     18.0 %
MSR Pool 2
     16.0 %     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
     16.2 %     12.1 %     35.0 %
23 bps
     17.6 %
MSR Pool 3 - Recapture Agreement
     8.0 %     10.0 %     35.0 %
21 bps
     17.6 %
MSR Pool 4
     18.3 %     15.8 %     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)         20.0 %
13 bps
     17.5 %
MSR Pool 5 - Recapture Agreement
     8.0 %     N/A(E)         20.0 %
 21 bps
     17.5 %
Held through Equity Method Investees (Note 6)
                            
MSR Pool 6
     19.6 %     8.8 %     35.0 %
25 bps
     17.4 %
MSR Pool 6 - Recapture Agreement
     10.0 %     6.0 %     35.0 %
23 bps
     17.4 %
MSR Pool 7
     13.8 %     8.4 %     35.0 %
16 bps
     15.2 %
MSR Pool 7 - Recapture Agreement
     10.0 %     5.0 %     35.0 %
19 bps
     15.2 %
MSR Pool 8
     15.2 %     7.4 %     35.0 %
19 bps
     15.0 %
MSR Pool 8 - Recapture Agreement
     10.0 %     5.0 %     35.0 %
19 bps
     15.0 %
 
(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”). Management considers collateral-specific prepayment experience when determining this vector. For the Recapture Agreements and recaptured loans, Newcastle also considers industry research on the prepayment experience of similar loan pools (i.e., loan pools composed of refinanced loans). This data is obtained from remittance reports, market data services and other market sources.
 
Delinquency rates are based on the pool-specific experience of loans that missed their latest mortgage payments. For the Recapture Agreements and recaptured loans, delinquency rates are based on the experience of similar loan pools originated by Nationstar and delinquency experience over the past year. Management believes this time period provides a reasonable sample for projecting future delinquency rates while taking into account current market conditions. Additional consideration is given to loans that are expected to become 30 or more days delinquent.

 

 
Recapture rates are based on actual average recapture rates experienced by Nationstar on similar mortgage loan pools. Generally, Newcastle looks to one year worth of actual recapture rates, which management believes provides a reasonable sample for projecting future recapture rates while taking into account current market conditions.
 
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 originated by Nationstar over the past year and other general market considerations. Management believes this time period provides a reasonable sample for projecting future excess mortgage servicing amounts while taking into account current market conditions.
 
The discount rates Newcastle uses are derived from a range of observable pricing on mortgage servicing rights backed by similar collateral.
 
Newcastle uses different prepayment and delinquency assumptions in valuing the Excess MSRs relating to the original loan pools, the Recapture Agreements and the Excess MSRs relating to recaptured loans. The prepayment speed and delinquency rate assumptions differ because of differences in the collateral characteristics, eligibility for the Home Affordable Refinance Program 2.0 (“HARP 2.0”) and expected borrower behavior for original loans and loans which have been refinanced. Newcastle uses the same assumptions for recapture and discount rates when valuing Excess MSRs and Recapture Agreement. These assumptions are based on historical recapture experience and market pricing.
 
Newcastle’s MSRs investments measured at fair value on a recurring basis using Level 3B inputs changed during the period ended March 31, 2013 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, 2012
   $ 40,910     $ 39,322     $ 35,434     $ 15,036     $ 114,334     $ 245,036  
Transfers (B)
                                                
Transfers from Level 3A
     —       —       —       —       —       —  
Transfers into Level 3A
     —       —       —       —       —       —  
Gains (losses) included in net income (C)
     440       897       798       98       (375 )     1,858  
Interest income
     1,970       1,485       1,628       601       4,340       10,024  
Purchases, sales and repayments
                                                
Purchases
     —       —       —       —       —       —  
Purchase adjustments
     —       —       —       —       —       —  
Proceeds from sales
     —       —       —       —       —       —  
Proceeds from repayments
     (3,632 )     (3,129 )     (3,182 )     (1,061 )     (9,359 )     (20,363 )
Balance at March 31, 2013
   $ 39,688     $ 38,575     $ 34,678     $ 14,674     $ 108,940     $ 236,555  
 
(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.
 
Equity Method Investees Valuation
 
Fair value estimates of Newcastle’s investments were based on internal pricing models.  Newcastle estimated the fair value of the assets and liabilities of the underlying entities in which it holds an equity interest.  The valuation technique is based on discounted cash flows.  Significant inputs represent the inputs required to estimate the fair value of the Excess MSRs held by the entities and 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.  Refer to the Excess MSRs Valuation section above for further details.
 

 
Newcastle’s investments in equity method investees measured at fair value on a recurring basis using Level 3B inputs changed during the period ended March 31, 2013 as follows:
 
       
   
Three Months
Ended March 31,
2013
  
Balance at December 31, 2012
   $ —  
Contributions to equity method investees
     109,588  
Distributions of earnings from equity method investees
     (1,344 )
Distributions of capital from equity method investees
     (6,625 )
Change in fair value of investments in equity method investees
     969  
Balance at March 31, 2013
   $ 102,588  
 
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
  
2013
    
2012
  
Derivative Assets
              
Interest rate caps, not designated as hedges
Derivative Assets
     176       165  
      $ 176     $ 165  
Derivative Liabilities
                  
Interest rate swaps, designated as hedges
Derivative Liabilities
   $ 10,331     $ 12,175  
Interest rate swaps, not designated as hedges
Derivative Liabilities
     16,281       19,401  
      $ 26,612     $ 31,576  

 
The following table summarizes information related to derivatives:
 
   
March 31, 2013
    
December 31, 2012
  
Cash flow hedges
            
Notional amount of interest rate swap agreements
   $ 154,100     $ 154,450  
Amount of (loss) recognized in OCI on effective portion
     (10,207 )     (12,050 )
Deferred hedge gain (loss) related to anticipated financings, which have subsequently occurred, net of amortization
    221       237  
Deferred hedge gain (loss) related to dedesignation, net of amortization
    (195 )     (210 )
Expected reclassification of deferred hedges from AOCI into earnings over the next 12 months
    5       4  
                 
Expected reclassification of current hedges from AOCI into earnings over the next 12 months
    (6,181 )     (6,259 )
                 
Non-hedge Derivatives
                
Notional amount of interest rate swap agreements
     281,869       294,203  
Notional amount of interest rate cap agreements
     23,400       23,400  
 
The following table summarizes gains (losses) recorded in relation to derivatives:
 
     
Three Months Ended
March 31,
  
 
Income statement location
  
2013
    
2012
  
Cash flow hedges
              
   Gain (loss) on the ineffective portion
Other income (loss)
   $ —     $ 30  
   Gain (loss) immediately recognized at dedesignation
Gain (loss) on sale of investments;
Other income (loss)
     —       (276 )
   Amount of gain (loss) reclassified from AOCI into
                  
      income, related to effective portion
Interest expense
     (1,865 )     (10,646 )
   Deferred hedge gain reclassified from AOCI into income,
                  
      related to anticipated financings
Interest expense
     16       15  
   Deferred hedge gain (loss) reclassified from AOCI into
                  
      income, related to effective portion of dedesignated hedges
Interest expense
     (16 )     442  
Non-hedge derivatives gain (loss)
Other income (loss)
     3,126       2,056  
 

 

 
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