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Newcastle Investment 10-Q 2008

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2
Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2008

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 001-31458

 

 

Newcastle Investment Corp.

(Exact name of registrant as specified in its charter)

 

 

 

Maryland   81-0559116

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

1345 Avenue of the Americas, New York, NY   10105
(Address of principal executive offices)   (Zip Code)

(212) 798-6100

(Registrant's telephone number, including area code)

 

(Former name, former address and former fiscal year, if changed since last report)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x     No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨ (Do not check if a smaller reporting company)

Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the last practicable date.

Common stock, $0.01 par value per share: 52,789,050 shares outstanding as of August 8, 2008.

 

 

 


Table of Contents

NEWCASTLE INVESTMENT CORP.

FORM 10-Q

INDEX

 

         PAGE

PART I. FINANCIAL INFORMATION

  

Item 1.

 

Financial Statements

  
 

Consolidated Balance Sheets as of June 30, 2008 (unaudited) and December 31, 2007

   1
 

Consolidated Statements of Operations (unaudited) for the three and six months ended June 30, 2008 and 2007

   2
 

Consolidated Statements of Stockholders’ Equity (unaudited) for the six months ended June 30, 2008

   3
 

Consolidated Statements of Cash Flows (unaudited) for the six months ended June 30, 2008 and 2007

   4
 

Notes to Consolidated Financial Statements (unaudited)

   6

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   18

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

   35

Item 4.

 

Controls and Procedures

   38

PART II. OTHER INFORMATION

  

Item 1.

 

Legal Proceedings

   39

Item 1A.

 

Risk Factors

   39

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

   39

Item 3.

 

Defaults upon Senior Securities

   40

Item 4.

 

Submission of Matters to a Vote of Security Holders

   40

Item 5.

 

Other Information

   40

Item 6.

 

Exhibits

   41

SIGNATURES

   42


Table of Contents

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except share data)

 

 

     June 30, 2008
(Unaudited)
    December 31,
2007
 

Assets

    

Real estate securities, available for sale

   $ 3,116,151     $ 4,835,884  

Real estate related loans, net

     1,761,940       1,856,978  

Residential mortgage loans, net

     585,155       634,605  

Subprime mortgage loans subject to call option

     395,906       393,899  

Investments in unconsolidated subsidiaries

     1,882       24,477  

Operating real estate, held for sale

     27,980       34,399  

Cash and cash equivalents

     181,967       55,916  

Restricted cash

     91,560       133,126  

Derivative assets

     1,647       4,114  

Receivables and other assets

     52,119       64,372  
                
   $ 6,216,307     $ 8,037,770  
                

Liabilities and Stockholders’ Equity

    

Liabilities

    

CBO bonds payable

   $ 4,368,784     $ 4,716,535  

Other bonds payable

     446,988       546,798  

Repurchase agreements

     657,690       1,634,362  

Financing of subprime mortgage loans subject to call option

     395,906       393,899  

Junior subordinated notes payable (security for trust preferred)

     100,100       100,100  

Derivative liabilities

     114,581       133,510  

Dividends payable

     15,447       40,251  

Due to affiliates

     7,741       7,741  

Accrued expenses and other liabilities

     13,327       16,949  
                
     6,120,564       7,590,145  
                

Stockholders’ Equity

    

Preferred stock, $0.01 par value, 100,000,000 shares authorized, 2,500,000 shares of 9.75% Series B Cumulative Redeemable Preferred Stock, 1,600,000 shares of 8.05% Series C Cumulative Redeemable Preferred Stock, and 2,000,000 shares of 8.375% Series D Cumulative Redeemable Preferred Stock, liquidation preference $25.00 per share, issued and outstanding

     152,500       152,500  

Common stock, $0.01 par value, 500,000,000 shares authorized, 52,786,441 and 52,779,179 shares issued and outstanding at June 30, 2008 and December 31, 2007, respectively

     528       528  

Additional paid-in capital

     1,033,401       1,033,326  

Dividends in excess of earnings

     (394,538 )     (236,213 )

Accumulated other comprehensive income (loss)

     (696,148 )     (502,516 )
                
     95,743       447,625  
                
   $ 6,216,307     $ 8,037,770  
                

See notes to consolidated financial statements

 

1


Table of Contents

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(dollars in thousands, except share data)

 

 

 

     Three Months ended
June 30,
    Six Months Ended
June 30,
 
     2008     2007     2008     2007  

Revenues

        

Interest income

   $ 115,018     $ 191,864     $ 247,912     $ 354,080  
                                
     115,018       191,864       247,912       354,080  
                                

Expenses

        

Interest expense

     73,713       133,898       163,088       250,649  

Loan and security servicing expense

     1,788       3,698       3,518       5,681  

Provision for credit losses

     1,868       3,089       4,373       5,125  

General and administrative expense

     1,892       1,435       3,484       2,728  

Management fee to affiliate

     4,597       4,545       9,194       8,451  

Incentive compensation to affiliate

     —         2,521       —         6,209  

Depreciation and amortization

     73       71       145       144  
                                
     83,931       149,257       183,802       278,987  
                                

Operating Income

     31,087       42,607       64,110       75,093  
                                

Other Income (Loss)

        

Gain (loss) on sale of investments, net

     (37 )     6,977       6,489       9,189  

Other income (loss), net

     1,427       5,747       (17,881 )     6,464  

Other-than-temporary impairment

     (101,797 )     (5,953 )     (148,169 )     (5,953 )

Loan impairment

     (16,759 )     —         (37,085 )     —    

Provision for losses, loans held for sale

     —         (5,754 )     —         (5,754 )

Gain (loss) on extinguishment of debt

     —         (7,280 )     8,533       (7,280 )

Equity in earnings of unconsolidated subsidiaries

     7,062       819       7,770       1,666  
                                
     (110,104 )     (5,444 )     (180,343 )     (1,668 )
                                

Income (loss) from continuing operations

     (79,017 )     37,163       (116,233 )     73,425  

Income (loss) from discontinued operations

     (5,263 )     (50 )     (8,951 )     (121 )
                                

Net Income (Loss)

     (84,280 )     37,113       (125,184 )     73,304  

Preferred dividends

     (3,376 )     (3,375 )     (6,751 )     (5,890 )
                                

Income (Loss) Applicable to Common Stockholders

   $ (87,656 )   $ 33,738     $ (131,935 )   $ 67,414  
                                

Income (Loss) Per Share of Common Stock

        

Basic

   $ (1.66 )   $ 0.65     $ (2.50 )   $ 1.35  
                                

Diluted

   $ (1.66 )   $ 0.64     $ (2.50 )   $ 1.34  
                                

Income (loss) from continuing operations per share of common stock, after preferred dividends

        

Basic

   $ (1.56 )   $ 0.65     $ (2.33 )   $ 1.35  
                                

Diluted

   $ (1.56 )   $ 0.64     $ (2.33 )   $ 1.34  
                                

Income (loss) from discontinued operations per share of common stock

        

Basic

   $ (0.10 )   $ (0.00 )   $ (0.17 )   $ (0.00 )
                                

Diluted

   $ (0.10 )   $ (0.00 )   $ (0.17 )   $ (0.00 )
                                

Weighted Average Number of Shares of Common Stock Outstanding

        

Basic

     52,783,006       52,273,988       52,781,662       49,936,428  
                                

Diluted

     52,783,006       52,467,019       52,781,662       50,158,085  
                                

Dividends Declared per Share of Common Stock

   $ 0.25     $ 0.72     $ 0.50     $ 1.41  
                                

See notes to consolidated financial statements

 

2


Table of Contents

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Unaudited)

FOR THE SIX MONTHS ENDED JUNE 30, 2008

(dollars in thousands)

 

 

     Preferred Stock    Common Stock    Additional
Paid-in
Capital
   Dividends
in Excess of
Earnings
    Accum. Other
Comp. Income
(Loss)
    Total Stockholders’
Equity
 
     Shares    Amount    Shares    Amount          

Stockholders’ equity—December 31, 2007

   6,100,000    $ 152,500    52,779,179    $ 528    $ 1,033,326    $ (236,213 )   $ (502,516 )   $ 447,625  

Dividends declared

   —        —      —        —        —        (33,141 )     —         (33,141 )

Issuance of common stock to directors

   —        —      7,262      —        75      —         —         75  

Comprehensive income:

                     

Net (loss)

   —        —      —        —        —        (125,184 )     —         (125,184 )

Net unrealized (loss) on securities

   —        —      —        —        —        —         (189,979 )     (189,979 )

Reclassification of net realized (gain) on securities into earnings

   —        —      —        —        —        —         (7,439 )     (7,439 )

Foreign currency translation

   —        —      —        —        —        —         (515 )     (515 )

Net unrealized gain on derivatives designated as cash flow hedges

   —        —      —        —        —        —         5,069       5,069  

Reclassification of net realized (gain) on derivatives designated as cash flow hedges into earnings

   —        —      —        —        —        —         (768 )     (768 )
                           

Total comprehensive income (loss)

                        (318,816 )
                                                       

Stockholders’ equity—June 30, 2008

   6,100,000    $ 152,500    52,786,441    $ 528    $ 1,033,401    $ (394,538 )   $ (696,148 )   $ 95,743  
                                                       

See notes to consolidated financial statements

 

3


Table of Contents

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(dollars in thousands)

 

 

     Six Months Ended June 30,  
     2008     2007  

Cash Flows From Operating Activities

    

Net income (loss)

   $ (125,184 )   $ 73,304  

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities (inclusive of amounts related to discontinued operations):

    

Depreciation and amortization

     493       671  

Accretion of discount and other amortization

     (20,739 )     (13,649 )

Deferred rent

     174       151  

Provision for credit losses

     4,373       5,125  

Provision for losses, loans held for sale

     —         5,754  

Non-cash directors’ compensation

     75       60  

(Gain) on sale of investments

     (6,913 )     (9,113 )

Unrealized (gain) loss on non-hedge derivatives and hedge ineffectiveness

     20,376       (6,338 )

Other-than-temporary impairment

     157,219       5,953  

Loan impairment

     37,085       —    

(Gain) loss on extinguishment of debt

     (8,533 )     6,260  

Equity in earnings of unconsolidated subsidiaries

     (7,770 )     (1,666 )

Distributions of earnings from unconsolidated subsidiaries

     7,770       1,666  

Purchase of loans held for sale

     —         (1,089,202 )

Change in:

    

Restricted cash

     3,196       62,681  

Receivables and other assets

     16,034       (10,458 )

Due to affiliates

     —         (5,724 )

Accrued expenses and other liabilities

     (1,874 )     899  
                

Net cash provided by (used in) operating activities

     75,782       (973,626 )
                

Cash Flows From Investing Activities

    

Purchase of real estate securities

     —         (289,027 )

Proceeds from sale of real estate securities

     1,151,012       116,555  

Proceeds from settlement of loans

     12,636       —    

Purchase of and advances on loans

     —         (862,978 )

Repayments of loan and security principal

     219,447       632,005  

Margin received on derivative instruments

     60,471       55,152  

Return of margin on derivative instruments

     (52,022 )     (39,960 )

Margin deposits on total rate of return swaps (treated as derivative instruments)

     (22,200 )     (56,249 )

Return of margin deposits on total rate of return swaps (treated as derivative instruments)

     29,891       59,941  

Net proceeds from termination of derivative instruments

     (37,591 )     24,191  

Purchase and improvement of operating real estate

     (604 )     (865 )

Contributions to unconsolidated subsidiaries

     —         (201 )

Distributions of capital from unconsolidated subsidiaries

     22,595       435  

Change in restricted cash from investment in CBOs

     —         (11,614 )
                

Net cash provided by (used in) in investing activities

     1,383,635       (372,615 )
                

Continued on Page 5

 

4


Table of Contents

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOW (Unaudited)

(dollars in thousands)

 

 

     Six Months Ended June 30,  
     2008     2007  

Cash Flows From Financing Activities

    

Repayments of CBO bonds payable

     (332,643 )     (984,776 )

Issuance of other bonds payable

     —         587,628  

Repayments of other bonds payable

     (100,443 )     (55,123 )

Repayments of notes payable

     —         (35,073 )

Borrowings under repurchase agreements

     20,819       3,399,557  

Repayments of repurchase agreements

     (997,991 )     (1,709,386 )

Return of margin deposits under repurchase agreements

     78,963       —    

Margin deposits under repurchase agreements

     (72,656 )     —    

Issuance of repurchase agreements subject to ABCP facility

     —         247,409  

Repayments of repurchase agreements subject to ABCP facility

     —         (110,002 )

Draws under credit facility

     —         382,800  

Repayments of credit facility

     —         (476,600 )

Issuance of common stock

     —         199,791  

Exercise of common stock options

     —         1,443  

Issuance of preferred stock

     —         50,000  

Costs related to issuance of preferred stock

     —         (1,760 )

Dividends paid

     (57,944 )     (69,464 )

Payment of deferred financing costs

     (337 )     (1,711 )

Restricted cash returned from refinancing activities

     128,866       20,000  
                

Net cash provided by (used in) financing activities

     (1,333,366 )     1,444,733  
                

Net Increase (Decrease) in Cash and Cash Equivalents

     126,051       98,492  

Cash and Cash Equivalents, Beginning of Period

     55,916       5,371  
                

Cash and Cash Equivalents, End of Period

   $ 181,967     $ 103,863  
                

Supplemental Disclosure of Cash Flow Information

    

Cash paid during the period for interest expense

   $ 146,339     $ 231,226  

Cash paid during the period for income taxes

   $ —       $ —    

Cash paid during the year for federal excise tax

   $ 316     $ —    

Supplemental Schedule of Non-Cash Investing and Financing Activities

    

Common stock dividends declared but not paid

   $ 13,197     $ 38,001  

Preferred stock dividends declared but not paid

   $ 2,250     $ 2,785  

 

5


Table of Contents

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2008

(dollars in tables in thousands, except share data)

 

1. GENERAL

Newcastle Investment Corp. (and its subsidiaries, “Newcastle”) is a Maryland corporation that was formed in 2002. Newcastle conducts its business through four primary segments: (i) investments financed with non-recourse collateralized bond obligations (“CBOs”), (ii) investments financed with other non-recourse debt, (iii) investments financed with recourse debt, including FNMA / FHLMC securities, and (iv) unlevered investments.

In the second quarter of 2008, Newcastle changed the structure of its internal organization such that the basis of the composition of its reportable segments changed from investment type to financing type. Management believes this presentation better reflects the benefits and risks of the company’s structure.

Newcastle is organized and conducts its operations to qualify as a real estate investment trust (“REIT”) for U.S. federal income tax purposes. As such, Newcastle will generally not be subject to U.S. federal corporate income tax on that portion of its net income that is distributed to stockholders if it distributes at least 90% of its REIT taxable income to its stockholders by prescribed dates and complies with various other requirements.

Newcastle is party to a management agreement (the “Management Agreement”) with FIG LLC (the “Manager”), an affiliate of Fortress Investment Group LLC, under which the Manager advises Newcastle on various aspects of its business and manages its day-to-day operations, subject to the supervision of Newcastle’s board of directors. For its services, the Manager receives an annual management fee and incentive compensation, both as defined in the Management Agreement.

Approximately 5.0 million shares of Newcastle’s common stock were held by the Manager, through its affiliates, and its principals at June 30, 2008. In addition, the Manager, through its affiliates, held options to purchase approximately 1.5 million shares of Newcastle’s common stock at June 30, 2008.

The accompanying consolidated financial statements and related notes of Newcastle have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared under U.S. generally accepted accounting principles have been condensed or omitted. In the opinion of management, all adjustments considered necessary for a fair presentation of Newcastle's financial position, results of operations and cash flows have been included and are of a normal and recurring nature. The operating results presented for interim periods are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. These financial statements should be read in conjunction with Newcastle’s consolidated financial statements for the year ended December 31, 2007 and notes thereto included in Newcastle’s annual report on Form 10-K filed with the Securities and Exchange Commission. Capitalized terms used herein, and not otherwise defined, are defined in Newcastle’s consolidated financial statements for the year ended December 31, 2007.

 

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Table of Contents

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2008

(dollars in tables in thousands, except share data)

 

 

2. INFORMATION REGARDING BUSINESS SEGMENTS

Newcastle conducts its business through four primary segments: (i) investments financed with non-recourse collateralized bond obligations (“CBOs”), (ii) investments financed with other non-recourse debt, (iii) investments financed with recourse debt, including FNMA / FHLMC securities, and (iv) unlevered investments. In the second quarter of 2008, Newcastle changed the structure of its internal organization such that the basis of the composition of its reportable segments changed from investment type to financing type. Management believes this presentation better reflects the benefits and risks of the company’s structure.

Summary financial data on Newcastle's segments is given below, together with a reconciliation to the same data for Newcastle as a whole:

 

     CBOs     Other
Non-Recourse (A)
    Recourse (B)     Unlevered (C)     Unallocated     Total  
June 30, 2008 and the Six Months then Ended             

Gross revenues

   $ 157,600     $ 46,257     $ 27,957     $ 14,966     $ 1,132     $ 247,912  

Operating expenses

     (820 )     (7,041 )     (25 )     (39 )     (12,644 )     (20,569 )

Interest expense

     (104,585 )     (34,436 )     (20,006 )     (302 )     (3,759 )     (163,088 )

Depreciation and amortization

     —         —         —         —         (145 )     (145 )
                                                

Operating income (loss)

     52,195       4,780       7,926       14,625       (15,416 )     64,110  

Other-than-temporary and loan impairment

     (145,422 )     (1,222 )     (2,432 )     (36,178 )     —         (185,254 )

Other income (loss) excluding impairment

     3,037       (548 )     (5,434 )     8,443       (587 )     4,911  
                                                

Income (loss) from continuing operations

     (90,190 )     3,010       60       (13,110 )     (16,003 )     (116,233 )

Income (loss) from discontinued operations

     —         —         —         (8,951 )     —         (8,951 )
                                                

Net income (loss)

     (90,190 )     3,010       60       (22,061 )     (16,003 )     (125,184 )

Preferred dividends

     —         —         —         —         (6,751 )     (6,751 )
                                                

Income (loss) applicable to common stockholders

   $ (90,190 )   $ 3,010     $ 60     $ (22,061 )   $ (22,754 )   $ (131,935 )
                                                
Three Months Ended June 30, 2008             

Gross revenues

   $ 73,401     $ 22,002     $ 11,547     $ 7,472     $ 596     $ 115,018  

Operating expenses

     (408 )     (3,235 )     (6 )     (39 )     (6,457 )     (10,145 )

Interest expense

     (47,492 )     (16,540 )     (7,614 )     (187 )     (1,880 )     (73,713 )

Depreciation and amortization

     —         —         —         —         (73 )     (73 )
                                                

Operating income (loss)

     25,501       2,227       3,927       7,246       (7,814 )     31,087  

Other-than-temporary and loan impairment

     (84,545 )     —         —         (34,011 )     —         (118,556 )

Other income (loss) excluding impairment

     821       (548 )     440       7,736       3       8,452  
                                                

Income (loss) from continuing operations

     (58,223 )     1,679       4,367       (19,029 )     (7,811 )     (79,017 )

Income (loss) from discontinued operations

     —         —         —         (5,263 )     —         (5,263 )
                                                

Net income (loss)

     (58,223 )     1,679       4,367       (24,292 )     (7,811 )     (84,280 )

Preferred dividends

     —         —         —         —         (3,376 )     (3,376 )
                                                

Income (loss) applicable to common stockholders

   $ (58,223 )   $ 1,679     $ 4,367     $ (24,292 )   $ (11,187 )   $ (87,656 )
                                                
June 30, 2008             

GAAP

            

Assets, carrying value

   $ 4,103,169     $ 889,815     $ 803,358     $ 235,249     $ 184,716     $ 6,216,307  

Liabilities, carrying value (D)

     4,452,588       863,256       674,695       2,469       127,556       6,120,564  

Preferred stock

             152,500       152,500  
                                                

GAAP book value

   $ (349,419 )   $ 26,559     $ 128,663     $ 232,780     $ (95,340 )   $ (56,757 )
                                                

GAAP book value per share

             $ (1.08 )

Fair Value

            

Assets, fair value (E)

   $ 3,961,953     $ 825,425     $ 773,855     $ 224,311     $ 184,716     $ 5,970,260  

Liabilities, fair value

   $ 3,149,305     $ 832,189     $ 674,695     $ 2,469     $ 102,977     $ 4,761,635  

Preferred stock

             152,500       152,500  
                                                

Adjusted book value

   $ 812,648     $ (6,764 )   $ 99,160     $ 221,842     $ (70,761 )   $ 1,056,125  
                                                

Adjusted book value per share (F)

             $ 20.01  

 

(A) Includes all of the manufactured housing loan financing (Note 5) of which $91.4 million (carrying value) is recourse.
(B) Includes FNMA/FHLMC securities as shown in Note 5.
(C) Includes real estate held for sale.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2008

(dollars in tables in thousands, except share data)

 

 

(D) Carrying values of recourse and nonrecourse debt at June 30, 2008 are as follows:

 

     CBOs    Other
Non-Recourse (A)
   Recourse (B)    Unlevered (C)    Unallocated    Total

Nonrecourse

   $ 4,368,784    $ 751,463    $ —      $ —      $ —      $ 5,120,247

Recourse

   $ —      $ 91,431    $ 657,690    $ —      $ 100,100    $ 849,221
(E) Only financial instruments are reflected at fair value, other assets are reflected at their carrying value.
(F) Represents GAAP book value as if Newcastle had elected to measure all of its financial assets and liabilities at fair value under SFAS 159.

 

     CBOs     Other
Non-Recourse (A)
    Recourse (B)     Unlevered (C)     Unallocated     Total  
December 31, 2007             

Total assets

   $ 4,968,184     $ 995,594     $ 1,750,643     $ 265,026     $ 58,323     $ 8,037,770  
Six Months Ended June 30, 2007             

Gross revenues

   $ 190,681     $ 51,911     $ 94,229     $ 16,958     $ 301     $ 354,080  

Operating expenses

     (979 )     (8,199 )     (1,644 )     (5 )     (17,367 )     (28,194 )

Interest expense

     (141,042 )     (38,436 )     (64,282 )     (815 )     (6,074 )     (250,649 )

Depreciation and amortization

     —         —         —         —         (144 )     (144 )

Operating income (loss)

     48,660       5,276       28,303       16,138       (23,284 )     75,093  

Other income (loss)

     (2,894 )     522       (1,244 )     1,944       4       (1,668 )
                                                

Income (loss) from continuing operations

     45,766       5,798       27,059       18,082       (23,280 )     73,425  

Income (loss) from discontinued operations

     —         —         —         (121 )     —         (121 )
                                                

Net income (loss)

     45,766       5,798       27,059       17,961       (23,280 )     73,304  

Preferred dividends

     —         —         —         —         (5,890 )     (5,890 )
                                                

Income (loss) applicable to common stockholders

   $ 45,766     $ 5,798     $ 27,059     $ 17,961     $ (29,170 )   $ 67,414  
                                                
Three Months Ended June 30, 2007             

Gross revenues

   $ 98,795     $ 25,313     $ 58,324     $ 9,211     $ 221     $ 191,864  

Operating expenses

     (538 )     (4,727 )     (1,510 )     (3 )     (8,510 )     (15,288 )

Interest expense

     (72,982 )     (18,989 )     (39,220 )     (304 )     (2,403 )     (133,898 )

Depreciation and amortization

     —         —         —         —         (71 )     (71 )

Operating income (loss)

     25,275       1,597       17,594       8,904       (10,763 )     42,607  

Other income (loss)

     (5,530 )     472       (1,348 )     959       3       (5,444 )
                                                

Income (loss) from continuing operations

     19,745       2,069       16,246       9,863       (10,760 )     37,163  

Income (loss) from discontinued operations

     —         —         —         (50 )     —         (50 )
                                                

Net income (loss)

     19,745       2,069       16,246       9,813       (10,760 )     37,113  

Preferred dividends

     —         —         —         —         (3,375 )     (3,375 )
                                                

Income (loss) applicable to common stockholders

   $ 19,745     $ 2,069     $ 16,246     $ 9,813     $ (14,135 )   $ 33,738  
                                                

 

(A) Includes all of the manufactured housing loan financing (Note 5) of which $98.3 million (carrying value) is recourse.
(B) Includes FNMA/FHLMC securities as shown in Note 5.
(C) Includes real estate held for sale.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2008

(dollars in tables in thousands, except share data)

 

 

At June 30, 2008 and December 31, 2007, Newcastle had $14.0 million and $21.4 million, respectively, of long-lived assets in Canada. In connection with such assets, Newcastle recognized revenue of $1.8 million and $1.5 million for the six months ended June 30, 2008 and 2007, respectively.

Newcastle has committed to a plan, and is actively working, to sell all of its operating real estate. As a result, all of the real estate has been classified as held for sale at June 30, 2008 and marked to the lower of cost or market, resulting in a recorded loss of $9.1 million for the six months ended June 30, 2008. All of the related operations, including this loss, have been classified as discontinued operations for all periods presented. In July 2008, Newcastle closed on the sales of two real estate properties and received net proceeds of approximately $11.5 million.

Gain (Loss) on Sale of Investments, Net and Other Income (Loss), Net

These items are comprised of the following:

 

     Six Months Ended
June 30,
 
     2008     2007  

Gain (loss) on sale of investments, net

    

Gain on sale of real estate securities

   $ 6,459     $ 15,502  

Loss on sale of real estate securities

     (979 )     (6,390 )

Gain on disposition of loans held for sale

     1,434       —    

Realized gain (loss) on termination of derivative instruments

     (425 )     77  
                
   $ 6,489     $ 9,189  
                

Other income (loss), net

    

Realized (loss) on total rate of return swaps

   $ (7,145 )   $ —    

Unrealized (loss) on total rate of return swaps

     (3,624 )     (113 )

Gain (loss) on non-hedge derivative instruments

     (8,405 )     5,887  

Unrealized (loss) recognized at de-designation of hedges

     (990 )     —    

Hedge ineffectiveness

     213       488  

Other income

     2,070       202  
                
   $ (17,881 )   $ 6,464  
                

Unconsolidated Subsidiaries

The following table summarizes the activity for significant subsidiaries affecting the equity held by Newcastle in unconsolidated subsidiaries:

 

     Operating Real Estate     Real Estate Loan  

Balance at December 31, 2007

   $ 13,391     $ 10,984  

Contributions to unconsolidated subsidiaries

     —         —    

Distributions from unconsolidated subsidiaries

     (20,307 )     (10,053 )

Equity in earnings of unconsolidated subsidiaries

     6,916       850  
                

Balance at June 30, 2008

   $ —       $ 1,781  
                

In April 2008, Newcastle closed on the sale of our interests in the operating real estate joint venture and received net proceeds of $19.8 million. As a result, Newcastle recorded a gain of approximately $6.2 million.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2008

(dollars in tables in thousands, except share data)

 

 

3. REAL ESTATE SECURITIES

The following is a summary of Newcastle’s real estate securities at June 30, 2008, all of which are classified as available for sale and are therefore reported at fair value with changes in fair value recorded in other comprehensive income, except for securities that are other-than-temporarily impaired.

 

Asset Type

   Outstanding
Face Amount
   Amortized Cost Basis    Gross Unrealized     Carrying Value    Number
of
Securities
   Weighted Average
      Before
Impairment
   Other-Than-
Temporary
Impairment (A)
    After
Impairment
           S&P
Equivalent
Rating
   Coupon     Yield     Maturity
(Years)
              Gains    Losses                 

CMBS-Conduit

   $ 1,371,182    $ 1,314,336    $ (1,893 )   $ 1,312,443    $ 10    $ (393,138 )   $ 919,315    171    BBB    5.67 %   6.33 %   6.8

CMBS- Single Borrower

     781,362      769,052      —         769,052      2,273      (89,084 )     682,241    72    BB+    5.77 %   6.10 %   3.7

CMBS-Large Loan

     95,159      95,147      —         95,147      —        (17,494 )     77,653    13    BB+    4.23 %   4.26 %   1.9

CMBS- CDO

     16,000      14,730      (14,730 )     —        —        —         —      1    CC    10.14 %   0.00 %   —  

REIT Debt

     652,516      663,071      —         663,071      109      (55,526 )     607,654    65    BBB    6.24 %   5.78 %   5.2

ABS-Subprime

     578,928      546,124      (244,411 )     301,713      4,817      (38,884 )     267,646    124    BB-    4.10 %   10.43 %   5.6

ABS-Manufactured Housing

     61,723      59,982      —         59,982      —        (6,342 )     53,640    9    BBB-    6.68 %   7.44 %   4.8

ABS-Franchise

     41,316      41,452      —         41,452      —        (15,566 )     25,886    17    BBB    5.72 %   5.74 %   4.4

FNMA/FHLMC (B)

     409,190      414,517      —         414,517      6,571      —         421,088    15    AAA    5.65 %   5.61 %   3.8
                                                                             
                               

Subtotal/Average (C)

     4,007,376      3,918,411      (261,034 )     3,657,377      13,780      (616,034 )     3,055,123    487    BBB    5.55 %   6.40 %   5.2
                                                                             
                               

Retained Securities (D)

     80,380      73,591      (22,686 )     50,905      1,119      (4,271 )     47,753    7    B+    4.58 %   14.60 %   12.2

Residual Interests (D)

     13,275      60,200      (46,925 )     13,275      —        —         13,275    2    NR    0.00 %   20.00 %   2.8
                                                                             

Total/Average

   $ 4,101,031    $ 4,052,202    $ (330,645 )   $ 3,721,557    $ 14,899    $ (620,305 )   $ 3,116,151    496    BBB-    5.52 %   6.56 %   5.4
                                                                             

 

(A) Represents the cumulative impairment against amortized cost basis recorded through earnings.
(B) FNMA/FHLMC securities have an implied AAA rating. Amortized cost basis and carrying value include principal receivable of $4.0 million.
(C) The total outstanding face amount of fixed rate securities was $3.0 billion, and of floating rate securities was $1.1 billion.
(D) Represents the retained bonds and equity from Subprime Portfolios I and II. The residuals do not have stated coupons and therefore their coupons have been treated as zero for purposes of the table.

Unrealized losses that are considered other-than-temporary are recognized currently in income. During the six months ended June 30, 2008, Newcastle recorded other-than-temporary impairment charges of $148.2 million, relating to securities with an aggregate post impairment amortized cost basis of $195.3 million at June 30, 2008. Management closely monitors market valuations and, based on the results of recent events, has concluded that these securities are other-than-temporarily impaired under GAAP. The remaining unrealized losses on Newcastle’s securities are primarily the result of changes in market factors, rather than issuer-specific credit impairment, and Newcastle has performed credit analyses in relation to such securities which support its belief that the carrying values of such securities are fully recoverable over their expected holding period. Such market factors include changes in market interest rates and credit spreads, or certain macroeconomic events, including market disruptions and supply changes, which do not directly impact our ability to collect amounts contractually due. Management continually evaluates the credit status of each of Newcastle’s securities and the collateral supporting those securities. This evaluation includes a review of the credit of the issuer of the security (if applicable), the credit rating of the security, the key terms of the security (including credit support), debt service coverage and loan to value ratios, the performance of the pool of underlying loans and the estimated value of the collateral supporting such loans, including the effect of local, industry and broader economic trends and factors. These factors include loan default expectations and loss severities, which are analyzed in connection with a particular security’s credit support, as well as prepayment rates. The result of this evaluation is considered in relation to the amount of the unrealized loss and the period elapsed since it was incurred. Significant judgment is required in this analysis.

 

Securities in an Unrealized Loss
Position

   Outstanding
Face Amount
   Amortized Cost Basis    Gross Unrealized     Carrying Value    Number
of
Securities
   Weighted Average
      Before
Impairment
   Other-Than-
Temporary
Impairment
   Gains    Losses           S&P
Equivalent
Rating
   Coupon     Yield     Maturity
(Years)

Less Than Twelve Months

   $ 455,833    $ 429,157    $ —      $ —      $ (39,876 )   $ 384,281    62    BBB+    5.91 %   7.06 %   4.8

Twelve or More Months

     2,632,852      2,589,166      —        —        (580,429 )     2,008,737    304    BBB-    5.58 %   5.81 %   5.4
                                                                     

Total

   $ 3,088,685    $ 3,018,323    $ —      $ —      $ (620,305 )   $ 2,393,018    366    BBB    5.63 %   5.99 %   5.3
                                                                     

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2008

(dollars in tables in thousands, except share data)

 

 

4. REAL ESTATE RELATED LOANS, RESIDENTIAL MORTGAGE LOANS AND SUBPRIME MORTGAGE LOANS

The following is a summary of real estate related loans, residential mortgage loans and subprime mortgage loans at June 30, 2008. The loans contain various terms, including fixed and floating rates, self-amortizing and interest only. They are generally subject to prepayment.

 

Loan Type

   Outstanding
Face Amount
   Carrying
Value
   Loan
Count
   Wtd. Avg.
Yield
    Weighted
Average
Maturity
(Years) (A)
   Floating Rate
Loans as a %
of Face
Amount
    Delinquent Face
Amount (B)

Mezzanine Loans

   $ 766,733    $ 763,192    22    6.46 %   3.5    87.2 %   $ —  

Corporate Bank Loans

     540,794      515,004    16    6.98 %   3.5    100.0 %     —  

B-Notes

     420,140      392,627    15    5.83 %   3.1    86.0 %     —  

Whole Loans

     80,755      80,671    3    4.41 %   2.8    100.0 %     —  

ICH Loans

     11,229      10,446    5    7.64 %   8.1    0.0 %     —  
                                          

Total Real Estate Related Loans

   $ 1,819,651    $ 1,761,940    61    6.38 %   3.4    90.8 %   $ —  
                                          

Residential Loans

   $ 92,740    $ 93,139    292    3.85 %   3.6    100.0 %   $ 7,394

Manufactured Housing Loans

     503,802      492,016    14,668    8.51 %   6.0    10.8 %     3,611
                                          

Total Residential Mortgage Loans (C)

   $ 596,542    $ 585,155    14,960    7.76 %   5.6    24.7 %   $ 11,005
                                          

Subprime Mortgage Loans Subject to Call Option

   $ 406,217    $ 395,906             
                          

 

(A) The weighted average maturities were calculated based on constant prepayment rates (CPR) of 20% and 30% for the residential loan pools, and 8% and 9% for the manufactured housing loan pools.
(B) This face amount of loans is 60 or more days past due, in foreclosure or real estate owned. The face amount of non-accrual loans was $39.7 million at June 30, 2008.
(C) Carrying value includes interest receivable of $0.4 million for the residential housing loans and principal and interest receivable of $12.4 million for the manufactured housing loans.

The following is a reconciliation of the related loss allowance.

 

     Real Estate
Related Loans
    Residential
Mortgage Loans
 

Balance at December 31, 2007

   $ (600 )   $ (6,917 )

Provision for credit losses

     (200 )     (4,173 )

Provision for impaired loans

     (35,863 )     (1,222 )

Realized losses

     —         2,920  
                

Balance at June 30, 2008

   $ (36,663 )   $ (9,392 )
                

As of June 30, 2008, Newcastle held an aggregate of $124.0 million notional amount of total rate of return swaps (including an unfunded asset with a notional amount of $19.1 million) on 5 reference assets on which it had deposited $36.2 million of margin. These total rate of return swaps had an aggregate fair value of approximately ($5.3) million, a weighted average receive interest rate of LIBOR + 2.9%, a weighted average pay interest rate of LIBOR + 0.93%, and a weighted average swap maturity of 0.3 years.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2008

(dollars in tables in thousands, except share data)

 

 

The following table presents information on the retained interests in Newcastle’s securitizations of subprime mortgage loans and the sensitivity of their fair value to maturity date for immediate 10% and 20% adverse changes in the assumptions utilized in calculating such fair value, at June 30, 2008:

 

     Subprime Portfolio  
     I     II  

Total securitized loans (unpaid principal balance)

   $ 797,756     $ 975,641  

Average loan seasoning (months)

     34       17  

Loans subject to call option (carrying value)

   $ 293,025     $ 102,881  

Retained interests (fair value) (A)

   $ 31,257     $ 29,770  

Weighted average life (years) of residual interest

     2.7       2.8  

Weighted average expected credit losses (B)

     11.2 %     16.3 %

Effect on fair value of retained interests of 10% adverse change

   $ (6,460 )   $ (3,755 )

Effect on fair value of retained interests of 20% adverse change

   $ (15,809 )   $ (6,875 )

Weighted average constant prepayment rate (C)

     16.9 %     13.3 %

Effect on fair value of retained interests of 10% adverse change

   $ (1,982 )   $ (1,895 )

Effect on fair value of retained interests of 20% adverse change

   $ (4,053 )   $ (3,777 )

Weighted average discount rate

     13.0 %     13.4 %

Effect on fair value of retained interests of 10% adverse change

   $ (1,477 )   $ (2,019 )

Effect on fair value of retained interests of 20% adverse change

   $ (2,798 )   $ (3,776 )

 

(A) The retained interests include residual interests and retained bonds of the securitizations. Their fair value is estimated based on pricing models.
(B) Represents the percentage of losses on the original principal balance of the loans at the time of the respective securitizations (April 2006 and July 2007) to the maturity of the loans.
(C) Represents the weighted average voluntary prepayment rate for the loans from the time of the respective securitizations (April 2006 and July 2007) to the maturity of such loans.

The sensitivity analysis is hypothetical and should be used with caution. In particular, the results are calculated by stressing a particular economic assumption independent of changes in any other assumption; in practice, changes in one factor may result in changes in another, which might counteract or amplify the sensitivities. Also, changes in the fair value based on a 10% or 20% variation in an assumption generally may not be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear.

The following table summarizes certain characteristics of the underlying subprime mortgage loans in the securitizations as of June 30, 2008:

 

     Subprime Portfolio  
     I     II  

Loan unpaid principal balance (UPB)

   $ 797,756     $ 975,641  

Delinquencies of 60 or more days (UPB)

   $ 153,802     $ 118,007  

Net credit losses for the six months ended June 30, 2008

   $ 14,013     $ 3,052  

Cumulative net credit losses

   $ 17,584     $ 3,052  

Cumulative net credit losses as a % of original UPB

     1.17 %     0.28 %

Percentage of ARM loans (A)

     60.1 %     69.2 %

Percentage of loans with loan-to-value ratio >90%

     10.5 %     17.6 %

Percentageof interest-only loans

     28.5 %     4.5 %

 

(A) ARM loans are adjustable-rate mortgage loans. An option ARM is an adjustable-rate mortgage that provides the borrower with an option to choose from several payment amounts each month for a specified period of the loan term. None of the loans in the subprime portfolios are an option ARM.

Delinquencies include loans 60 or more days past due, in foreclosure or real estate owned. Newcastle received net cash inflows of $5.0 million and $10.0 million from the retained interests of Subprime Portfolios I and II, respectively, during the six months ended June 30, 2008.

The weighted average yields of the retained notes of Subprime Portfolios I and II were 11.7% and 15.0%, respectively, as of June 30, 2008. The loans subject to call option and the corresponding financing recognize interest income and expense based on the expected weighted average coupons of the loans subject to call option at the call date of 9.24% and 8.68%, for Subprime Portfolios I and II, respectively.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2008

(dollars in tables in thousands, except share data)

 

 

5. DEBT OBLIGATIONS

The following table presents certain information regarding Newcastle’s debt obligations and related hedges at June 30, 2008:

 

Debt Obligation/Collateral

  

Month
Issued

   Outstanding
Face
Amount
   Carrying
Value
   Unhedged
Weighted
Average
Funding
Cost (A)
 

Final
Stated
Maturity

   Weighted
Average
Funding
Cost (B)
    Weighted
Average
Maturity
(Years)
   Face
Amount
of
Floating
Rate Debt
   Collateral
Amortized
Cost
Basis (C)
   Collateral
Carrying
Value (D)
   Collateral
Weighted
Average
Maturity
(Years)
   Face
Amount
of
Floating
Rate
Collateral
(C)
   Aggregate
Notional
Amount
of
Current
Hedges
CBO Bonds Payable                                     

Portfolio V

   Mar 2004    $ 411,085    $ 408,890    3.54%   Mar 2039    4.09 %   4.1    $ 382,750    $ 438,842    $ 366,378    4.5    $ 191,121    $ 177,300

Portfolio VI

   Sep 2004      454,500      451,912    3.40%   Sep 2039    4.17 %   4.7      442,500      486,467      391,478    4.9      224,422      208,836

Portfolio VII

   Apr 2005      447,000      443,660    2.97%   Apr 2040    4.26 %   5.7      439,600      453,233      364,918    5.9      191,417      242,429

Portfolio VIII

   Dec 2005      426,800      423,596    2.98%   Dec 2050    5.00 %   7.0      420,800      456,724      339,676    7.6      133,081      341,506

Portfolio IX

   Nov 2006      807,500      806,687    3.14%   Nov 2052    3.65 %   5.6      799,900      789,373      733,259    4.7      577,646      161,655

Portfolio X

   May 2007      585,750      586,894    3.07%   May 2052    3.46 %   5.3      585,750      777,877      770,773    3.6      598,990      91,979

Portfolio XI

   Jul 2007      1,247,750      1,247,145    2.60%   Jul 2052    4.93 %   6.6      1,247,750      1,250,849      1,074,821    5.2      311,076      980,974
                                                                        
        4,380,385      4,368,784         4.28 %   5.7      4,319,050      4,653,365      4,041,303    5.1      2,227,753      2,204,679
                                                                        
Other Bonds Payable                                     

Manufactured housing loans

   Jan 2006      173,593      173,237    LIBOR+1.25%   Jan 2009    6.08 %   0.5      173,593      192,293      192,293    6.5      3,109      175,050

Manufactured housing loans

   Aug 2006      275,257      273,751    LIBOR+1.25%   Aug 2011    7.07 %   2.5      275,257      299,722      299,722    5.6      51,442      244,043
                                                                        
        448,850      446,988         6.69 %   1.7      448,850      492,015      492,015    6.0      54,551      419,093
                                                                        
Repurchase Agreements (E)                                     

Real estate related loans

   Rolling      240,945      240,945    LIBOR+1.03%   Various (G)    3.49 %   0.6      240,945      331,877      331,877    2.6      332,033      —  

Other real estate securities (F)

   Rolling      19,220      19,220    LIBOR+2.50%   Apr 2009    6.71 %   0.8      19,220      —        —      —        —        —  
                                                                        
        260,165      260,165         3.73 %   0.6      260,165      331,877      331,877    2.6      332,033      —  

FNMA/FHLMC securities

   Rolling      397,525      397,525    LIBOR+0.05%   Jul 2008 (H)    4.61 %   0.2      397,525      414,516      421,088    3.8      —        301,952
                                                                        
        657,690      657,690         4.26 %   0.4      657,690      746,393      752,965    3.2      332,033      301,952
                                                                        

Corporate

                                    

Junior subordinated notes payable

  

Mar 2006

     100,100      100,100    7.57%(I)  

Apr 2036

   7.71 %   27.8      —        —        —      —        —        —  
                                                                        
        100,100      100,100         7.71 %   27.8      —        —        —      —        —        —  
                                                                        

Subtotal debt obligations

        5,587,025      5,573,562         4.53 %   5.2    $ 5,425,590    $ 5,891,773    $ 5,286,283    4.9    $ 2,614,337    $ 2,925,724
                                                                        

Financing on subprime mortgage loans subject to call option (J)

   (J)      406,217      395,906                            
                                            

Total debt obligations

      $ 5,993,242    $ 5,969,468                            
                                            

 

(A) Weighted average, including floating and fixed rate classes and excluding the amortization of deferred financing costs.
(B) Including the effect of applicable hedges.
(C) Including restricted cash held in CBOs.
(D) Collateral carrying value represents the aggregate of fair value for real estate securities and amortized cost basis for loans in accordance to GAAP, and restricted cash held in CBOs.
(E) Subject to potential mandatory prepayments based on collateral value. The counterparties on these repurchase agreements include: JP Morgan Chase ($226.4 million), Goldman Sachs ($234.5 million), Deutsche Bank ($99.6 million), Credit Suisse ($57.1 million) and Citigroup ($40.1 million).
(F) Debt carrying value exceeds collateral amortized cost basis as these repurchase agreements are secured by investments in Newcastle’s CBO bonds, which are eliminated in consolidation.
(G) The longest maturity is June 2009.
(H) These repurchase agreements were rolled in July 2008 with one-month and three-month maturities.
(I) LIBOR + 2.25% after April 2016.
(J) Issued in April 2006 and July 2007. See Note 4 regarding the securitizations of Subprime Portfolios I and II.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2008

(dollars in tables in thousands, except share data)

 

 

6. FAIR VALUE OF FINANCIAL INSTRUMENTS

Newcastle’s non-cash financial instruments fall into four major categories:

 

   

real estate securities, which are marked to market through other comprehensive income,

 

   

derivatives, which are generally marked to market through other comprehensive income (or through income if they are not effective hedges),

 

   

real estate related and residential mortgage loans, which are generally not marked to market, but for which fair value is disclosed, and

 

   

debt obligations, which are generally not marked to market, but for which fair value is disclosed.

Newcastle held the following financial instruments at June 30, 2008:

 

     Principal
Balance or
Notional
Amount
   Carrying Value    Fair Value   

Fair Value Method (A)

   Weighted
Average
Yield/Funding
Cost
    Weighted
Average
Maturity
(Years)
 

Assets:

                

Real estate securities, available for sale*

   $ 4,101,031    $ 3,116,151    $ 3,116,151    Broker quotations, counterparty quotations,    6.56 %   5.4  
            pricing models     

Real estate related loans

     1,819,651      1,761,940      1,590,112    Broker quotations, counterparty quotations,    6.38 %   3.4  
            pricing models     

Residential mortgage loans

     596,542      585,155      510,936    Pricing models    7.76 %   5.6  

Subprime mortgage loans subject to call option (B)

     406,217      395,906      395,906    (B)    9.09 %   (B )

Interest rate swaps, treated as hedges (C)*

     181,549      1,647      1,647    Counterparty quotations    N/A     (C )

Liabilities:

                

CBO bonds payable

     4,380,385      4,368,784      3,065,501    Counterparty quotations, pricing models    4.28 %   5.7  

Other bonds payable

     448,850      446,988      415,921    Pricing models    6.69 %   1.7  

Repurchase agreements

     657,690      657,690      657,690    Market comparables, pricing models    4.26 %   0.4  

Financing of subprime mortgage loans subject to call option (B)

     406,217      395,906      395,906    (B)    9.09 %   (B )

Junior subordinated notes payable

     100,100      100,100      75,521    Pricing models    7.71 %   27.8  

Interest rate swaps, treated as hedges (C)*

     2,744,175      107,839      107,839    Counterparty quotations    N/A     (C )

Total rate of return swaps (D)*

     124,002      5,255      5,255    Broker quotations, counterparty quotations    N/A     (D )

Non-hedge derivatives (E)*

     199,234      1,488      1,488    Counterparty quotations    N/A     (E )

 

* Measured at fair value on a recurring basis.
(A) Based on 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 are obtained or, finally, internal pricing models are used. Internal pricing models are only used for (i) securities and loans which are not traded in an active market, and therefore have little or no price transparency, and for which significant unobservable inputs must be used in estimating fair value, or (ii) loans or debt obligations which are private and untraded.
(B) These two items results from an option, not an obligation, to repurchase loans from Newcastle’s subprime mortgage loan securitizations (Note 4), are noneconomic until such option is exercised, and are equal and offsetting.

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2008

(dollars in tables in thousands, except share data)

 

 

(C) Represents current swap agreements as follows:

 

Year of Maturity

  

Weighted Average
Maturity

   Aggregate Notional
Amount
   Weighted Average
Fixed Pay Rate
    Aggregate Fair Value  

Agreements which receive 1-Month LIBOR:

       

2010

   Dec 2010    $ 35,565    4.711 %   $ 854  

2011

   Sep 2011      291,944    5.204 %     10,261  

2012

   Apr 2012      66,422    5.224 %     2,371  

2014

   Oct 2014      17,451    5.098 %     699  

2015

   Oct 2015      1,354,924    5.252 %     59,728  

2016

   Apr 2016      599,248    5.124 %     23,085  

2017

   Aug 2017      174,034    5.235 %     8,964  

Agreements which receive 3-Month LIBOR:

       

2011

   Feb 2011      32,000    5.078 %     1,249  

2014

   Jun 2014      354,136    4.196 %     (1,019 )
                    
      $ 2,925,724      $ 106,192  
                    

A positive fair value is recorded as a liability. Newcastle has recorded $1.6 million of gross interest rate swap assets and $109.3 million of gross interest rate swap liabilities.

(D) Represents total rate of return swaps which are treated as non-hedge derivatives. See Note 4 for a further discussion of these swaps. A positive fair value represents a liability; therefore, Newcastle has a net total rate of return swap liability.
(E) These include an interest rate swap with a notional balance of $30.6 million treated as a non-hedge derivative and two interest rate caps with notional balances of $151.1 million and $17.5 million, respectively. The maturity dates of the $30.6 million interest rate swap, the $151.1 million cap and the $17.5 million cap are June 2016, March 2009 and July 2009, respectively. The interest rate swap was recorded as a liability of $1.5 million and the caps had zero fair value at June 30, 2008.

Pursuant to SFAS 157, the methodologies used for valuing such instruments have been categorized into three broad levels as follows:

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 or counterparty quotes) 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.

Pursuant to SFAS 157, these levels form a hierarchy. 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 at June 30, 2008:

 

     Principal
Balance or
Notional
   Carrying
Value
   Fair Value
         Level 2    Level 3A    Level 3B    Total

Assets:

                 

Real estate securities, available for sale

   $ 4,101,031    $ 3,116,151    $ 2,848,798    $ 41,203    $ 226,150    $ 3,116,151

Interest rate swaps, treated as hedges

     181,549      1,647      1,647      —        —        1,647

Liabilites:

                 

Interest rate swaps, treated as hedges

     2,744,175      107,839      107,839      —        —        107,839

Total rate of return swaps

     124,002      5,255      5,255      —        —        5,255

Non-hedge derivatives

     199,234      1,488      1,488      —        —        1,488

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2008

(dollars in tables in thousands, except share data)

 

 

Newcastle’s investments in instruments measured at fair value using Level 3 inputs changed during the six months ended June 30, 2008 as follows:

 

     Level 3A     Level 3B     Total  
Assets       

Balance at January 1, 2008

   $ 130,968     $ 177,518     $ 308,486  

Total gains (losses) (A)

      

Included in net income (loss) (B)

     (3,571 )     (42,801 )     (46,372 )

Included in other comprehensive income

     (19,622 )     27,854       8,232  

Amortization included in interest income

     68       6,657       6,725  

Settlements or repayments

     (2,312 )     (20,087 )     (22,399 )

Transfers in (out) of Level 3

     (25,427 )     12,414       (13,013 )
                        

Balance at March 31, 2008

     80,104       161,555       241,659  
                        

Total gains (losses) (A)

      

Included in net income (loss) (B)

     (215 )     (101,619 )     (101,834 )

Included in other comprehensive income

     (2,072 )     97,015       94,943  

Amortization included in interest income

     115       6,127       6,242  

Settlements or repayments

     (1,797 )     (18,983 )     (20,780 )

Transfers in (out) of Level 3

     (34,932 )     82,055       47,123  
                        

Balance at June 30, 2008

   $ 41,203     $ 226,150     $ 267,353  
                        

 

(A) None of the gains (losses) recorded in earnings during the periods is attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates.
(B) These gains (losses) are recorded in the following line items in the consolidated statement of operations:

 

     Assets  
     Three Months Ended
June 30, 2008
    Three Months Ended
March 31, 2008
 

Gain (loss) on sale of investments, net

   $ (37 )   $ —    

Other income (loss), net

     —         —    

Other-than-temporary impairment

     (101,797 )     (46,372 )
                

Total

   $ (101,834 )   $ (46,372 )
                

During the six months ended June 30, 2008, Newcastle recorded $35.9 million of impairment on three real estate loans (Note 4) with an aggregate post impairment amortized cost basis of $23.7 million. These loans were written down to fair value at the time of the impairment, based on internal pricing models (level 3B valuations).

7. EARNINGS PER SHARE

Newcastle is required to present both basic and diluted earnings per share (“EPS”). Basic EPS is calculated by dividing net income available for common stockholders by the weighted average number of shares of common stock outstanding during each period. Diluted EPS is calculated by dividing net income available for common stockholders by the weighted average number of shares of common stock outstanding plus the additional dilutive effect of common stock equivalents during each period. Newcastle’s common stock equivalents are its outstanding stock options. Net income available for common stockholders is equal to net income less preferred dividends.

The following is a reconciliation of the weighted average number of shares of common stock outstanding on a diluted basis.

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2008    2007    2008    2007

Weighted average number of shares of common stock outstanding, basic

   52,783,006    52,273,988    52,781,662    49,936,428

Dilutive effect of stock options, based on the treasury stock method

   —      193,031    —      221,657
                   

Weighted average number of shares of common stock outstanding, diluted

   52,783,006    52,467,019    52,781,662    50,158,085
                   

As of June 30, 2008, Newcastle’s outstanding options were summarized as follows:

 

Held by the Manager

   1,549,340

Issued to the Manager and subsequently transferred to certain of the Manager’s employees

   935,269

Held by the independent directors

   14,000
    

Total

   2,498,609
    

 

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NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

JUNE 30, 2008

(dollars in tables in thousands, except share data)

 

 

8. RECENT ACTIVITIES

In January 2008, Newcastle repurchased $16.0 million face amount of a class of Portfolio V’s CBO bond for $6.7 million. As a result, Newcastle extinguished $16.0 million face amount of CBO debt and recorded a gain on extinguishment of debt of $9.2 million.

In February 2008, Newcastle repaid in full the debt associated with its first CBO in the amount of $331.2 million.

In February 2008, Newcastle terminated its credit facility. At the date of termination, no amounts were outstanding under the credit facility (and Newcastle did not incur any material costs related to the termination); at that time, previously incurred and deferred financing costs of $0.6 million were written off through gain (loss) on extinguishment of debt in the statement of operations.

In March 2008, Newcastle repurchased $2.9 million face amount of a class of Portfolio VIII’s CBO bond for $0.6 million. As a result, Newcastle extinguished $2.9 million face amount of CBO debt and recorded a gain on extinguishment of debt of $2.3 million.

In the first quarter of 2008, Newcastle sold face amounts of approximately $762.5 million of FNMA/FHLMC securities and $525.2 million of non-FNMA/FHLMC securities. Concurrent with the sales, Newcastle terminated the related interest rate swap and interest rate cap agreements, which were de-designated as hedges for accounting purposes at December 31, 2007. As a result, a portion of the gain on sale from these assets was offset by the loss on the termination of the derivatives. In connection with the investments sold in the first quarter, Newcastle recognized a net mark-to-market loss of $17.2 million in December 2007.

In the first quarter of 2008, Newcastle repaid $924.0 million of repurchase agreements.

In April 2008, Newcastle closed on a sale of its interest in the operating real estate joint venture and received net proceeds of approximately $19.9 million, resulting in a gain of approximately $6.2 million.

In April 2008, a $400 million term financing agreement was not extended. At such time, $99.6 million was drawn and the final maturity of such amount is April 2009.

In April 2008, a $400 million term financing agreement was not extended. At such time, $40.0 million was drawn and the final maturity of such amount is May 2010.

In July 2008, Newcastle closed on the sales of two real estate properties and received net proceeds of approximately $11.5 million. No additional gain (loss) is expected to be recorded in the third quarter of 2008 relating to these sales.

In July 2008, Newcastle repurchased $5.0 million face amount of a class of Portfolio VIII’s CBO bond for $0.6 million. As a result, Newcastle extinguished $5.0 million face amount of CBO debt and will record a gain on extinguishment of debt of $4.4 million in the third quarter of 2008.

In March 2008, Newcastle’s board of directors approved expanding the previously approved share repurchase to allow a potential repurchase of up to $125 million of Newcastle’s common stock or preferred stock. As of August 8, 2008, no shares have been repurchased.

 

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Table of Contents
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following should be read in conjunction with the unaudited consolidated financial statements and notes included herein.

GENERAL

Newcastle Investment Corp. is a real estate investment and finance company. We invest in real estate securities, loans and other real estate related assets. In addition, we consider other opportunistic investments which capitalize on our manager’s expertise and which we believe present attractive risk/return profiles and are consistent with our investment guidelines. We seek to deliver stable dividends and attractive risk-adjusted returns to our stockholders through prudent asset selection, active management and the use of match funded financing structures, when appropriate and available, which reduce our interest rate and financing risks. Our objective is to maximize the difference between the yield on our investments and the cost of financing these investments while hedging our interest rate risk. We emphasize portfolio management, asset quality, diversification, match funded financing and credit risk management.

We currently own a diversified portfolio of credit sensitive real estate debt investments including securities and loans. Our portfolio of real estate securities includes commercial mortgage backed securities (CMBS), senior unsecured debt issued by property REITs, real estate related asset backed securities (ABS), and FNMA/FHLMC securities. Mortgage backed securities are interests in or obligations secured by pools of mortgage loans. We generally target investments rated A through BB, except for our FNMA/FHLMC securities which have an implied AAA rating. We also own, directly and indirectly, interests in loans and pools of loans, including real estate related loans, commercial mortgage loans, residential mortgage loans, manufactured housing loans, and subprime mortgage loans.

We employ leverage in order to achieve our return objectives. We do not have a predetermined target debt to equity ratio as we believe the appropriate leverage for the particular assets we are financing depends on the credit quality of those assets. (As a result of our negative GAAP equity, our GAAP debt to equity ratio is not a meaningful measure as of June 30, 2008.) Our general investment guidelines adopted by our board of directors limit total leverage (as defined under the governing documents) to a maximum 9.0 to 1 debt to equity ratio. As of June 30, 2008, our debt to equity ratio, as computed under this method, was approximately 5.0 to 1.

We strive to maintain access to a broad array of capital resources in an effort to insulate our business from potential fluctuations in the availability of capital. We utilize multiple forms of financing including collateralized bond obligations (CBOs), other securitizations, term loans, and trust preferred securities, as well as short term financing in the form of repurchase agreements.

We seek to match fund our investments with respect to interest rates and maturities in order to minimize the impact of interest rate fluctuations on earnings and reduce the risk of refinancing our liabilities prior to the maturity of the investments. We seek to finance a substantial portion of our real estate securities and loans through the issuance of term debt, which generally represents obligations issued in multiple classes secured by an underlying portfolio of assets. Specifically, our CBO financings offer us the structural flexibility to buy and sell certain investments to manage risk and, subject to certain limitations, to optimize returns.

We conduct our business through four primary segments: (i) investments financed with non-recourse collateralized bond obligations (“CBOs”), (ii) investments financed with other non-recourse debt, (iii) investments financed with recourse debt, including FNMA / FHLMC securities, and (iv) unlevered investments. In the second quarter of 2008, Newcastle changed the structure of its internal organization such that the basis of the composition of its reportable segments changed from investment type to financing type. Revenues attributable to each segment are disclosed below (in thousands).

 

For the Six Months

Ended June 30,

   CBOs    Other
Non-Recourse
   Recourse    Unlevered    Unallocated    Total

2008

   $ 157,600    $ 46,257    $ 27,957    $ 14,966    $ 1,132    $ 247,912

2007

   $ 190,681    $ 51,911    $ 94,229    $ 16,958    $ 301    $ 354,080

Market Considerations

Our ability to maintain our dividends is dependent on our ability to invest our capital on a timely basis at attractive levels. The primary market factors that bear on this are credit spreads and the availability of financing on favorable terms.

Generally speaking, widening credit spreads reduce the unrealized gains on our current investments (or cause or increase unrealized losses) and increase our costs for new financings, but increase the yields available on potential new investments, while tightening credit spreads increase the unrealized gains (or reduce unrealized losses) on our current investments and reduce our costs for new financings, but reduce the yields available on potential new investments. By reducing unrealized gains (or causing unrealized losses), widening credit spreads also impact our ability to realize gains on existing investments if we were to sell such assets.

 

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In the first six months of 2008, credit spreads widened substantially. This net widening of credit spreads caused the net unrealized losses on our securities and derivatives, recorded in accumulated other comprehensive income, to increase and therefore caused our book value per share to be negative at the end of the first and second quarters of 2008. One of the key drivers of the widening of credit spreads has been the continued disruption in the subprime mortgage lending sector. This disruption has spread rapidly, causing adverse conditions and liquidity concerns throughout the credit markets.

Widening credit spreads, while reducing our book value per share, also result in higher yields on new investment opportunities. However, we must have access to capital at attractive terms in order to take advantage of these investment opportunities. Currently, we are unable to take meaningful advantage of the increased yields available on investments due to a lack of available capital, and we may continue to experience the same restrictions throughout the rest of 2008 and likely into 2009. Non-recourse term financing not subject to margin requirements is generally not available, and we must maintain our current sources of capital in order to meet our working capital needs.

In addition, the recent credit and liquidity crisis has adversely affected the market in which we operate in a number of other ways. For example, it has reduced the market trading activity for many real estate securities, resulting in less liquid markets for those securities. As the securities held by us and many other companies in our industry are marked to market at the end of each quarter, the decreased liquidity and concern over market conditions have resulted in what we believe are relatively conservative mark-to-market valuations of many real estate securities. These lower valuations, and expectations of future cash flows, have affected us by, among other things, decreasing our net book value, contributing to our decision to record significant impairment charges during the last five consecutive fiscal quarters and requiring us to pay additional amounts under certain financing arrangements.

In order to increase our liquidity, we have elected to retain the majority of our investment proceeds (including those from recent asset sales) in lieu of using those proceeds to make new investments, and to reduce our dividend below the level of our operating income. This approach has increased our available cash while reducing the earnings from our investments. We may elect to adjust any future dividend payments to reflect our current and expected cash from operations.

We do not currently know the full extent to which this market disruption will affect us or the markets in which we operate, and we are unable to predict its length or ultimate severity. If the disruption continues, we will likely experience further tightening of liquidity, additional impairment charges and increased margin requirements, as well as additional challenges in raising capital and obtaining investment financing on attractive terms. Future cash flows and our liquidity may be materially impacted if conditions do not improve. Should the current conditions worsen, or persist for an extended period of time, our available capital could be reduced upon the expiration or termination of our capital resources.

As of the date of this Quarterly Report on Form 10-Q, based on our cash balances and committed financing, as well as proceeds from select asset sales, we believe we have sufficient liquidity to maintain our ongoing operations in the current market environment.

Certain aspects of these effects are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Interest Rate, Credit and Spread Risk” as well as in “Quantitative and Qualitative Disclosures About Market Risk.”

 

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APPLICATION OF CRITICAL ACCOUNTING POLICIES

Management’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of financial statements in conformity with GAAP requires the use of estimates and assumptions that could affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses. Actual results could differ from these estimates. Management believes that the estimates and assumptions utilized in the preparation of the consolidated financial statements are prudent and reasonable. Actual results have been in line with management’s estimates and judgments used in applying each of the accounting policies described below. The following is a summary of our accounting policies that are most effected by judgments, estimates and assumptions.

Variable Interest Entities

In December 2003, Financial Accounting Standards Board Interpretation (“FIN”) No. 46R “Consolidation of Variable Interest Entities” was issued as a modification of FIN 46. FIN 46R clarified the methodology for determining whether an entity is a variable interest entity (“VIE”) and the methodology for assessing who is the primary beneficiary of a VIE. VIEs are defined as entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. A VIE is required to be consolidated by its primary beneficiary, and only by its primary beneficiary, which is defined as the party who will absorb a majority of the VIE’s expected losses or receive a majority of the expected residual returns as a result of holding variable interests.

We will continue to analyze future investments pursuant to the requirements of FIN 46R. These analyses require considerable judgment in determining the primary beneficiary of a VIE since they involve subjective probability weighting of subjectively determined possible cash flow scenarios. The result could be the consolidation of an entity acquired or formed in the future that would otherwise not have been consolidated or the non-consolidation of such an entity that would otherwise have been consolidated.

Valuation and Impairment of Securities

We have classified our real estate securities as available for sale. As such, they are carried at fair value with net unrealized gains or losses reported as a component of accumulated other comprehensive income. Fair value is based primarily upon broker quotations, as well as counterparty quotations, which provide valuation estimates based upon reasonable market order indications or a good faith estimate thereof. These quotations are subject to significant variability based on market conditions, such as interest rates and credit spreads. Certain securities are not traded in an active market and therefore have little or no price transparency. For a further discussion on this trend, see “– Market Considerations” above. In the instances where we have securities on which we expect adverse cash flow changes either from principal loss or delayed receipt of cash flows, we have estimated the fair value of these securities based on internal pricing models rather than quotations.

With respect to securities valued using pricing models, as of June 30, 2008, approximately $226.4 million amortized cost basis of securities post impairment (or 6.1 % of our total securities portfolio) was valued at $226.2 million. Based on our estimated loss and other assumptions, we expect to receive approximately $273.5 million of principal (excluding cash flows on residual interests) from these securities over time (which includes zero principal expected from 32 of our subprime securities from various vintages). The difference between estimated fair value and expected principal receipts represents unrealized losses which are not expected to be permanent, offset by the present value of expected interest receipts. With respect to these securities, $143.9 million of loss was recorded to the statement of operations as other-than-temporary impairment during the six months ended June 30, 2008 and $0.3 million of unrealized loss was recorded within accumulated other comprehensive income at June 30, 2008.

Changes in market conditions, as well as changes in the assumptions or methodology used to determine fair value, could result in a significant increase or decrease in our book equity. For securities valued using quotations, a 100 basis point change in credit spreads could impact the fair value by approximately $102.0 million. For securities valued using pricing models, the inputs include the discount rate, assumptions relating to prepayments, default rates and loss severities, as well as other variables. We validated the inputs and outputs of our models by comparing them to available independent third party market parameters and models for reasonableness. A 10% increase in the default rate assumption would result in a $29.3 million decrease in the estimated fair value of our securities valued with models.

We must also assess whether unrealized losses on securities, if any, reflect a decline in value which is other-than-temporary and, accordingly, write the impaired security down to its value through earnings. For example, a decline in value is deemed to be other-than-temporary if it is probable that we will be unable to collect all amounts due according to the contractual terms of a security which was not impaired at acquisition, or if we do not have the ability and intent to hold a security in an unrealized loss position until its anticipated recovery (if any). Temporary declines in value generally result from changes in market factors, such as market interest rates and credit spreads, or from certain macroeconomic events, including market disruptions and supply changes, which do not directly impact our ability to collect amounts contractually due. We continually evaluate the credit status of each of our securities and the collateral supporting our securities. This evaluation includes a review of the credit

 

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of the issuer of the security (if applicable), the credit rating of the security, the key terms of the security (including credit support), debt service coverage and loan to value ratios, the performance of the pool of underlying loans and the estimated value of the collateral supporting such loans, including the effect of local, industry and broader economic trends and factors. These factors include loan default expectations and loss severities, which are analyzed in connection with a particular security’s credit support, as well as prepayment rates. The result of this evaluation is considered in relation to the amount of the unrealized loss and the period elapsed since it was incurred. Significant judgment is required in this analysis.

Revenue Recognition on Securities

Income on these securities is recognized using a level yield methodology based upon a number of cash flow assumptions that are subject to uncertainties and contingencies. Such assumptions include the rate and timing of principal and interest receipts (which may be subject to prepayments and defaults). These assumptions are updated on at least a quarterly basis to reflect changes related to a particular security, actual historical data, and market changes. These uncertainties and contingencies are difficult to predict and are subject to future events, and economic and market conditions, which may alter the assumptions. For securities acquired at a discount for credit losses, the net income recognized is based on a “loss adjusted yield” whereby a gross interest yield is recorded to Interest Income, offset by a provision for probable, incurred credit losses which is accrued on a periodic basis to Provision for Credit Losses. The provision is determined based on an evaluation of the credit status of securities, as described in connection with the analysis of impairment above.

Valuation of Derivatives

Similarly, our derivative instruments are carried at fair value pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 133 “Accounting for Derivative Instruments and Hedging Activities,” as amended. Fair value is based on counterparty quotations. To the extent they qualify as cash flow hedges under SFAS No. 133, net unrealized gains or losses are reported as a component of accumulated other comprehensive income; otherwise, they are reported currently in income. To the extent they qualify as fair value hedges, net unrealized gains or losses on both the derivative and the related portion of the hedged item are reported currently in income. Fair values of such derivatives are subject to significant variability based on many of the same factors as the securities discussed above. The results of such variability could be a significant increase or decrease in our book equity and/or earnings.

Impairment of Loans

We purchase, directly and indirectly, real estate related, commercial mortgage and residential mortgage loans, including manufactured housing loans and subprime mortgage loans, to be held for investment. We must periodically evaluate each of these loans or loan pools for possible impairment. Impairment is indicated when it is deemed probable that we will be unable to collect all amounts due according to the contractual terms of the loan, or, for loans acquired at a discount for credit losses, when it is deemed probable that we will be unable to collect as anticipated. Upon determination of impairment, we would establish a specific valuation allowance with a corresponding charge to earnings. We continually evaluate our loans receivable for impairment. Our residential mortgage loans, including manufactured housing loans, are aggregated into pools for evaluation based on like characteristics, such as loan type and acquisition date. Individual loans are evaluated based on an analysis of the borrower’s performance, the credit rating of the borrower, debt service coverage and loan to value ratios, the estimated value of the underlying collateral, the key terms of the loan, and the effect of local, industry and broader economic trends and factors. Pools of loans are also evaluated based on similar criteria, including trends in defaults and loss severities for the type and seasoning of loans being evaluated. This information is used to estimate specific impairment charges on individual loans as well as provisions for estimated unidentified incurred losses on pools of loans. Significant judgment is required both in determining impairment and in estimating the resulting loss allowance.

Revenue Recognition on Loans

Income on these loans is recognized using a methodology that is similar to the methodology used on our securities and is subject to similar uncertainties and contingencies, which are also analyzed on at least a quarterly basis. For loan pools acquired at a discount for credit losses, the net income recognized is based on a “loss adjusted yield” whereby a gross interest yield is recorded to Interest Income, offset by a provision for probable, incurred credit losses which is accrued on a periodic basis to Provision for Credit Losses. The provision is determined based on an evaluation of the loans as described under “Impairment of Loans” above. A rollforward of the provision is included in Note 4 to our consolidated financial statements.

Impairment of Operating Real Estate

We review our operating real estate for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Upon determination of impairment, we would record a write-down of the asset, which would be charged to earnings. Significant judgment is required both in determining impairment and in estimating the resulting write-down. In addition, when operating real estate is classified as held for sale, it must be recorded at the lower of its carrying amount or fair value less costs of sale. Significant judgment is required in determining the fair value of such properties.

 

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Recent Accounting Pronouncements

In June 2007, Statement of Position No. 07-1, ‘‘Clarification of the Scope of the Audit and Accounting Guide — Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies” (‘‘SOP 07-1”) was issued. SOP 07-1 addresses whether the accounting principles of the Audit and Accounting Guide for Investment Companies may be applied to an entity by clarifying the definition of an investment company and whether those accounting principles may be retained by a parent company in consolidation or by an investor in the application of the equity method of accounting. SOP 07-1 eliminates the previously existing exemption for REITs from being considered investment companies. We are currently evaluating the potential effect on our financial condition, liquidity and results of operations upon adoption of SOP 07-1. If we, or any of our subsidiaries, are considered an investment company under this new guidance, it would result in material changes to our financial statements. The primary change would be the recording of all of our (or our subsidiaries’) investments at fair value, with changes in fair value being recorded through the income statement. In February 2008, the FASB indefinitely postponed the adoption of SOP 07-1.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 applies to reporting periods beginning after November 15, 2007. We adopted SFAS 157 on January 1, 2008. To the extent they are measured at fair value, SFAS 157 did not materially change our fair value measurements for any of our existing financial statement elements. SFAS 157 did change the reported value for our derivative obligations, but this did not have a material effect on our liabilities or accumulated other comprehensive income. As a result, the adoption of SFAS 157 did not have a material impact on our financial condition, liquidity or results of operations.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose to measure many financial instruments, and certain other items, at fair value. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 applies to reporting periods beginning after November 15, 2007. We adopted SFAS 159 on January 1, 2008. We did not elect to measure any items at fair value pursuant to the provisions of SFAS 159. As a result, the adoption of SFAS 159 did not have a material impact on our financial condition, liquidity or results of operations.

In December 2007, the American Securitization Forum (“ASF”) issued the “Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans” (the “ASF Framework”). The ASF Framework provides guidance for servicers to streamline borrower evaluation procedures and to facilitate the use of foreclosure and loss prevention efforts in an attempt to reduce the number of U.S. subprime residential mortgage borrowers who might default in the coming year because the borrowers cannot afford to pay the increased interest rate after their variable loan rate resets. The ASF Framework is focused on U.S. subprime first-lien adjustable-rate residential mortgages that have an initial fixed interest rate period of 36 months or less, are included in securitized pools, were originated between January 1, 2005 and July 31, 2007, and have an initial interest rate reset date between January 1, 2008 and July 31, 2010.

The ASF Framework requires a borrower to meet specific conditions, primarily related to the ability of the borrower to meet the initial terms of the loan and obtain refinancing, to qualify for a fast track loan modification under which the qualifying borrower’s interest rate will be kept at the existing initial rate, generally for five years following the upcoming reset. To qualify for fast-track modification, a loan must currently be no more than 30 days delinquent and no more than 60 days delinquent in the past 12 months, have a loan-to-value ratio greater than 97%, be subject to payment increases greater than 10% upon reset, and be for the primary residence of the borrower.

In January 2008, the SEC’s Office of Chief Accountant (the “OCA”) issued a letter (the “OCA Letter”) addressing accounting issues that may be raised by the ASF Framework. The OCA Letter expressed the view that if a qualifying subprime loan is modified pursuant to the ASF Framework and that loan could legally be modified, the OCA will not object to the continued status of the transferee as a QSPE under SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, because it would be reasonable to conclude that defaults on such loans are “reasonably foreseeable” in the absence of any modification.

The servicer for Subprime Portfolios I and II may make loan modifications in accordance with the ASF Framework in 2008, but we do not expect any such modifications to have a material effect on the accounting for our subprime mortgage loans subject to call options or retained interests in the securitizations of Subprime Portfolios I and II. Furthermore, we do not expect that the ASF Framework will affect the off balance sheet treatment of the securitizations of Subprime Portfolios I and II.

In February 2008, the FASB issued FASB Staff Position No. FAS 140-3 (“FSP FAS 140-3”), “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions.” FSP FAS 140-3 provides guidance on accounting for a transfer of a financial asset and a repurchase financing. It presumes that an initial transfer of a financial asset and a repurchase financing are considered part of the same arrangement (a linked transaction) unless certain criteria are met. If the criteria are not met, the linked transaction would be recorded as a net investment, likely as a derivative, instead of recording the purchased financial asset on a gross basis along with a repurchase financing. FSP FAS 140-3 applies to reporting periods beginning after

 

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November 15, 2008 and is only applied prospectively to transactions that occur on or after the adoption date. As a result of the prospective nature of the adoption, we do not expect the adoption of FSP FAS 140-3 to have a material impact on our financial condition, liquidity or results of operations, unless we enter into transactions of this type after January 1, 2009.

In March 2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments and Hedging Activities.” SFAS 161 applies to reporting periods beginning after November 15, 2008. SFAS 161 requires enhanced disclosures about an entity’s derivative and hedging activities. It does not change the accounting for such activities. As a result, while the adoption of SFAS 161 will change our disclosures, we do not expect it to have a material impact on our financial condition, liquidity or results of operations.

 

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RESULTS OF OPERATIONS

The following table summarizes the changes in our results of operations from the three and six months ended June 30, 2007 to the three and six months ended June 30, 2008 (dollars in thousands):

 

     Six Months     Three Months     Explanations
of Material
Changes
     Amount Change     Percent Change     Amount Change     Percent Change    

Interest income

   $ (106,168 )   (30.0 )%   $ (76,846 )   (40.1 )%   (1)

Interest expense

     (87,561 )   (34.9 )%     (60,185 )   (44.9 )%   (1)

Loan and security servicing expense

     (2,163 )   (38.1 )%     (1,910 )   (51.7 )%   (1)

Provision for credit losses

     (752 )   (14.7 )%     (1,221 )   (39.5 )%   (2)

General and administrative expense

     756     27.7 %     457     31.8 %   (3)

Management fee to affiliate

     743     8.8 %     52     1.1 %   (4)

Incentive compensation to affiliate

     (6,209 )   (100.0 )%     (2,521 )   (100.0 )%   (4)

Depreciation and amortization

     1     0.7 %     2     2.8 %   N/A

Gain (loss) on sale of investments, net

     (2,700 )   (29.4 )%     (7,014 )   (100.5 )%   (5)

Other income (loss), net

     (24,345 )   N.M.       (4,320 )   N.M.     (6)

Other-than-temporary impairment

     (142,216 )   N.M.       (95,844 )   N.M.     (7)

Loan impairment

     (37,085 )   N.M.       (16,759 )   N.M.     (7)

Provision for credit losses, loans held for sale

     5,754     N.M.       5,754     N.M.     (8)

Gain (loss) on extinguishment of debt

     15,813     N.M.       7,280     N.M.     (9)

Equity in earnings of unconsolidated subsidiaries

     6,104     366.4 %     6,243     762.3 %   (10)
                              

Income (loss) from continuing operations

   $ (189,658 )   (258.3 )%   $ (116,180 )   (312.6 )%  
                              

 

N.M. - Not meaningful

(1) Changes in interest income and expense are primarily related to our acquisition and disposition during these periods of interest bearing assets and related financings, as follows:

 

     Six Months     Three Months  
     Period to Period Increase (Decrease)     Period to Period Increase (Decrease)  
     Interest Income     Interest Expense     Interest Income     Interest Expense  

Acquisition of securities and loans

   $ (22,867 )   $ (16,734 )   $ (25,463 )   $ (17,824 )

Disposition of securities and loans

     (18,387 )     (17,455 )     (11,311 )     (11,146 )

New debt obligations

     (17,219 )     (20,039 )     (12,059 )     (13,939 )

Repayment of debt obligations

     (15,034 )     (10,438 )     (8,882 )     (6,642 )

Other (primarily changes in rates)

     (31,984 )     (22,895 )     (18,454 )     (10,634 )
                                
   $ (105,491 )   $ (87,561 )   $ (76,169 )   $ (60,185 )
                                

Changes in loan and security servicing expense are also primarily due to these acquisitions and paydowns.

(2) This change is primarily due to the decreased provision for our pools of manufactured housing loans as a result of paydowns.
(3) This change is primarily due to the increases in insurance expenses, software license fees and professional fees.
(4) The increase in management fees is a result of our increased size resulting from our equity issuances. As a result of impairment charges, we will not owe incentive compensation to our manager for an indefinite period of time.
(5) Sales of real estate securities, and the proceeds therefrom, are based on a number of factors including credit, asset type and industry, and liquidity needs, and can be expected to increase or decrease from time to time. Periodic fluctuations in the sales of securities is dependent upon, among other things, management’s assessment of credit risk, asset concentration, portfolio balance, liquidity and other factors.
(6) This change is primarily due to the unrealized loss on total rate of return swaps and the realized loss on the termination of derivative instruments.
(7) This change is due to impairment changes recorded during 2008 as a result of continued credit market disruption.
(8) This change results from the 2007 unrealized loss on the pool of subprime mortgage loans which was considered held for sale as of June 30, 2007.
(9) This change is primarily due to the gain on the repurchase of our own debt offset by the write off of deferred financing fees upon repayments of debt obligations recorded during the six months ended June 30, 2008.
(10) This change is primarily the result of the gain on sale of our interests in the operating real estate joint venture recorded during the six months ended June 30, 2008.

 

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LIQUIDITY AND CAPITAL RESOURCES

Liquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain investments, and other general business needs. Additionally, to maintain our status as a REIT under the Internal Revenue Code, we must distribute annually at least 90% of our REIT taxable income. Our primary sources of funds for liquidity consist of net cash provided by operating activities, borrowings under loans, and the issuance of debt and equity securities when available. Additional sources of liquidity include investments that are readily saleable prior to their maturity. Our debt obligations are generally secured directly by our investment assets.

As of the date of this Quarterly Report on Form 10-Q, management believes that our cash on hand, when combined with our cash flow provided by operations, as well as proceeds from the repayment or sale of investments and borrowings, is sufficient to satisfy our liquidity needs with respect to our current investment portfolio. In this regard, we had unencumbered assets with a carrying value of approximately $151.0 million at June 30, 2008, excluding unrestricted cash of $164.5 million. As of August 8, 2008, we had an unrestricted cash balance of $170 million and $39.2 million of restricted cash held in CBO financing structures pending its investment in real estate securities and loans.

We expect to meet our long-term liquidity requirements, specifically the repayment of our debt obligations, through additional borrowings and the liquidation or refinancing of our assets at maturity. We believe that the value of our assets is, and will continue to be, sufficient to repay our debt at maturity under either scenario. Our ability to meet our long-term liquidity requirements relating to capital required for the growth of our investment portfolio is subject to obtaining additional equity and debt financing. Decisions by investors and lenders to enter into such transactions with us will depend upon a number of factors, such as our historical and projected financial performance, compliance with the terms of our current credit arrangements, industry and market trends, the availability of capital and our investors’ and lenders’ policies and rates applicable thereto, and the relative attractiveness of alternative investment or lending opportunities. We strive to maintain access to a broad array of capital resources in an effort to insulate our business from potential fluctuations in the availability of capital. Our core business strategy is dependent upon our ability to finance our real estate securities, loans and other real estate related assets with match funded debt at rates that provide a positive net spread. Currently, spreads for such liabilities have widened and demand for such liabilities has become extremely limited, thereby restricting our ability to execute future financings. This restriction is exacerbated by the requirement to post margin on existing obligations.

Our cash flow provided by operations differs from our net income due to these primary factors: (i) accretion of discount or premium on our real estate securities and loans (including the accrual of interest and fees payable at maturity), discount on our debt obligations, deferred financing costs and interest rate cap premiums, and deferred hedge gains and losses, (ii) gains and losses from sales of assets financed with CBOs, (iii) the provision for credit losses recorded in connection with our loan assets, as well as other-than-temporary impairment recorded on our securities, (iv) unrealized gains or losses on our non-hedge derivatives, particularly our total rate of return swaps, and (v) the non-cash charges associated with our early extinguishment of debt. Proceeds from the sale of assets which serve as collateral for our CBO financings, including gains thereon, are required to be retained in the CBO structure until the related bonds are retired and are therefore not available to fund current cash needs outside of these structures.

Our match funded investments are financed under long-term arrangements and we continuously monitor their credit status. Consequently, we expect these investments to generate a generally stable current return, subject to interest rate fluctuations. See “Quantitative and Qualitative Disclosures About Market Risk — Interest Rate Exposure” below. Our remaining investments, generally financed with short term repurchase agreements, are also subject to refinancing risk upon the maturity of the related debt.

With respect to two of our real estate related loans, we were committed to fund up to an additional $95.5 million at August 8, 2008, subject to certain conditions to be met by the borrowers, with details as follows (in thousands):

 

     Total Unfunded
Commitment
   Committed CBO
Financing
   Remaining
Unfunded
Commitment

Real estate loan 1

   $ 76,466    $ 14,366    $ 62,100

Real estate loan 2

     19,063      —        19,063
                    

Total

   $ 95,529    $ 14,366    $ 81,163
                    

Real estate loan 1 is a construction loan, which is expected to be funded over the next twenty-one months.

As described below, under “Interest Rate, Credit and Spread Risk,” we are subject to margin calls in connection with our assets financed with repurchase agreements or total rate of return swaps.

See “- Market Considerations” above for a further discussion of recent trends and events affecting our liquidity.

 

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Investment Portfolio

The following summarizes our investment portfolio at June 30, 2008 (dollars in millions).

 

     Outstanding Face
Amount
   Amortized Cost
Basis
    Percentage of
Amortized Cost
Basis
    Number of
Investments
   Credit (1)     Weighted
Average Life
(years) (2)
Investment (3)               

Commercial

              

CMBS

   $ 2,264    $ 2,177     35.4 %   257    BBB-     5.5

Mezzanine Loans

     780      776     12.6 %   23    67 %   3.5

B-Notes

     420      393     6.4 %   15    61 %   3.1

Whole Loans

     83      82     1.3 %   4    65 %   2.8

ICH Loans

     11      10     0.2 %   5    —       8.1
                              

Total Commercial Assets

     3,558      3,438     55.9 %        4.7
                              

Residential

              

Manufactured Housing and

Residential Mortgage Loans

     597      572     9.3 %   14,960    695     5.6

Subprime Securities

     579      302     4.9 %   124    BB-     5.6

Subprime Retained Securities

     80      51     0.8 %   7    B+     12.2

Subprime Residual Interests

     13      13     0.2 %   2    645     2.8

Real Estate ABS

     103      101     1.6 %   26    BBB-     4.7
                              
     1,372      1,039     16.8 %        5.9
                              

FNMA/FHLMC securities

     409      411     6.7 %   15    AAA     3.8
                              

Total Residential Assets

     1,781      1,450     23.5 %        5.4
                              

Corporate

              

REIT Debt

     653      663     10.8 %   65    BBB     5.1

Corporate Bank Loans

     632      602     9.8 %   17    B-     3.2
                              

Total Corporate Assets

     1,285      1,265     20.6 %        4.2
                              

TOTAL

   $ 6,624    $ 6,153     100.0 %        4.8
                              

Reconciliation to GAAP total assets:

              

Net unrealized losses recorded in accumulated other comprehensive income

        (605 )         

Total rate of return swaps (4)

        (100 )         

Other assets

              

Subprime mortgage loans subject to call option (5)

        396           

Real estate held for sale

        28           

Cash and restricted cash

        274           

Other

        70           
                    

GAAP total assets

      $ 6,216           
                    

 

(1)

Credit represents weighted average rating for rated assets, LTV for non-rated commercial assets, FICO score for non-rated residential assets and an implied AAA rating for FNMA/FHLMC securities.

(2)

Mezzanine Loans, B-Notes and Whole Loans are based on the fully extended maturity dates.

(3)

The following tables summarize certain supplemental data relating to our investments ($ in thousands):

CMBS

 

Deal Vintage
(A)

   Average
Rating
   Number    Outstanding
Face Amount
   Amortized Cost
Basis
   Percentage of
Amortized
Cost Basis
    Delinquency
60+/FC/REO (B)
    Principal
Subordination (C)
    Weighted
Average Life
(years)

Pre 2004

   A-    79    $ 410,892    $ 406,905    18.6 %   0.9 %   9.4 %   4.4

2004

   BBB-    59      435,703      428,733    19.7 %   0.2 %   5.0 %   5.6

2005

   BB+     50      586,285      554,368    25.5 %   0.4 %   4.8 %   6.5

2006

   BB+    35      446,768      426,219    19.6 %   0.1 %   5.1 %   3.8

2007

   BBB+    34      384,056      360,418    16.6 %   0.1 %   9.0 %   6.8
                                              

Total / WA

   BBB-    257    $ 2,263,704    $ 2,176,643    100.0 %   0.3 %   6.4 %   5.5
                                              

 

  (A) The year in which the securities were issued.
  (B) The percentage of underlying loans that are 60+ days delinquent, or in foreclosure or considered real estate owned (REO).
  (C) The percentage of the outstanding face amount of securities and residual interests that is subordinate to our investments.

WA – Weighted average, in all tables.

 

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Table of Contents

Mezzanine Loans, B-Notes and Whole Loans

 

     Mezzanine     B-Note     Whole Loan     Total / WA  

Outstanding Face Amount

   $ 780,181     $ 420,140     $ 82,536     $ 1,282,857  

Amortized Cost Basis

   $ 775,550     $ 392,627     $ 82,452     $ 1,250,629  

Number

     23       15       4       42  

Weighted Average First $ Loan to Value

     55.6 %     45.4 %     0.0 %     48.7 %

Weighted Average Last $ Loan to Value

     66.9 %     60.5 %     64.8 %     64.6 %

Delinquency

     0 %     0 %     0 %     0 %

Manufactured Housing Loans

 

Deal

   Outstanding
Face Amount
   Amortized
Cost Basis
   Pertcentage
of Amortized
Cost Basis