Rithm Capital Corp. quarterly report, Q3 FY2018

New Residential Investment Corp. (now Rithm Capital Corp.) — 2018 Q3 Form 10-Q

Business context and reporting period

The filing covers the quarter and nine months ended September 30, 2018. New Residential was a publicly traded REIT focused primarily on mortgage servicing-related assets, residential mortgage-backed securities, residential mortgage loans and consumer loans. The company operated through Servicing and Originations, Residential Securities and Loans, Consumer Loans and Corporate segments and was externally managed by FIG LLC, an affiliate of Fortress Investment Group.

The financial statements are unaudited and presented in accordance with U.S. GAAP. The company completed its acquisition of Shellpoint Partners LLC on July 3, 2018, adding mortgage origination, servicing and recapture capabilities.

Financial performance and key metrics

Metric	Three months ended Sept. 30, 2018	Three months ended Sept. 30, 2017	Nine months ended Sept. 30, 2018	Nine months ended Sept. 30, 2017
Interest income	$425.5 million	$397.7 million	$1.213 billion	$1.162 billion
Net interest income	$262.7 million	$272.4 million	$791.8 million	$823.5 million
Servicing revenue, net	$175.4 million	$58.0 million	$538.8 million	$269.5 million
Gain on sale of originated mortgage loans	$45.7 million	—	$45.7 million	—
Income before taxes	$199.0 million	$272.3 million	$989.7 million	$835.3 million
Net income	$195.5 million	$239.7 million	$995.7 million	$714.3 million
Net income attributable to common stockholders	$184.6 million	$226.1 million	$963.6 million	$669.2 million
Diluted EPS	$0.54	$0.73	$2.86	$2.21
Dividends declared per share	$0.50	$0.50	$1.50	$1.48

Net interest margin pressure was evident: interest income increased, but interest expense rose faster, increasing by $37.5 million year over year in the quarter and $82.4 million for the nine-month period. The filing does not provide a consolidated GAAP net margin percentage; reported net interest income was approximately 61.7% of interest income in the quarter and 65.3% for the nine months.

Management reported non-GAAP core earnings of $214.7 million, or approximately $0.63 per share, for the third quarter and $606.9 million, or approximately $1.81 per share, for the nine months. Core earnings exclude or adjust for fair-value changes, impairments, incentive compensation, deferred taxes and other items and are not a substitute for GAAP net income.

Balance sheet, cash flow, debt and liquidity

Total assets were $30.091 billion at September 30, 2018, up from $22.214 billion at December 31, 2017.
Total equity was $5.837 billion, including $5.743 billion attributable to New Residential stockholders, compared with $4.796 billion and $4.690 billion, respectively, at year-end 2017.
Cash and cash equivalents were $330.1 million; cash, cash equivalents and restricted cash totaled $485.9 million.
Debt obligations were $21.642 billion, consisting principally of $14.387 billion of repurchase agreements and $7.255 billion of notes and bonds payable. Weighted average funding cost was 3.36% and weighted average debt life was approximately one year.
Available financing capacity was $3.281 billion against total borrowing capacity of $8.198 billion.
Net cash used in operating activities was $75.8 million for the nine months, compared with $617.8 million used in the prior-year period. Net cash used in investing activities was $5.024 billion, while net cash provided by financing activities was $5.140 billion.
Management stated that cash on hand, operating cash flow and the ability to roll repurchase agreements and servicer-advance financings were expected to satisfy anticipated liquidity needs for the next 12 months, subject to market and refinancing conditions.
The company had $14.4 billion of repurchase-agreement margin exposure. It was in compliance with all debt covenants at September 30, 2018.

Portfolio and material changes versus prior comparable periods

Mortgage servicing rights were $2.872 billion at fair value, versus $1.736 billion at December 31, 2017. MSR financing receivables were $1.681 billion, versus $599 million.
Servicer advance investments declined to $799.9 million from $4.027 billion, primarily reflecting the Ocwen transaction and related reclassifications.
Real estate and other securities increased to $11.650 billion from $8.071 billion. Non-Agency RMBS represented $8.976 billion of fair value and Agency RMBS represented $2.674 billion.
Residential mortgage loans held-for-sale increased to $1.996 billion from $1.726 billion, and newly originated loans held-for-sale at fair value totaled $524.9 million.
Consumer loans held for investment declined to $1.141 billion from $1.374 billion.
Direct and equity-method Excess MSR investments totaled approximately $622.0 million at September 30, 2018, compared with $1.345 billion of direct and equity-method carrying value at year-end 2017; the reduction primarily reflected the Ocwen transaction.
Servicing revenue increased $117.3 million in the third quarter and $269.3 million for the nine months, driven by MSR acquisitions, Shellpoint and favorable valuation changes associated principally with lower prepayment rates and higher custodial earnings.
Other income declined by $170.4 million in the third quarter because of negative fair-value changes in MSR financing receivables, compared with a large positive valuation gain in the prior-year quarter. For the nine months, other income declined by $56.9 million.
General and administrative expenses increased $78.7 million in the quarter and $91.4 million for the nine months, primarily due to Shellpoint-related compensation and operating costs.
Net income attributable to common stockholders declined 18.4% in the quarter but increased 44.0% for the nine months. Diluted quarterly EPS declined from $0.73 to $0.54, while nine-month diluted EPS increased from $2.21 to $2.86.

Shellpoint acquisition and unusual items

The company acquired Shellpoint for cash consideration of $212.3 million. Total acquisition consideration, including $42.8 million of contingent earnout consideration and $180.3 million related to settlement of preexisting relationships, was $435.4 million. The transaction added preliminary goodwill of $48.9 million and may require up to $60.0 million of future earnout payments. Shellpoint contributed $97.0 million of revenue and $11.7 million of net income from the acquisition date through September 30, 2018.

The Ocwen arrangements resulted in significant reclassification of Excess MSRs and servicer advance investments into MSR financing receivables and related receivables. Through September 30, 2018, approximately $334.2 million of related lump-sum payments had been made or accrued to Ocwen, and a $279.6 million fee restructuring payment was made in January 2018.

The company recorded $23.2 million of other-than-temporary impairment on securities for the nine months, compared with $8.7 million in the prior-year period. Valuation and loss provisions on loans and REO were $28.1 million, down from $65.4 million. Accumulated other comprehensive income increased to $469.0 million from $364.5 million at year-end 2017.

Guidance, outlook, commentary and risks

Management expected additional MSR sales and opportunities to acquire servicing assets as banks and capital-constrained non-bank servicers continued to sell mortgage servicing portfolios, but noted that competition had tightened spreads and made accretive investments more difficult to source.
Management viewed rising interest rates as generally favorable for MSR values through lower prepayment rates, but noted that higher rates increase borrowing costs and can pressure certain asset values and liquidity.
A 50-basis-point increase in short-term rates was estimated to reduce next-12-month cash flows by approximately $14.4 million. Separately, the same increase was estimated to increase net book value by approximately $399.1 million, while a 25-basis-point widening in credit spreads was estimated to reduce net book value by approximately $198.4 million.
Key risks include refinancing and margin-call exposure, counterparty concentration, reliance on Nationstar, Ocwen, Ditech, PHH and other servicers, delayed or unrecoverable servicer advances, prepayment and delinquency assumptions, credit losses in Non-Agency RMBS and consumer loans, illiquid fair-value estimates and regulatory changes affecting mortgage servicing.
The Shellpoint acquisition introduced additional mortgage origination, servicing, licensing, consumer-protection, repurchase and litigation risks.
Pending or unsettled MSR transactions remained subject to third-party consents and other conditions, including approximately $3.7 billion of PHH-related private-label MSR UPB with a purchase price of approximately $21.0 million that had not settled.
The company intends to maintain REIT status and its exclusion from registration under the Investment Company Act, but failure to satisfy the applicable requirements could materially affect taxes, operations, leverage and distributions.
The board declared and subsequently paid a third-quarter dividend of $0.50 per common share. The filing provides no formal earnings or dividend guidance beyond management’s liquidity expectations.
Management concluded that disclosure controls and procedures were effective and that there were no material changes to internal control over financial reporting during the quarter.

Most important facts for investors to verify

Whether the large increase in reported earnings for the nine months is sustainable after separating Shellpoint contributions, fair-value changes, Ocwen-related reclassifications and other unusual items.
The sensitivity of MSR, Excess MSR and MSR financing-receivable valuations to prepayment, delinquency, recapture and discount-rate assumptions.
The company’s ability to renew or replace short-term repurchase and servicer-advance financing and to meet potential margin calls.
Exposure to Nationstar, Ocwen, Ditech and PHH, including servicing performance, regulatory matters, transfer consents and counterparty or bankruptcy risk.
Actual recoverability and timing of the $3.217 billion servicer advances receivable and the company’s future advance-funding requirements.
Credit performance and valuation of the $8.976 billion Non-Agency RMBS portfolio, residential mortgage loans and consumer loans.
Progress and final accounting for the Shellpoint acquisition, including contingent earnout payments, goodwill and integration costs.
Compliance with REIT qualification, Investment Company Act exclusion, debt covenants and applicable mortgage-servicing licenses and regulations.
Differences between GAAP earnings, core earnings, taxable income and cash available for dividends.