Drive Shack Inc. Quarterly report pursuant to Section 13 or 15(d)

Quarterly report pursuant to Section 13 or 15(d)

FAIR VALUE

FAIR VALUE

9 Months Ended

Sep. 30, 2015

Fair Value Summary Table

The following table summarizes the carrying values and estimated fair values of Newcastle’s financial instruments at September 30, 2015:



	Carrying Value		Estimated Fair Value		Fair Value Method (A)
Assets
Real estate securities, available-for-sale	$	61,508	$	61,508	Broker/counterparty quotations, pricing services, pricing models
Real estate securities, pledged as collateral	370,342		370,342		Broker/counterparty quotations, pricing services
Real estate related and other loans, held-for-sale, net	142,802		158,874		Broker/counterparty quotations, pricing services, pricing models
Residential mortgage loans, held-for-sale, net	569		603		Broker/counterparty quotations, pricing models
Subprime mortgage loans subject to call option (B)	392,342		392,342		(B)
Restricted cash	5,759		5,759
Cash and cash equivalents	31,493		31,493
Non-hedge derivative assets (C)	3,712		3,712		Counterparty quotations, pricing services

Liabilities
CDO bonds payable (D)	$	92,812	$	16,243	Pricing models
Other bonds and notes payable (D)	7,494		8,003		Pricing models
Repurchase agreements	415,442		415,859		Market comparables, counterparty quotations
Credit facilities and obligations under capital leases	12,003		12,003		Pricing models
Financing of subprime mortgage loans subject to call option (B)	392,342		392,342		(B)
Junior subordinated notes payable	51,226		38,696		Pricing models
Non-hedge derivatives (C)	6,124		6,124		Counterparty quotations, pricing services

(A)

Methods are listed in order of priority. In the case of real estate securities and real estate related and other 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)	Represents an option, not an obligation, to repurchase loans from Newcastle’s subprime mortgage loan securitizations (Note 6).


(C)	Represents derivative assets and liabilities including TBA forward contracts (Note 12).

(D)

Newcastle notes that the unrealized gain on the liabilities within such structures cannot be fully realized. Assets held within CDOs and other non-recourse structures are generally not available to satisfy obligations outside of such financings, except to the extent Newcastle receives net cash flow distributions from such structures. 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.

Fair Value Measurements

Valuation Hierarchy

The fair value of financial instruments is categorized based on the priority of the inputs to the valuation technique and categorized into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). Newcastle follows this hierarchy for its financial instruments measured at fair value.

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

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


•	quoted prices for similar assets or liabilities in active markets,


•	inputs other than quoted prices that are observable for the asset or liability (such as interest rates and yield curves observable at commonly quoted intervals, implied volatilities and credit spreads), and


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

Level 3 - Valuations determined using unobservable inputs that are supported by little or no market activity, and that are significant to the overall fair value measurement. Level 3 assets and liabilities include financial instruments whose value is determined using non-binding market quotations, pricing models, discounted cash flow methodologies, or similar techniques where significant inputs are unobservable, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

Fair value may be based upon broker quotations, counterparty quotations or pricing services quotations, which provide valuation estimates based upon reasonable market order indications or management's good faith estimate, and are subject to significant variability based on market conditions, such as interest rates, credit spreads and market liquidity. A significant portion of Newcastle’s loans, securities and debt obligations are currently not traded in active markets and therefore have little or no price transparency. As a result, Newcastle has estimated the fair value of illiquid instruments based on internal pricing models or quotations subject to Newcastle's controls described below.

Newcastle has various processes and controls in place to ensure that fair value measurements are reasonably estimated. With respect to broker and pricing service quotations, and in order to ensure these quotes represent a reasonable estimate of fair value, Newcastle’s quarterly procedures include a comparison of such quotations to quotations from different sources, outputs generated from its internal pricing models and transactions completed, 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, where available, 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 and other 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 accompanied by directionally similar changes in the assumptions used for the loss severity and the prepayment speed.

Recurring Fair Value Measurements - Real Estate Securities and Derivatives

The following table summarizes financial assets and liabilities measured at fair value on a recurring basis at September 30, 2015:



			Fair Value
	Carrying Value		Level 2		Level 3				Total
			Market Quotations (Observable)		Market Quotations (Unobservable)		Internal Pricing Models
Assets
Real estate securities, available-for-sale:
CMBS	$	42,562	$	—	$	42,562	$	—	$	42,562
Non-Agency RMBS	9,763		—		9,763		—		9,763
CDO (A)	9,183		—		—		9,183		9,183
Real estate securities, available-for-sale total	$	61,508	$	—	$	52,325	$	9,183	$	61,508

Real estate securities, pledged as collateral:
FNMA/FHLMC	$	370,342	$	370,342	$	—	$	—	$	370,342
Real estate securities, pledged as collateral total	$	370,342	$	370,342	$	—	$	—	$	370,342

Derivative assets:
TBAs, not treated as hedges	$	3,712	$	3,712	$	—	$	—	$	3,712
Derivative assets total	$	3,712	$	3,712	$	—	$	—	$	3,712

Liabilities
Derivative liabilities:
TBAs, not treated as hedges	$	6,124	$	6,124	$	—	$	—	$	6,124
Derivative liabilities total	$	6,124	$	6,124	$	—	$	—	$	6,124


(A)	Represents non-consolidated CDO securities, excluding eight securities with zero value, which had an aggregate face amount of $115.5 million as of September 30, 2015.

Significant Unobservable Inputs

The following table provides quantitative information regarding the significant unobservable inputs used by Newcastle for assets and liabilities measured at fair value on a recurring basis as of September 30, 2015. This table excludes inputs used to measure fair value that are not developed by Newcastle, such as broker prices and other third-party pricing service valuations.



					Weighted Average Significant Input
Asset Type	Amortized Cost Basis		Fair Value		Discount Rate		Prepayment Speed		Cumulative Default Rate		Loss Severity
CDO	$	—	$	9,183	10.5	%	4.7	%	28.8	%	62.5	%
Total	$	—	$	9,183

All of the inputs used in the table 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 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.

Newcastle’s investments in instruments measured at fair value on a recurring basis using Level 3 inputs changed during the nine months ended September 30, 2015 as follows:



	CMBS			Non-Agency RMBS			Equity/Other Securities			Total
Balance at December 31, 2014	$	178,763		$	45,035		$	7,956		$	231,754
Transfers
Transfers into Level 3	—			—			367			367
Total gains (losses)
Included in net income (A)	12,038			14,826			(367		)	26,497
Included in other comprehensive income (loss)	(17,671		)	(12,846		)	1,227			(29,290		)
Amortization included in interest income	5,611			2,699			—			8,310
Purchases, sales and repayments
Purchases	—			—			—			—
Proceeds from sales	(102,607		)	(37,582		)	—			(140,189		)
Proceeds from repayments	(33,572		)	(2,369		)	—			(35,941		)
Balance at September 30, 2015	$	42,562		$	9,763		$	9,183		$	61,508


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



	Nine Months Ended September 30, 2015
Gain (loss) on settlement of investments, net	$	28,854
OTTI, net	(2,357		)
Total	$	26,497

Non-Recurring Fair Value Measurements - Loans

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 and other 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 and other loans and residential mortgage loans held-for-sale as of September 30, 2015:



					Significant Input
					Range		Weighted Average
	Carrying		Fair		Discount	Loss	Discount		Loss
Loan Type	Value		Value		Rate	Severity	Rate		Severity
Mezzanine	$	19,433	$	19,433	0.0%-8.0%	0%-100%	8.0	%	47.8	%
Bank Loan	123,369		139,441		0.0%-22.5%	0%-100%	22.4	%	23.7	%
Total Real Estate Related and other Loans Held-for-Sale, Net	$	142,802	$	158,874



					Significant Input (Weighted Average)

	Carrying		Fair		Discount		Prepayment		Constant		Loss
Loan Type	Value		Value		Rate		Speed		Default Rate		Severity
Residential Loans	569		603		69.3	%	0.9	%	83.7	%	22.4	%
Total Residential Mortgage Loans, Held-for-Sale, Net	$	569	$	603

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 flows. Significant inputs include:
		l	Underlying security and loan prepayment, default and cumulative loss expectations
		l	Amount and timing of expected future cash flows
		l	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 flows. Significant inputs include:
		l	Amount and timing of expected future cash flows
		l	Interest rates
		l	Broker quotations
		l	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:
		l	Amount and timing of expected future cash flows
		l	Interest rates
		l	Collateral funding spreads

Golf credit facilities	Level 3	Valuation technique is based on discounted cash flows. Significant inputs include:
		l	Amount and timing of expected future cash flows
		l	Interest rates

Junior subordinated notes payable	Level 3	Valuation technique is based on discounted cash flows. Significant inputs include:
		l	Amount and timing of expected future cash flows
		l	Interest rates
		l	Market yields and the credit spread of Newcastle

- Definition

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

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