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Executives

Ken Riis - President and Chief Executive Officer

Brian Sigman - Chief Financial Officer

Nadean Finke - Investor Relations

Analysts

Rick Shane - Jefferies & Company

David Fick - Stifel Nicolaus

Matthew Howlett - Fox-Pitt Kelton

Newcastle Investment Corp. (NCT) Q3 2008 Earnings Call November 7, 2008 11:00 AM ET

Operator

Welcome to the Newcastle third quarter earnings call.

(Operator Instructions).

I would now like to turn the conference over to Nadean Finke. Please go ahead.

Nadean Finke

Thank you, Brandy. Good morning, everyone. I want to welcome all of you to Newcastle's third quarter Earnings Call. Joining us today are, Ken Riis, our CEO and President, Brian Sigman, our Chief Financial Officer, and Lilly Donohue, Director of Investor Relations.

Before I turn the call over to Ken, as the mentioned this call is being recorded and the replay number is 1800-642-1687 from within the US and 706-645-9291 for international callers, with an access code of 70221244. This call will also be available on our website located at www.newcastleinv.com.

I would also like to point out that statements today, which are not historical facts maybe forward-looking statements, actual results may differ materially from the estimates or expectations in any forward-looking statements. These statements represent the company's beliefs regarding events that by their nature are uncertain and outside of company's control. So you should not place undue reliance on any of these statements. I would encourage you to review the forward-looking statements disclaimer in our quarterly earnings release, including a recommendation to review the risk factors contained in our annual and quarterly reports filed with the SEC.

Now I would like to turn the call over to Ken Riis. Ken…

Ken Riis

Thanks Nadean. Good morning everybody and welcome to our third quarter earnings call. Let's just get right to it, the quarter was definitely challenging, as the economic environment and dislocation in the financial markets continue to drive credit spreads wider and reduce the appetite for risk.

These market events have affected Newcastle in two ways that I would like to highlight on this call. First, the uncertainty in the economy and more directly the real estate markets have caused us to use a more conservative expectation of future cash flows on our higher risk assets in our portfolio. This resulted in asset impairments, even though; the majority are currently making payments as contracted.

Secondly, widening credit spreads have reduced the mark-to-market value of our securities held as available for sale, contributing to the decline of our GAAP book value. Fortunately for us, the majority of our assets are financed with long-term debt within our CDOs. These liabilities are not callable to the changes in the market value of the assets in our non-recourse to Newcastle.

The expected maturity of the asset is actually shorter than the liabilities at 4.7 years on the assets, versus 5.5 years on the liabilities. As assets pay down and mature within our CDOs, we're able to reinvest the proceeds at attractive yields. In the quarter, we had $34 million of paydowns and we invested $44 million of restricted cash to purchase $59 million face amount of securities, with an average rating of AA, and an average yield of 12.2%.

In the quarter, we focused on three things relating to our business, cash flow generation, recourse debt reduction, and liquidity. First, starting with our cash flows; in the third quarter; we earned $0.49 of operating income, slightly higher than our expectations.

Secondly, we continued to focus on financing risk through the reduction of recourse debt. Since the end of the second quarter, we have reduced recourse debt by 41% or $335 million. Currently, 9% of our total debt is recourse to Newcastle and we are focused on further reductions.

Thirdly, we currently have $143 million of liquidity, comprised of $108 million of unrestricted cash on our balance sheet, and $38 million of restricted cash in our CDOs. We do not plan to use our unrestricted cash for new investments until we further reduce our recourse debt.

Although, I don't anticipate the value of these assets, financed with recourse debt, to decline much below their current levels, it is prudent to be conservative with our liquidity given the current market environment. Our focus will remain on cash flow generation, reinvesting cash in our CDOs at higher yields, and strengthening our balance sheet.

I look forward to updating everyone on our progress on our next conference call for the fourth quarter.

Now, I'll hand it over to our CFO, Brian Sigman to review our third quarter financial results. Brian…

Brian Sigman

Thank you, Ken. Good morning, everyone. First, I will address our financial results of the quarter, and then, I will close with some key points.

In the third quarter, as Ken mentioned, operating income, net of the preferred dividends, was $0.49 per share. In addition to that, we had $0.28 per share of a net loss due to the following five items.

One, $0.10 per share of gains from the repurchase of our outstanding CDO debt, which we are able to purchase 6 million of stake at a weighted average purchase price of $0.11 and a weighted average rating of A minus.

Two, we had a $0.03 per share of income that we earned on exit fees and loan resolutions.

Three, we had a loss of $0.18 per share due to the decrease in value on $94 million of loans being financed with total return swaps, that for GAAP are treated as derivatives. Every quarter the change in the fair value of these assets will run through our income statement, whether the price change is a result of market illiquidity or credit issues.

Four, we had a loss of $0.18 per share due to derivative ineffectiveness, primarily resulted from our fourth quarter agency securities sales, for which, GAAP required us to go back and mark all these derivates through our income statement in the third quarter.

And five, we had a loss of $0.05 per share on the sale of $15 million of bank loan and $18 million of securities in the third quarter.

Unfortunately, due to the continuation in the unprecedented deterioration in the financial markets, we have updated our future cash flow assumptions to better reflect current market condition.

We did it by slowing prepayment speeds, increasing default and increasing severities. Due to these changes, we have booked impairment charges of $161 million in the third quarter.

The five primary drivers of this impairment were; one $44 million on our subprime securities portfolio, primarily relating to our 2004, 2005 vintage securities, two, $52 on our two subprime deals including $42 million on the retained bonds and $10 million on retained residual interest, three, a $26 million charge on three B-Notes, four, a $20 million charge on three CMBS conduit securities, and five, a $14 million charge on four senior bank loans.

Adding the above three components gets us to our net loss for the quarter of a $149 million or $2.83 per share.

As most of you know, there has been a lot of discussion regarding distribution requirements amongst mortgages (inaudible), and as Ken mentioned in our previous call, we would like to give some color as to our dividend process.

Every quarter, our Board meets to determine the dividend for the current quarter, in that decision they consider several factor, including cash flows generated from operation, expected monetary earnings, current liquidity, potential investment opportunities, and estimated taxable income.

Based on our current estimate, for 2008 taxable income, we think we have satisfied our distribution requirement for 2008, but to reiterate, this is only one of the factors that will go into the Board's decision in the coming fourth quarter.

I'd like to point out from additional disclosures that we are going to have in our 10-Q filing that we expect to be filed on Monday, that I think many of you will find very helpful.

One, we added a breakout of our derivative counterparties that we have exposure to. Two, we added a breakout of our financing counterparties, differentiating between agency and non-agency recourse financing. Three, we broke out our financings between our two manufactured housing deals. And four; we added a table summarizing the geographic distribution of collateral securing our CMBS.

Some of you may have noticed that S&P and Fitch downgraded its rating from 13 classes of liability issued by CDO to six. I just want to note that these specific S&P and Fitch rating actions do not have any direct impact on the company.

And lastly, I wanted to quickly discuss the margin calls that we have been making. In the third quarter, we posted $20 million of margin on our recourse financing, primarily after the failure of Lehman and AIG. To-date, in the fourth quarter, we have already posted an additional $52 million of margin.

While we are obviously not happy with having to meet so many margin calls, as you know, we were maintaining a large cash position specifically for that possibility. Although we definitely expect to still have some margin calls in the future, we feel that the levels where these assets have been marked down to should be close to the bottom in terms of pricing in of the current market illiquidity.

In terms of the actual underlying credit of dispositions, we feel that these specific loans, subject to our mark-to-market financings, are performing well, are in general very good credit.

Next, I'll turn it over to the operator for question.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Rick Shane with Jefferies & Company.

Rick Shane - Jefferies & Company

Hi, guys. Thanks for taking my question this morning. I'd like to focus on the residuals in retained securities and on the subprime portfolios. My question to this right now in D.C. there is a lot of discussion about different strategies on loan modifications and that's creating a tremendous amount of uncertainty about residual values in potential cash flows. How are you looking at this and what do you see as the range of outcomes when you hear the different plans? What are the good scenarios for you, what are the bad scenarios? So as we hear this develop, we can sort of plot what that means for Newcastle?

Ken Riis

This is Ken. I think that as it relates to our retained securities and our residual interest, what we did this quarter was, I think, we didn't anticipate any benefit from what's going on in Washington right now and what we did is basically changed our assumptions in terms of defaults and severities and cumulative losses in the pools that secure our residual and maintain securities that we basically just mark them down to a very low value. For example, our residuals, our basis remained in residuals is basically nothing. I think it is about, what is about?

Brian Sigman

$2.69 million.

Ken Riis

$2.6 million, and on the retained interest, we've mark the securities down to a value of about $0.11.

Brian Sigman

$9 million.

Ken Riis

So, we're not planning any benefit, relating to any outcome in Washington, if there is some upside. We've impaired these securities, so we would realize that over time through our income statement, but we can't mark the securities back up. So, I think, we took a very conservative approach to these assets and wrote them down to very conservative levels.

Rick Shane - Jefferies & Company

It's interesting to me that you see modifications as potentially a benefit; couldn't they potentially accelerate losses? And again, I understand that you guys increased your team loss assumptions, but it seems to be more due to duration extension and slower prepayments than from the (inaudible) potential and my concern is that it would cause principle write-downs that would offset residuals?

Ken Riis

Well, our basis in the residuals is $2 million, so I guess our downside is $2 million.

Rick Shane - Jefferies & Company

Okay.

Ken Riis

I will say that modification go two ways, and you have less defaults in the future, but if they reduce the balance to some amount and reduce the interest rate, you get less cash flows to the residuals, even though, the defaults may be lessened in the future? We really only have $2 million of risk there.

Rick Shane - Jefferies & Company

That's a very fair point. Thank you, guys.

Ken Riis

Sure

Operator

Your next question comes from the line of David Fick with Stifel Nicolaus.

David Fick - Stifel Nicolaus

Could you review for us your covenants and where you stand with your credit facilities vis-à-vis those covenants?

Ken Riis

At 9:30, we were in compliance with all covenants. We actually don't give specific disclosures on what those covenants are, but they are all measured on a, outside of CDOs on a quarterly basis and they are measured by the financial statement issuance. So we monitor those every day and to the extend we need to take action we will. And other than that, we're in compliance.

David Fick - Stifel Nicolaus

It would help us better just to have some idea of how close you are to needing to take action on these covenants?

Ken Riis

Well, we are not disclosing the amount of cushion, if that's what you are asking, but we could actually talk about that and if you want to in the fourth quarter and give some guidance on that.

David Fick - Stifel Nicolaus

One would think it's the most relevant single fact with respect to an investment in your shares?

Ken Riis

We do disclose a lot about it in our 10-Q, which you'll see on Monday. That might help answer some of your questions.

David Fick - Stifel Nicolaus

Great, thanks, we'll follow back on that. You have a stated weighted average loan portfolio LTV of 64%, but that's on origination, and you just impaired about $21 million of these loans, would you do a separate analysis of LTV to today's market?

Ken Riis

We do update in our underwriting. We are constantly updating our asset risk and part of that underwriting is the current value of the collateral that secures our loan, and we take that in consideration to evaluate impairments in future cash flow.

David Fick - Stifel Nicolaus

But that's not reflected in your 64% LTV disclosure?

Ken Riis

I think we disclosed the original LTV, is that correct?

David Fick - Stifel Nicolaus

Right. Where would it be today?

Ken Riis

And that's based on original appraised values.

David Fick - Stifel Nicolaus

Which is were typically loan is done at the peak of the market, so what I'm trying to get to is, are we closer to 90% LTV today, 95% LTV, do you have any perspective on that?

Ken Riis

Right now I can't answer that question, I think that there are a lot of assets that we monitor, and I'm not prepared to answer that right now.

David Fick - Stifel Nicolaus

Okay. And then lastly, the impairments that you've been taking can you give us some guidance on when they become a tax benefit?

Ken Riis

We don't give specifics but we have some guidance from the accounting firms that we are able to use some of them, but taxes due to adds to GAAP, so taxes are more as they are realized, although I can say that a lot of these securities are still cash flowing, so we will be realizing some this year, but some of that will be out in the future.

David Fick - Stifel Nicolaus

Okay, great. I appreciate your responses. I would just comment that more disclosure is better than less in this market considering the [C&P] surprises by the day. Thanks.

Ken Riis

You should take a look at the 10-Q, like I said, for a little bit more help.

David Fick - Stifel Nicolaus

Okay. We'll do that. Thanks.

Operator

Your next question comes from the line of Matthew Howlett with Fox-Pitt Kelton.

Matthew Howlett - Fox-Pitt Kelton

Thanks for taking my questions. With respect to the dividend, do I understand this correctly that in any dividend that you satisfied all taxable income requirements in terms of payout this year, and anything you distribute further, this year would be look as a return of capital, from that area standpoint?

Ken Riis

It's based on an estimate, but based on that estimate you are correct.

Matthew Howlett - Fox-Pitt Kelton

Okay. Do I understand that the cash flows are still there, so it's not really a cash flow per share estimates, its more of a sort of IRS technicality which makes it taxable income?

Ken Riis

100%.

Matthew Howlett - Fox-Pitt Kelton

Good, great. Okay, and then switching to the 10-Q, I know we'll see the par value test, where they stand in the quarter, I know there were some downgrades with the CMBS in the quarter and that some of that corporate assets and I'm not sure if those are in that, your CDOs are not, but you guys go out and project these cash flows through your modeling's. Can you give us any type of indication as to whether or not these par value test, which I think are the biggest risk to the cash flows underlying your CDOs, your cash flows, any sort of assurance that these CDOs can withstand some type of stress environment, where its further downgrades, anything you can give us on that front?

Ken Riis

Yeah, we do have 7 CDOs and we do actively monitor the triggers and assets in the portfolios and the effect on triggers, there is lot of details around that, but we do closely monitor that, because it does impact cash flows to the company. And there have been recent downgrades that have put pressure on our triggers, although, at the end of the third quarter, we were in compliance with all our over collateralization and interest coverage triggers in our CDOs.

Future downgrades or recent downgrades, on the assets in the portfolios do put more pressure on those triggers. Unfortunately, we have the ability to manage our portfolios and manage that risk to extend that we can and we do that all the time, its one of our, obviously our main focuses. So there are lot of details around that, I think that we did give good disclosure in our Q relating to each of our portfolios and our CDOs. I would encourage you to look at that, for your information, because I need a lot of details to go over on the phone, but we do monitor it closely.

Matthew Howlett - Fox-Pitt Kelton

Let me ask it this way, do you feel that you have a lot of seasoned CMBS in these deals that are, in your call, pre '06. do you feel that they have better ratings stability sort of going forward and that really the real downgrades we'll see in the CMBS will be in the '06, '07 vintages?

Ken Riis

Yeah I would agree with that.

Matthew Howlett - Fox-Pitt Kelton

Okay; great.

Ken Riis

And that's what we are seeing right now,'06, '07 vintages are having more ratings pressure than their earlier vintages, yes.

Matthew Howlett - Fox-Pitt Kelton

Okay. Good. And most of your CDOs are really concentrated in that those older buckets. And then just a question on the agency REIT portfolio, could you sell those assets and delever that portfolio without preaching your (inaudible) to free up liquidity if you had to, I know there is some re-test you have to make.

Ken Riis

We actually did, we sold about $275 million at the end of October. And these are non-core portfolio assets that we do hold for compliance reasons. And to the extent that we don't need them for compliance reasons, you are right. We would look to dispose them and like I said, that we sold 75% of our portfolio

Matthew Howlett - Fox-Pitt Kelton

How much further could you sell, is there an estimate that you can give us?

Ken Riis

No not really, it fluctuates every month. We don't try and test by $1 I'll say you that.

Matthew Howlett - Fox-Pitt Kelton

Okay. Fair enough. Thanks a lot.

Ken Riis

Sure.

Operator

We have reached the allotted time for questions. I will now turn the call back to Management for any closing remarks.

Nadean Finke

Great. Thank you all for joining us this afternoon.

Operator

This concludes today's Newcastle third quarter earnings call. You may now disconnect.

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Source: Newcastle Investment Corp. Q3 2008 Earnings Call Transcript
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