Rithm Capital Corp. quarterly report, Q3 FY2013

Business Context and Reporting Period

Rithm Capital Corp. was named New Residential Investment Corp. (NYSE: NRZ) during the period. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2013. The company became an independent, publicly traded REIT following its spin-off from Newcastle Investment Corp. on May 15, 2013. It invests primarily in excess mortgage servicing rights (Excess MSRs), Agency and Non-Agency RMBS, residential mortgage loans and consumer loans, and is externally managed by an affiliate of Fortress Investment Group.

Comparisons with 2012 are affected by the spin-off and the fact that prior-period financial statements were prepared on a spin-off basis and do not necessarily reflect results as an independent company.

Financial Highlights

Metric	Three Months Ended September 30, 2013	Nine Months Ended September 30, 2013	Comparable 2012 Period
Interest income	$21.9 million	$61.1 million	$12.3 million / $18.8 million
Interest expense	$3.4 million	$7.0 million	$0.3 million / $0.3 million
Net interest income	$18.4 million	$54.1 million	$12.0 million / $18.5 million
Other income	$56.2 million	$157.2 million	$1.8 million / $6.5 million
Operating expenses	$11.5 million	$22.1 million	$2.0 million / $4.1 million
Net income	$63.1 million	$185.4 million	$11.8 million / $20.9 million
Basic EPS	$0.25	$0.73	$0.05 / $0.08
Core earnings	$37.9 million	$93.2 million	$10.0 million / $15.8 million

The company reported strong growth in net income, primarily from expansion of the investment portfolio, Excess MSR fair-value gains, consumer-loan equity-method earnings and a gain on settlement of securities. Nine-month net income included $3.8 million of other-than-temporary impairment on securities related to the spin-off. The filing does not present a single revenue figure or a GAAP operating margin; net income as a percentage of interest income plus other income was approximately 80% for the quarter and 85% for the nine-month period, but this is not a company-defined margin.

Balance Sheet, Debt and Liquidity

• Total assets were $2.93 billion at September 30, 2013, compared with $534.9 million at December 31, 2012.
• Stockholders’ equity was $1.26 billion, including $85.8 million of retained earnings and $15.7 million of accumulated other comprehensive income.
• Repurchase-agreement liabilities were $1.47 billion, compared with $150.9 million at year-end 2012. The weighted-average funding cost was approximately 0.90% at quarter-end.
• Cash and cash equivalents were $172.2 million at September 30, 2013.
• Nine-month operating cash flow was $104.6 million; investing activities used $301.1 million and financing activities provided $368.7 million.
• The company stated that available liquid assets, including unrestricted cash and Agency ARM RMBS, were sufficient for short-term recourse liabilities and that expected cash on hand and operating cash flow should meet anticipated needs for the next twelve months, subject to market and financing risks.
• Quarter-end Excess MSR carrying value was $665.6 million, consisting of $307.6 million held directly and $358.0 million through equity-method investees. Underlying mortgage pools had aggregate unpaid principal balances of approximately $242.2 billion.
• Real estate securities had a carrying value of $1.86 billion, comprising $1.28 billion of Agency ARM RMBS and $581.8 million of Non-Agency RMBS.
• Consumer-loan equity-method investments were $192.5 million, representing a 30% interest in companies holding approximately $3.49 billion of consumer-loan unpaid principal balance. Those entities had approximately $2.14 billion of debt at September 30, 2013.

Material Changes Versus the Prior Comparable Period

• Third-quarter net income increased 436.6% to $63.1 million from $11.8 million; nine-month net income increased 786.0% to $185.4 million from $20.9 million.
• Third-quarter net interest income increased 53.7% to $18.4 million. Nine-month net interest income increased 192.1% to $54.1 million.
• Other income increased substantially because 2013 included $20.6 million of Excess MSR equity-method fair-value gains, $24.1 million of consumer-loan earnings and an $11.2 million securities settlement gain in the third quarter.
• Operating expenses increased to $11.5 million in the quarter, reflecting the post-spin-off management fee, incentive compensation and higher public-company costs. Nine-month management and incentive compensation to the affiliate totaled $6.7 million and $5.3 million, respectively.
• The company made significant new investments during 2013, including Agency and Non-Agency RMBS, Excess MSRs, reverse mortgage loans and consumer loans. The balance sheet expanded more than fivefold from year-end 2012.
• Dividends declared were $0.175 per share for the third quarter and $0.245 per share for the nine-month period. The third-quarter dividend totaled $44.3 million and was paid in October 2013.
• Agency ARM RMBS net interest spread was 0.94% at September 30, 2013, versus 1.08% at June 30, 2013. Non-Agency RMBS net interest spread was 2.85% at quarter-end; the MD&A also cites 2.83% in a comparative discussion.

Outlook, Commentary, Risks and Unusual Items

Management expected continued opportunities in Excess MSRs as banks and non-bank servicers sell servicing interests, but noted that competition, pricing and availability could reduce future returns. The company expected to continue co-investing with Nationstar, while acknowledging that Nationstar has no obligation to offer future opportunities.

• Excess MSRs are valued using Level 3 discounted-cash-flow models that depend materially on prepayment, delinquency, recapture, excess servicing spread and discount-rate assumptions. A 10% increase in the discount rate would reduce the estimated fair value of directly held Excess MSRs by approximately $12.1 million and those held through equity-method investees by approximately $15.2 million.
• Nationstar serviced all underlying Excess MSR pools and the entire Non-Agency portfolio was serviced by Nationstar, creating significant counterparty and servicer-concentration risk. Springleaf serviced or was expected to service the consumer-loan portfolio.
• Repurchase agreements were subject to maturity, refinancing and margin-call risk. A $342.9 million term agreement was replaced on October 30, 2013 with a $414.2 million facility bearing interest at LIBOR plus 1.75% and subject to margin provisions and financial covenants.
• Subsequent to quarter-end, the company committed $32.3 million and $23.3 million to additional Excess MSR investments, subject in part to GSE approval, and committed $106.6 million to purchase non-performing loans with approximately $197.3 million of face value.
• The company intended to qualify as a REIT and generally distribute at least 90% of REIT taxable income. Failure to maintain REIT qualification could result in corporate-level taxation, reduced distributions and potential NYSE delisting.
• The company also relied on an exemption from registration under the Investment Company Act of 1940; regulatory or portfolio changes could impair that exemption.
• No material litigation was reported as of the filing date. Management stated that disclosure controls and procedures were effective and that no material changes had occurred in internal control over financial reporting.
• Effective November 13, 2013, Michael Nierenberg became Chief Executive Officer and President, and Susan Givens became Chief Financial Officer and Treasurer. Kenneth Riis resigned those roles, and Robert Williams resigned as CFO.

Important Facts for Investors to Verify

• Whether reported earnings and core earnings remain sustainable after separating recurring cash income from fair-value gains, securities gains and other unusual items.
• The performance of Excess MSR portfolios relative to the filing’s prepayment, delinquency and recapture assumptions, including sensitivity to higher prepayments or lower recapture rates.
• Nationstar’s and Springleaf’s servicing performance, liquidity, regulatory standing and ability to continue servicing the underlying assets.
• Repurchase-agreement renewal terms, collateral haircuts, margin-call exposure and the company’s ability to refinance short-term borrowings.
• The cash coverage of dividends, given the distinction between GAAP earnings, taxable income, core earnings and cash received from equity-method investees.
• Credit performance and valuation of the Non-Agency RMBS and consumer-loan portfolios, including delinquencies, defaults, loss severity and impairment risk.
• The company’s continuing compliance with REIT and Investment Company Act requirements, including the treatment of Excess MSRs and consumer-loan investments.
• Post-quarter-end commitments, including additional Excess MSRs and non-performing loans, and their effect on liquidity, leverage and concentration risk.