Newcastle Investment Corp. (NYSE:NCT)
Q4 2011 Earnings Call
March 1, 2012 11:00 a.m. ET
Cameron McDougall - Company Representative
Kenneth Riis - President and CEO
Wes Edens - Chairman
Brian Sigman - CFO
Matthew Howlett - Macquarie Research Equities
Joshua Barber - Stifel Nicolaus
Good morning. My name is Christie, and I will be your conference operator today. At this time, I would like to welcome, everyone, to the Newcastle Fourth Quarter 2011 Earnings Conference Call. (Operator Instructions)
I would now like to hand the program over to Mr. Cameron McDougall.
Thanks and good morning. I’d like to welcome everyone today, March 1, 2012, to Newcastle’s Fourth Quarter and Full Year 2011 Earnings Conference Call. Joining us today are Ken Riis, our CEO and President, Wes Edens, the Chairman of our Board of Directors and Brian Sigman, our CFO.
Before I turn the call over to Ken, I would like to point out that certain statements made today may be forward-looking statements. Forward-looking statements are not statements of fact instead, these statements describe the company’s current beliefs regarding events that by their nature are uncertain and outside of the company’s control.
The company’s actual results may differ materially from the estimates or expectations expressed in any forward-looking statements. So you should not place undue reliance on any forward-looking statements. I encourage you to review the disclaimers in our earnings release regarding forward-looking statements and expected returns and to review the risk factors contained in our Annual and Quarterly Reports filed with the SEC.
Now, I’d like to turn the call over to Ken.
Thanks, Cameron. Thank you for joining our fourth quarter call today. Today I want to talk about our fourth quarter and full year operating results. But before I get into that, one housekeeping thing I want to touch upon is we're in the process of finalizing a supplement that we're going to be adding to our website. We think that'll be done in the next week or so and will be posted on our website. The goal of this is to give good transparency into our business and how we make our money. And I think it would be helpful for all our investors. So look for that. Hopefully it'll be done in the next week or so.
Relating the full year and fourth quarter, we had a very good year. If you look at our business, we primarily invest in two distinct areas. First, real estate, securities and loans and real estate debt. And second, a new focus of ours is investing in excess MSRs. Last year was transformational for us as we stabilized operations and reinstated our dividends.
In the second quarter, we paid a $0.10 dividend. In the third and fourth quarter increased that to $0.15. In 2011, core earnings were $118 million or $1.44 per share. And in the fourth quarter core earnings were $32 million or $0.30 a share. Net cash flow in the fourth quarter net of preferred dividends was $18 million versus our common dividend of $15.8 million or $0.15 a share.
Last year we raised $213 million of common equity in March and September. We invested $193 million of that capital at just under a 20% return. Also in December 2011, we made our first investment in excess MSRs and we expect that to be an increased focus of ours going forward.
Newcastle's historical business model has been focused on investing in real estate debt, financing it to term, and earning a net spread. Going forward we expect to add to this business in the excess MSR arena. Late last year, we received a private letter ruling allowing us to qualify excess MSR income as a good REIT asset and good REIT income.
Excess MSRs basically are the mortgage servicing rights and net of a base fee you pay the servicers to perform all the servicing functions and net of the gross fee and net fee results in the excess mortgage servicing right, which is what we invest in.
In the fourth quarter we generated $18 million of net cash flow and if we we're fully invested with our first MSR investment that we made in December, that number would have increased to about $20 million. Again, we paid out $0.15 or $15 million of dividends. So even with that full run rate investment for the quarter, including that plus new investments we're going to make, we see a lot of outside in our dividend and potentially – we have the potential to increase the dividend but we'll make that determination at the end of the quarter, as is the normal course with our Board.
Just looking at our real estate debt portfolio, it's $3.8 billion of assets with a carrying value of $2.9 billion as of the end of the year. It's financed with $2.8 billion of match-funded debt and we earn a net spread on that business.
Now I'll hand it over to Wes to talk about our excess MSR investments and the opportunity in that sector.
Great. Thanks, Ken. Welcome, everyone. As Ken mentioned we made a significant addition to our investing plan here at Newcastle in the fourth quarter and we made an investment that totaled $44 million to acquire a 65% interest in approximately a $10 billion pool of mortgages that were from one of the GSEs.
Earlier in the year we applied to the IRS, as Ken said, for a private letter ruling to clarify that the income from this investment would be a good REIT investment. We received that ruling, which we think is significant and it allows us then to really proceed with this as an investment component of our plan at full speed ahead.
That first transaction, one of the things that Ken mentioned is we're going to be posting some disclosure next week or hope to be next week, on the company broadly speaking but specifically we'll be update our MSR portfolio and giving you real clarity as to what is going on underpinning it.
In particular the things that we will highlight and you'll see in this report certainly on a quarterly basis and we're considering actually updating it monthly as you get prepayments and refinancing activity and the balance of the loan balance of the loan portfolio. So this is a pool that started at $9.9 billion, the current balance at the end of the quarter was $9.7 billion. So there's just the one month of pay downs.
The prepayment rate for the portfolio is 9.5%. And life-to-date the prepayment speed has been about 7%. And the recapture rate on the refinancing of the underlying loans for that first month was 2.9% of the pool. That is very much of an aberrant number and then you'll expect to see that grow dramatically as you get your refinancing pipeline up and running.
So again just to restate kind of what the investment thesis is, you're buying a strip of mortgage servicing in partnership with a major servicer and in this case it's Nationstar is the partner, so we basically bought 65% of the excess, they bought 35% of the excess. One of the key structural elements that we spent a lot of time working on was so that we participate along with them on the refinancing activity on any of the loans that get refinanced inside that pool.
And a really simple example, if you had a $10 billion portfolio and $1 billion of those loans prepaid over the course of the year, so the prepayment speed was 10%. If you were successful in recapturing all of those loans, you'd have the perpetual money machine. You'd be constantly replenishing your loan portfolio and this would go on to infinity. Of course that's not what is possible.
We do think though that based on their experience on other portfolios that a recapture rate of 25%, 35%, maybe as much as 50% is possible. And that adds dramatically to both the stability of the investment as well as to its absolute returns. So one of the things you should look for and we'll report with great transparency, will be the percentage of recapture each one of these investments that we make.
I think our goal is to show this first investment to you, you'll see it with some clarity and we are hard at work on a number of other transactions that we are optimistic will come to fruition in the near-term, which we'll add to that and you'll see a portfolio of these things that are detailed in front of you on a month-by-month basis.
Just a little bit of context on the marketplace and why we're excited about this is that the pipeline for these transactions is a very significant one. The broad-based theme is that the bulk of the mortgage servicing in the United States is still conducted by banks. The total market is about $10.3 trillion in MSRs so there's $10.3 trillion in mortgages that have been serviced. Of that over 90% of it are done by the banks. And one of the things we've seen very clearly over the past several years is a real change afoot where the banks are moving out of that business in a substantial way and non-banks, of which there is a handful, including Nationstar are taking a bigger and bigger role with it.
In the past 18 months we've seen about $250 billion in MSR sales that have been completed and there's a pipeline of over three quarters of $1 trillion dollars of actionable transactions that are being evaluated as we speak. Obviously, we're not in a position to buy all of those. But we do have still about $150 million in free cash flow.
The numbers that Ken ran through and that Brian will touch on our financial results here in a minute, do not presume the investment of that incremental capital. The impact of that, if we were able to invest it under the same terms as this first investment that we made, would be substantial.
In the vernacular that Ken was expressing if our dividend is $0.15 and our free cash flow is about $0.18, full investment of cash on hand would increase that up to about $0.24 per share. So it would have a substantial impact on it. Obviously, that would be something we would take directly into account when we looked at our dividend and obviously if and when that new investment activity comes to pass, you'll see a fee that reflected from us immediately.
So a lot of new words in terms of the excess servicing and MSR and a lot of not previously defined acronyms. We have posted the road show that we used in September. Has been on our webpage ever since then. And I encourage you to take a look at it. It's a very, very basic walk-through of what an MSR is, why we think it's interesting. That also is something that we will look to add to as we get and more detailed and update information on it as well.
And look forward to having a very good year this year. So with that, let me turn it over to Brian. Brian?
Thanks, Wes, and good morning, everyone. Based on Ken and Wes' broader view of Newcastle in the market, I'll drill down on our financial results for the quarter and our liquidity.
In the fourth quarter we had GAAP income of $0.18 per share representing three main components. First, core earnings of $0.30 per share. Second, we had other income of $0.12 per share, which was primarily due to a gain of $0.05 per share on the repurchase of our CDO debt, a net gain of $0.03 on the sale of real estate securities and a gain of $0.03 per share primarily resulting from a mark-to-market gain on our interest rate derivative and our CDOs.
Third, has a $0.24 per share net mark-to-market loss on our loans held for sale, an impairment that we recorded on (eight) real estate securities. Adding components of $0.30 per share, $0.12 and subtracting the $0.24, gets us to the total GAAP income for the quarter of $0.18 per share.
With respect to our liquidity, we currently have $152 million of unrestricted cash and an additional $133 million of restricted cash for reinvestment in CDOs IX and X. We have an $8 million repurchase agreement that is financing $29 million of our CDO VI senior bonds that we purchased back in 2010 and the recourse on this repurchase agreement to the company is limited to 25% of the then outstanding balance of the (repo), which was only $2 million.
We also have $228 million of repurchase agreements that are financing $229 million face of Fannie Mae and Freddie Mac one-year ARM securities. We use this type of investment and related financing for compliance purposes with the Investment Company Act of 1940.
Lastly, I'd just like to touch on some key points. During the quarter we were very active investing the cash within our CDOs, investing $138 million to purchase $159 million face amount of assets at an unlevered yield of 10%. We committed to invest an additional $53 million of CDO cash that we expect to settle soon and we expect to invest the remaining $80 million in the near-term.
Second and lastly, we finalized our 2010 taxable income and we've disclosed that as of December 31, 2010 we had a net operating loss carry-forward of $675 million and a net capital loss carry-forward of $375 million.
Thank you. And we'll turn it over to the operator for questions.
(Operator Instructions) Your next question comes from the line of Matthew Howlett with Macquarie Research.
Yes. Thanks for taking my question. Congratulations on strong cash flows once again. I think that's really the point that I think the market may be missing on the story here. But I guess I really want to focus on what's really driving the earnings. I know you guys have been diversifying away from the CDO business, but really CDO VIII, IX and X continue to generate these very high returns. I calculate the cash-on-cash return just for CDO X is in the mid-20% range. You're not fully invested yet in all three of them. What can you tell us about these returns going forward. Are we still going to get these terrific cash returns from the three of them? They all look like they're in great shape compliance wise?
I'll take that. This is Ken. We really worked hard to stabilize the cash flows generated from these three portfolios and our expectation when we look at our operating earnings and cash flows, we expect those to continue to pay excess interest to us going forward.
And I guess we always ask about CDO IV, and it looked like it's improving a little bit. Could that potentially come online in terms of cash flowing? And then how do you feel about CDO X, it looks like that was the one you've always been sort of slightly concerned about but it just seems like it's been really stable the last few quarters and there's not a lot on watch or anything of that nature.
The three CDOs that are cash flowing to us are very stable and have stabilized. CDO IV, could potentially turn on down the road, I wouldn't say immediately but further out we could get some positive cash flows from CDO IV. But in the near-term we're not expecting that to turn on.
Okay. That could obviously offer potential upside. And then just on buying back the debt, I know you haven't been incredibly active the last two quarters. You bought I think $17 million of face last quarter. Is there still an opportunity to acquire that debt at a significant IRR?
Yes. There are – a large percentage of the holders of our existing debt are banks. And they come out periodically and we're on top of all of them that come out. Yes, and there is – as time goes on there will be good opportunities to buy back debt. So that would be another focus of ours going forward and there will be good opportunities going forward from here.
Okay. Great. And then just moving to the subject of lowering your cost of capital. I calculate you guys have somewhere around $900 million of book value equity. You said that there's only really $2 million of credit recourse debt against the company. You don't have a lot of preferred. You've cleaned out a lot of the preferred in the capital structure. We've seen REITs go out and issue debt somewhere in the high single-digit range and maybe access to preferred market in that range as well. What can you tell us about lowering the cost of capital given the high ROEs that the company continues to generate? I just think that the market would certainly love some clarity on that point.
This is Wes. I think that it's a really good question. In the next kind of phase of life and growth for the company we're obviously very focused on both stable and growing operations but also doing so in as non-dilutive a fashion as possible. And I think that corporate debt is something that we have talked about at some length and I think we'll continue to explore that. And as the company gets larger and has a bigger capital base and more diversified operations that becomes a more and more viable track for us to pursue.
So nothing to report at this moment in time but something is definitely on the radar and we'll see how the next quarter or so goes.
Any additional disclosures just highlighting that capability I think would be really appreciated among the marketplace. It just seems like you guys are really generating these great returns and you're effectively unleveraged. So certainly keep up the good work and thanks for taking my questions.
Your next question comes from the line of Joshua Barber with Stifel Nicolaus.
Hi. Good morning. Following up somewhat on Matt's question, can you talk a little bit more about your $133 million of restricted cash that you noted but you said about $53 million is still awaiting settlement. Is that additional CDO debt repurchases? Or would that be assets within the CDOs that are CDO debt?
No. Those are assets that we're purchasing outside of our repurchase of CDO debt. So those are just straight investments in real estate loans and real estate securities.
Okay. When you look at the duration of the assets in CDO VIII, IX and X, would you say that that’s probably comparable to your weighted average portfolio life of about four year? And how successful have you been in the few quarters of being able to term that out as much as possible?
Most of our assets until we really invest more of the cash are in the CDOs. So it's definitely that weighting is definitely geared to CDOs VIII, IX and X. And we have over the past six to nine months, we'll continue to try and extend out the life if it makes sense in the CDOs in order to keep the excess spread going.
When I look at the disclosures on your CDO cash receipts, about $17.1 million in the quarter. I noticed one of the footnotes noted that about $3.1 million of that interest was some retained and repurchases CDO bonds. Is that something that's new? Looking at previous disclosures you generally just included the excess interest and the collateral fees. How would you say that compares to the cash flow from repurchased CDO bonds that you had throughout the entire year?
We really just tried to give more disclosure so we did just break it down further. The number was always there. It's roughly about $3 million a quarter of interest on that debt. We just wanted to give the breakout specific to exactly what was in the $17 million.
Okay. So – but the $3 million has always been pretty much flowing through for the last year?
Yes. Obviously as we bought back more, it's grown a little bit. But, yes.
Okay. My last question is focusing on new business lines. You guys have talked about the MSR business and the returns there certainly seem very attractive right now. But are there any other places that you're looking at going today. It could even be the old Newcastle business. We've seen some of the other REITs today that have gotten new credit lines and gone back into CMBS and CRE lending. Is that something that you'd like to do with your cash position today and hopefully get some financial flexibility to do that.
The original CBO that we did for Newcastle, we did I guess in 1998, right. It was a long time ago. It was the first that was done. It was really term financed. And the initial thesis of it then is still very much applicable today. It was basically to buy high quality diversified pool of both CMBS and REIT debt. Finance it modestly, to term and manage for interest rate and credit exposure over that period of time and collect the next spread.
That initial transaction did very well. The market really took off from that point and there was a lot of activity. Some of it that ended up not working out so well and some of the more volatile assets like some of the residential stuff and the like, but for us fortunately the lion's share of these CDOs have managed the test of time well.
And really the focus over the period of financial crisis in 2009 and 2010 in particular was to reduce balance sheet exposure so that really the bulk of our investing activity was done inside these locked up debt-financing structures. To the extent that there was a) a good market opportunity to make investments that we thought made sense and b) access long-term financing markets, this would absolutely be a viable part of the investing structure of the company.
And I think both of those things are possible as the world continues to mend here a bit. You haven't seen some CLOs that have gotten done. I'd say the new supply of investable assets has not really regenerated itself in the way that a lot of people including I would have guessed it would have. In other words the CMBS market is still a pretty dormant market when you compare to its heydays in 2005, 2006, 2007.
But circumstances change and I think as again if the economy continues to bump along and things improve, I do think that the structured financing markets will also respond and that'll be a new supply of assets and we would look hard at it.
One of the things that we think is so interesting about the MSR investment is that the supply/demand technical's there are very attractive, i.e., there's a lot more for sale then they are people that are set up to buy them. Since we hit the road in September talked to investors about this, about what our thoughts and plans were for, and then subsequently made the investment, there has been a lot of activity in the sector. So I think the work that we did on the road was a little pioneering four or five months ago. Since then you've had a lot of things written about the various service providers, the biggest being really Nationstar and (Aquin) in particular but there's others.
(Aquin) priced a transaction earlier this week, HLSS, that is a in some part, a form of what we're talking about investing here. They're investing brief includes both servicing advances as well as MSRs and whatnot so it's not a direct comparable to this. But I do think you're going to see a lot of investment activity around this sector given the nature of the assets and we think what one of the things that makes it so attractive is of course that in addition to them being very attractive returns and very cash flow front end loaded, you're also able to achieve those at lower and in our case, no leverage.
So an asset that has got that kind of investment profile without having to take on financial leverage we think is really a terrific asset and that's why we've been there. But that’s not to say that the old business is not a good business because it has been at times a terrific business and we obviously have the infrastructure and the capability to transact if that becomes more actionable.
That's really helpful. But just to clarify one comment. Would you need a – what comes first when you're looking at those business plans? Would you need to be able to do term financing on the right side of the balance sheet or if there was a number of assets that you were comfortable with on the left side of the balance sheet, would you say I'm willing to play with financing that may be less than optimal if the returns are really there on the asset side.
It's not really possible to put it in absolute terms, at least not in my view. I think that the number one cause of death for financial services companies is a lack of liquidity. Bad credit performance. Bad investment will kill you in the long run. But a lack of liquidity we know historically has been the number one cause of death and it certainly was the case from the financial crisis.
We didn't die and in fact lived and are now we think on the road to prosperity. So adhering to that financing principal we think is not just a good idea, but it's a hard and fast rule. That said, if we really thought that the right thing to do would be to lay into that in some capacity and put some form of short-term debt, we would certainly consider it.
But I'm very happy with the position where we are right now, which is we essentially have a balance sheet of term financed assets, cash and unleveraged investments in the form of MSRs. That's a rock solid balance sheet. We like that profile and by and large we intend to continue to pursue that. (inaudible) a direct answer as what you're looking for but I think that that's where it is right now.
I do think it's possible – certainly in the realm of possibility that this year you'll see a return to a more actionable financing market assuming the world continues to move along in a constructive way. But that's – the future is not yet written so we'll find out.
I think we'd all be pretty happy to see that. All right. Thank you very much.
We have reached the allotted time for questions and answers. Thank you for your participation. I hand the program back over to management for closing remarks.
We thank everyone for attending today and we look forward to speaking with you next quarter. Thanks so much.
This concludes today's conference call. You may now disconnect.