At this time, I would like to welcome, everyone, to the Newcastle first quarter 2012 earnings conference call. (Operator Instructions) I would now hand the conference over to Ms. Ivy Hernandez.
Thanks and good morning. I'd like to welcome you today, May 10, 2012, to Newcastle's first quarter 2012 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'd 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, Ivy. Thanks everyone for joining our first quarter earnings conference call. Before I go into the discussion on the first quarter, I want to let everybody know that in addition to posting our press release last night, we also posted our first quarter supplement on our website at www.newcastleinv.com.
Since first doing this in March, we see the lot of positive feedbacks. And I think it's a good resource for our shareholders to gain a better understanding of how we make our money. And now, we slide into the quarter.
We had a great first quarter in first four months of the year. Our portfolio continues to generate stable cash flows and we are seeing attractive investment opportunities to deploy capital at 18% to 20% return.
Our first excess mortgage servicing investment is performing better than expected, which we'll discuss in a minute and our operating metrics continue to improve. Quarter-over-quarter, core earnings improved $0.03 to $0.33 per share and cash available for distribution increased $1.5 million or $0.02 per share to $0.19.
We have been very active on the investment side. In the quarter we committed to invest $170 million in excess mortgage servicing rights and purchased $70 million of assets for our CDOs. Our MSR pipeline is robust and we expect to deploy additional capital in the sector in the near term.
On the call today, Wes and I will highlight our activity in the real estate debt and excess mortgage servicing businesses. And Brian will close with a discussion on the overall financial highlight for the quarter. So let's first talk about the real estate debt business.
In the quarter this segment generated $35 million of total cash flow, an increase of $1.5 million over the fourth quarter. The overall value of our real estate debt portfolio increased by $100 million or 3.5% to an average price of 97.5% of par. And I see meaningful upside from here as credits improve and spreads tighten.
The over collateralization in CDOs VIII, IX and X has been stable and currently stands at $233 million. In the coming quarters, I expect the OC in these three CDOs to remain constant with the potential to increase slightly, as we successfully workout and restructure assets or receive payouts of higher valuations in the current amount of OC credits received in the CDOs.
We ended the quarter with $95 million of restricted cash to invest in our CDOs. We invested $60 million to purchase $70 million face amount of CMBS, ABS and commercial real estate loans at an average price of 87% of par and average yield of 10%.
Finally, resourced and repurchased $30 million of our CDO liability. In the quarter, we bought 100% of the A-3 class in CDO X at a price of $30 million, investing $9 million as an expected return of 18%.
Since we started buying back our CDO liabilities in 2008, we have repurchased a total of $950 million at an average price of $0.38 on the $1. We continue to have active dialogue with current third-party holders anticipate increased selling in the coming quarters.
Now, I'll pass it over to Wes, our Chairman.
Thanks Ken, welcome everyone. I'm going to give just a few comments on the newest lines of business, the mortgage servicing rights excess servicing interest that we have invested in and a couple of thoughts on those markets.
As we have told you before, we've made a handful of investments in the sector. We've currently have or we've committed to about $250 million of investment in MSRs. The first investment which we've made back in November is detailed in our supplement you can see it up on our webpage. The performance of that investment continues to be terrific. We made a $44 million investment. It has been slower in prepayments that we anticipated.
The recapture rate which is our term that we created to describe the refinance activity by Nationstar which is our partner on this investment, on has been terrific and it has gone really pretty much inline with what we had hope where they startled out, obviously are recapturing zero because it was a new portfolio to them.
The last couple of months it is averaged around 35%, so we captured about a third of them. The net of all that in terms of the returns to investors or our shareholders has been a terrific one. We have a life-to-date return in the low 20s on unleveraged basis, about 23%. And we've gotten back about 17% of the investment that we have made, only a few short months ago.
So the characteristics of these investments are mid-teens, mid-20s, on leverage returns based on our expectations with a significant amount of upside, either prepayments coming a bit slower, the defaults are bit slower or certainly the interest rates are to rise at some point and prepayment sort of slow down substantially.
So we feel great about that. That's the first one. The second one we have committed to is expected to close here in the next couple of weeks which is the MSRs from the Aurora Bank transaction. Aurora was the bank that is owned by the bankrupt Lehman Brothers of state. They had a large servicing portfolio, just about $66 billion at the time we committed. It's now $63 billion that schedule to close in the next couple of weeks.
And our investment to that is going to be about a $170 million plus or minus. So we feel great about that. We've got a third of these transactions, so we expect to get down with in the very near term, we're very close to kind of final closure on that. And then there was a fourth transaction that is quite a large one that still very much pending, but we're very optimistic it's going to come to pass here in the next couple of days.
So needless to say, there is a lot of activity around that, and we think the dynamics again for that business in that sector for us continue to be very attractive ones. And the returns, as you can see from the supplement, kind of highlight why we think it's such a compelling and interesting career for us.
In addition to the MSR investment, one of things that we've been very focused on is that as our partner in these transactions, Nationstar as they have added to their portfolio of non-agency securities that they have service that has opened up a new window for us to look at investments that we think are also very attractive on the security side.
So Nationstar themselves were a modest issuer of securities, kind of historically they had originated a handful of billion dollars of transaction that they service. They than with this Aurora transaction they add another $63 billion of which a big chunk of that about $45 billion over there, so is non-agency security they service.
This other transaction which is pending is incrementally another big chunk of that as well. So we did end up with well over a $100 plus billion in securities that are service spot Nationstar.
That the enrollments to us from an investment standpoint is that we have made our first quarter investment of any kind of consequent in a security which is solely service by them. We bought a security back few weeks ago that was part of the Maiden Lane transaction. It is a $42 million current base security. We bought in un-leverage basis that it returned plus or minus around 10% with any kind of modest leverage at all that moves into the mid-teens or low-20s.
And obviously the thing that we're focused on there is about the performance from the credit standpoint of the security, would it be service by Nationstar, we take a look of great deal will come from that. Also we think that with HAMP and other prepayment initiatives that are in the marketplace, there is a good potential with a good servicer and a good originator, both of which we think is the case with Nationstar, then the increased prepayments, any kind of margin on increasing prepayments on a portfolio investment like this would have a substantial impact on returns.
And just to put some context and it's been prepayment about 2% which also generates a 10% on leverage return, if that 2% went to 5%, it goes in the mid-teens, then if went 10% it goes into the low-20s on unleveraged basis.
A lot of wood to chop. It is something that I think you'll see more from us again as Nationstar continues to add servicing on those non-agency securities. That's something that we think is interesting and that's something we're going to be focused on. So a lot of more that to come.
As Ken said, we're excited about the quarter. We think it has been a good quarter, and we're excited about the pipeline of investments activities. And with that, I'll turn it over to Brian.
Thank Wes. We had good financial results in the quarter. First we had GAAP income of $0.68 per share, this included core earnings of $0.33 which was up 10% or $0.03 from Q4.
In the quarter, we had a gain of $21 million or $0.27 per share in connection with the purchase of our CDO debt. We generated $20 million of cash available for distribution of CAD in the quarter, an increase of 8% over Q4 and in March we declared our first quarter dividend of $0.20 per share, up from $0.15.
As Ken and Wes described, we have been breaking out our results by our two business lines. This quarter we show the full effect of our first Excess MSR investment. And while the MSR business only generated 10% of our total cash flow, we expected to grow to approximately 40% with a full quarter of the overall investment.
As we close on our outstanding commitments, our operating earnings and cash flow naturally increased. In the first quarter, we had approximately $140 million of average uninvested cash on our balance sheet. Putting that capital to work is an 18% return with increased quarterly CAD by $0.04 to $0.05, which could potentially grow our dividend to $0.23 to $0.25.
Although, we currently have $220 million of unrestricted cash, we expect to close on the Aurora transaction later this month, leaving around $50 million of cash to invest. We currently have an additional $55 million of restricted cash in our CDOs, all of which is held in CDO X and which we expect to invest in the near term at 8% to 10% on unlevered yields.
Lastly, we are pleased to have had three new research analysts, pickup coverage of our company in the past couple of months. Combined with the two analysts that have been with us for a while, we think investors will have great resources at their disposal to learn more about our company. The contact information for all our research analysts can be found on our website in the Investor Relation section.
That ends our prepared remarks. We will now take your questions.
(Operator Instructions) And your first question comes from the line of Josh Barber with Stifel Nicolaus.
Josh Barber - Stifel Nicolaus
First, the supplemental information is very helpful, so thank you for posting that. Two quick questions. You mentioned in this quarter's supplemental report it looks like the CPR and your original $9.9 billion MSR deal is about 30%. I believe in the original underwriting there was 20%. Can you talk about what's going on with that portfolio in light of assumptions have changed?
The average prepayment rate for the life of the pool was 20%. So we factored in a spike in prepayments for that and through the HARP 2.0 period through December 2013. And if you look on in our supplement, you'll see a ramp prepayment rate going up to 30% for the next 18 months, but on average it's 20%. And as you can see in April, our prepayment rate was only 13. So materially lower than what we've projected in our prepayment assumption.
Josh Barber - Stifel Nicolaus
Across the entire duration, would it still be 20% or so?
Josh Barber - Stifel Nicolaus
Wes, you referenced a larger deal and I think we all have an idea of what that is. Can you talk about, would that be something that's fully done or will that be something that done in conjunction with a number of other Fortress entities?
I think there's been a lot that has been reported on it. I mean one day I would say there's obviously been a lot of activity from our standpoint. We've spent a lot of time working on this large deal and I think it will come to pass one way or the other, in the next handful of day.
So it's near the end of the period, at least would either start our involvement or end our involvement with it. And we're pretty optimistic how it's all going to turn out.
With regards to how that capital be provided and what we're thinking about there. I think it's safe to say that there is a lot of interest in investing in the MSRs across the firm. We have lots of different capital that we manage in addition to that.
And so we'll make an allocation process that's consistent with the capital availability, diversification, and other kinds of factors. So I know that's probably not as clear response as you'd like, but I think under the circumstances that's probably best I can do.
Your next question comes from the line of Jason Stewart with Compass Point.
Jason Stewart - Compass Point
One strategic question, when you think about the size of the market opportunity and your balance sheet. Is there an optimal size or is there a point at which making the marginal investments it creates problems down the road or is that is such a nascent industry that you've got a tremendous ramp to go?
I think if you step back and look at the size of the mortgage servicing business in total. If there's just over $10 trillion in mortgages in the U.S., and let's make the example simple, let's assume, if the servicing is worth roughly 1% on that, that's not probably precisely right, but it's a good estimate.
So the market then would be a $100 billion addressable market, which sounds like a great tech market, and in fact it is. But historically, the vast majority of that asset class was owned by the banks and was created by them, as they created mortgages and sold them along, and it never really traded.
So the market seemed quite large, but in true actionable amount it was actually quite small. That has changed fairly, dramatically in the past year or so, where for a variety of reasons, which we've talked about before. But for a variety of reasons the banks I think are less good owners of the asset, both from a regulatory capital, from the regulatory standpoint, from just kind of the headline exposure of it. But I think that they are less good owners. And so if you think that, 90 plus percent of the business is owned by the banks today.
So if there are $90 billion of the $100 of actionable amount and some material portion of that is sold which indeed we've seen $300 to $400 billion that could easily be two or three times of that in the near terms. So it's actually sold. Then you're looking at potentially market of $10 billion or $20 billion or $30 billion in transactions over a relatively short period of time, over a coupled year of period.
I do think we are on the very early edge of what's should be a substantial amount of activity and that's exciting and interesting for us. And so obviously in the context of all that we're trying to make every marginal investment be a good one and we've got the two that we've committed to. The third, we're very close to and a fourth potential is very close to as well. So that's a great place to start.
We've tried to get great clarity. In fact, even before we made our first investment, we actually did a road show. We talked to investors to tell them that we're thinking about this, because I wanted to have people to have a sense of exactly what we thought of the opportunity and what it was. And I think that that was the right thing to do, and we did that earlier last fall. And that's been followed by obviously a lot of activity, but we do think that there is hopefully a long, long ways to go.
Jason Stewart - Compass Point
The disclosure has been incredible, we all appreciate that. Along this line with your balance sheet, have you thought about what's your philosophy on adding debt to return to action to an investment like excess MSRs?
One of the things I'd say, when Ken was just starting about prepayments a minute ago, one of the great things about this type of investment is you can get really excellent performance early, it reduces your risk substantially. So in the first five months of this, one that we show in the supplement, having prepayments today of just about 10% versus a forecast of 20% to life, when you have no debt on it and that money comes back. It obviously educes your basis rapidly. And it reduces kind of the tail exposure that you have fairly substantially.
So I understand your arithmetic. If we add a leverage to it, it would increase the returns a lot. It would also increase the risk of it a fair bit as well.
So one of things that we have thought a lot about and I do think that this is just leads into this first investments that we made in this non-agency security is that if we can make investments in other assets that have excellent returns and good profiles and do so again on a very low leverage on un-leverage basis, that gives a lot of balance sheet flexibility because one of the elements of the MSR investments is that they are fairly episodic and see make a commitment.
And then it funds at some point in the future and you don't want to have either an unfunded balance sheet, that's a very bad idea and a good way to go out of business, nor do you want to have just a bunch of capital that sits around, that's un-invested. And so I think making investments in some of the related securities and doing so on a low leverage basis, gives us a lot of balance sheet flexibility and then also gives a good kind of base level of return to shareholders during the time when you committed and not yet invested.
So as the portfolio gets bigger and it's gets little more diversification, I think you'll see that play out a little bit. But that's obviously what we're focused on. And that's what this first investments represents and so kind of more on that to follow up.
Jason Stewart - Compass Point
And then just one final quick one, the non-agency securities that you're purchasing on a Maiden Lane, is this going into the CDOs or on balance sheet?
The one that I talked about was actually just on balance sheet.
Your next question comes from the line of Bose George with KBW.
Bose George - KBW
Actually just on the portfolio, the MSR that you guys purchased in December, I mean given that the prepayments are so low. I'm wondering what your thought are there on HARP, do you think it's just coming in a lot lower than expected, that it's going to kick in later than expected. Just curios how you're thinking about that?
I think there have been a number of government initiatives since the financial crises to try to encourage repayments, obviously getting people that are overly leveraged on there house, to be able to take advantage of low interest rates is a good thing for consumers. It's a good thing for the housing market. It's just a good thing for, in terms of what the governments are trying to support.
That said, the net impact of those prepayment program to date, I think has been disappointing to the government and considerably less than what has been forecast. I think that the latest around of it, we think the latest around of it is the most comprehensive, the most actionable and the most potential.
And it still is not really a noble kind of what the impact is going to be. We think it could have a big impact, that's obviously what Ken mentioned in the prepayment speech, we do think that there is a factor of a surge of prepayments here in the next handful of months. But it has not really manifested itself yet obviously on this portfolio, nor we've seen it kind of more broadly.
Bose George - KBW
And then just, that you're thinking in kind of longer term in terms of your MSR investment opportunities. Do you envision other companies competing directly with Nationstar against you for some of these assets? I mean could that potentially happen?
Look mid-teens and mid-20s on leverage returns is attractive, right? So we do think that there is a lot of interest in trying to access them. That the good news is that it's relatively difficult to kind of put all the pieces together to compete against it, right? Because when you think about it from our standpoint, we wanted to be partners with a servicer that, number one, is a great servicer because performing loans don't prepay and defaulted loans is excess of prepayment. So keeping people in there house and making there payments is a big part of the picture.
Number two, we want to invest with a partner that has a lot of capital so that they co-invest with this. There interests are in line, kind of shoulder to shoulder. And number three, and it's a new launch but it's a really important one is that we want a servicer treats other borrowers like customers and actually is a big participant in every financing activity.
And that's a productive thing in terms of elongating the life of that MSR and it really does shut down the tail exposure to the dramatic win, it's been a big, big part of this. That's why this whole notion of recapture that is a term that we coined and I think it's sounds like a child's game but it's actually it's an important element of the returns.
If you can recapture substantial portion of those people that are going to refinance anyhow, in the ordinary course, it really does adds to the base level of returns substantially and it cuts down the tail exposure dramatically.
So you add those three things up and you say how many servicers out there that are great servicers that have a lot of capital. That also really, really capable financing kind of parties and it's a pretty short list. But there is certainly are competitors and I expect competition and obviously we know that by being transparent with what we own, it's good for investors, it's also probably good for our competitors, because they can see directly (inaudible) and that's the bad news. But I think on balance, it's a really good thing for shareholder. So we're prepared to be competitors and hopeful we will win more than our share.
Your next question comes from the line of Matthew Howlett of Macquarie.
Matthew Howlett - Macquarie
It's just a follow-on of the first pool, it's clearly prepaying at the ramp is below of what you guys thought it was. And HARP hasn't been as effective as we once thought it could have been. But the issue is with just cross-servicers or refis? Is it just simply what you guys have seen arbitrage with other servicers not coming in and willing to underwrite or refi someone else's pool? And despite HARPs attempt to try to get that to happen, to indemnify origination, simply hasn't happened yet?
I don't know the specific answer to that. What I will tell you as you think about a consumer facing business, one of your large costs is that of customer acquisitions, right? So if you're in a consumer business and you're trying to sell more or transact more, or whatever you're doing. A big, big part of your cost structure is to go out and pay to kind of acquire those customers.
One of the beauties of refinancing, our existing customers at Nationstar is that there existing customers. And so our hot leads comes from people picking up the phone and calling us and telling us they'd like to refinance. That's a great place to start.
Obviously, there's a lot of technology that can use to try to identify people that are looking to refinance albeit. They start to pull down credit scores from bureaus and things like that. There's a whole host of other things that are going to besides simply answering the phone.
But I do think that at Nationstar they have made a recapture of focus of their origination activities. It's been a very productive focus thus far. And we're very keen on having as many of those customers stay with us as possible. From an MSR standpoint, we could recapture a 100% of either perpetual money machine all right so, and 100% is not possible.
What we've seen and even demonstrate there, we've gone from zero to four, 16, 35, 33, 36. I mean the numbers are pretty consistent and we hope that that's going to continue to be the case.
Matthew Howlett - Macquarie
Now, the government, from what I can tell, is expanding HARP. I mean I think there's another bill working its way to Congress. I mean anything I think to address some of the cost-servicing issues and other things like HARP isn't working. Is there anything out there? From my sense, the market really isn't paying much attention to it, doesn't think it will be effective. Do you think there is some fatigue in Washington that they've basically tried to announce and there's been nothing else monumental in terms of trying to get refis going again?
Look I think that if you can take people that are paying 6% and get them to take advantage of the current interest rate and pay 4% that's good for them and stimulated for the economy. There's a lot of good signs behind that. I think the practical limitations of making it all happen has been challenging.
And now I think it's not just the burnout in Washington, I guess it's burnout with the borrowers, right. They've been contacted, lord knows, how many times over the past four years, but people are trying to refinance in some way they perform. So I think there's a lot. And today anecdotally I've heard from the origination, so there is a lot of burnout with people who've gotten dozen solicitations, this is the 13th one and even now it really works.
I do think that there is going to be an impact. We think there is. And so obviously modeling that into our numbers is a 100% the right thing. But I do think your point about disappointment, I think that the government has to be disappointed that they things they try to do with the best of intentions over the past couple of years have not been as successful.
They'll continue to try though. And one of these times, I think you'll get it right, get a big (search). That's why actually being aligned with an originator is so important obviously.
Matthew Howlett - Macquarie
And then just moving to just a broader question, I mean CDO X's reinvestment period is coming to an end in the summer. You guys have always had a big presence in the origination space, as an issuer, as a lender. And with all of the CDOs now exiting their reinvestment period, how will you be keeping the origination by platform going on the commercial side? I mean you have excess securitization, because you've been a big issuer. I mean what are the plans in the commercial and to keep the platform going as these reinvestment periods end on your existing CDO portfolio?
Well, as you see we are very active in reinvesting cash in our CDOs at very good returns, in assets that are trading in a discount, high yields, unlevered returns say 10% as we did in the last quarter. And we're seeing great opportunities there. And we're able to be very selective, because we have a selective amount of capital to invest.
Going forward, it really depends on what happens in the financing markets and how we're able to very conservatively finance without taking a lot of market-to-market or recourse financing against the assets that we want to buy.
Not to say that that market isn't going to come around. I'm hearing that as the economy improves and credit spreads tighten, I think you'll see the financing markets come back on the commercial real-estate side and I think we're obviously very ready to take advantage of that.
Matthew Howlett - Macquarie
That was going to be my question, I mean how much you're open to CRE, CDO market. As again, I know that's coming back but would you look to just make loans and then D notes and (mezzanine loans) securitize and just access the market, that's why you hold on to the BPs like you have done traditionally? Is that how you would look to access the commercial markets again?
Yes. I think so. I think that's a very viable alternative for us going forward and again as you want flexibility in our financing to give us ability to manage the portfolio that we acquire. And if we're able to finance ourselves that way, it's a great opportunity for us. And it's not here today but I think it will evolve over the coming month.
That is the all I have time for questions and answer sessions for today. I hand the program back over to management for further comments or closing remarks.
Thanks again, for joining us today. We appreciate your participation and we look forward to speaking with you next quarter.
Alright, thanks everyone.
That does conclude today's conference call. And you may now disconnect.
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