Business Context and Reporting Period
Rithm Capital Corp. was then named New Residential Investment Corp. (NYSE: NRZ), an externally managed Delaware REIT focused on residential mortgage-related assets. The unaudited Form 10-Q covers the three and nine months ended September 30, 2014, with comparisons to the corresponding 2013 periods. The company became independent from Newcastle Investment Corp. on May 15, 2013; therefore, pre-spin-off comparisons are not fully comparable.
Principal investment segments were Excess mortgage servicing rights (MSRs), servicer advances, real estate securities, residential mortgage loans, consumer loans and corporate activities. Nationstar was the servicer for the company’s Excess MSR and servicer-advance investments, while Springleaf serviced the consumer-loan portfolio.
Financial Position and Key Metrics
| Metric | Three months ended September 30 | Nine months ended September 30 |
|---|---|---|
| Interest income | $97.6 million, versus $21.9 million | $261.7 million, versus $61.1 million |
| Net interest income | $64.3 million, versus $18.4 million | $152.9 million, versus $54.1 million |
| Other income | $122.1 million, versus $56.2 million | $335.0 million, versus $157.2 million |
| Net income | $152.1 million, versus $63.1 million | $391.2 million, versus $185.4 million |
| Net income attributable to common stockholders | $126.4 million, versus $63.1 million | $298.6 million, versus $185.4 million |
| Diluted EPS | $0.88, versus $0.49 | $2.16, versus $1.45 |
| Dividends declared per share | $0.35, versus $0.35 | $1.20, versus $0.49 |
- Total assets were $7.77 billion at September 30, 2014, up from $5.96 billion at December 31, 2013.
- Common stockholders’ equity was $1.58 billion, compared with $1.27 billion at year-end 2013; total equity, including noncontrolling interests, was $1.86 billion.
- Cash and cash equivalents were $187.6 million, compared with $272.0 million at December 31, 2013. Restricted cash was $30.0 million.
- Investment balances included $3.21 billion of servicer advances, $751.8 million of Excess MSRs held directly and through equity-method investees, $2.08 billion of real estate securities, $1.12 billion of residential mortgage loans and $264.0 million of consumer-loan equity investments.
- Debt obligations were $5.59 billion, consisting primarily of $2.74 billion of repurchase agreements and $2.85 billion of notes payable. Weighted-average funding cost was 2.17% and weighted-average life was 1.3 years.
- Available financing capacity was $2.05 billion, subject to eligible collateral and other borrowing conditions. Management stated that the company was in compliance with all debt covenants.
Cash Flow, Leverage and Liquidity
| Cash flow item | Nine months ended September 30, 2014 | Nine months ended September 30, 2013 |
|---|---|---|
| Cash provided by operating activities | $68.8 million | $104.6 million |
| Cash used in investing activities | $(1.58) billion | $(301.1) million |
| Cash provided by financing activities | $1.42 billion | $368.7 million |
| Net change in cash | $(84.4) million | $172.2 million increase |
Investing outflows reflected substantial purchases of servicer advances, Agency and Non-Agency RMBS, residential mortgage loans and derivatives. Financing inflows included additional repurchase borrowings, notes payable, equity issuance and third-party capital contributions to the servicer-advance vehicle.
Management represented that unrestricted cash and Agency RMBS were sufficient to satisfy short-term recourse liabilities and expected that cash on hand and operating cash flow would meet anticipated liquidity needs over the next twelve months. Liquidity remains sensitive to margin calls, asset values, refinancing availability, counterparty decisions and the timing of asset recoveries.
Material Changes Versus the Prior Comparable Period
- Interest income increased primarily because the company acquired servicer advances, additional residential loans and additional Excess MSRs after September 30, 2013.
- Net interest income increased by $45.8 million in the third quarter and $98.8 million for the nine-month period, despite a $29.9 million and $101.8 million increase in interest expense, respectively.
- Servicer advances were a major new earnings contributor, producing $153.8 million of interest income and $105.8 million of fair-value gains for the nine months ended September 30, 2014. The consolidated vehicle was approximately 45% owned by New Residential on average, with significant noncontrolling interests.
- Other income increased by $65.9 million in the third quarter and $177.8 million for the nine months. Nine-month gains included $57.8 million from investment settlements, principally securities sales, and $105.8 million of servicer-advance fair-value gains.
- Net income attributable to common stockholders increased 100% in the third quarter and 61% for the nine-month period, although the 2014 results included substantial fair-value changes and realized investment gains.
- Operating expenses increased by $13.8 million in the third quarter and $42.6 million for the nine months. Nine-month incentive compensation to the affiliate manager was $33.1 million, compared with $5.3 million in 2013.
- Income-tax expense increased to $7.8 million in the third quarter and $29.5 million for the nine months, primarily because servicer advances were held through taxable REIT subsidiaries.
- Core earnings, a non-GAAP measure, were $62.6 million for the third quarter and $160.8 million for the nine months, compared with $37.9 million and $93.2 million, respectively. Core earnings exclude or adjust for certain fair-value gains, realized gains, incentive compensation and other items.
Guidance, Outlook, Commentary and Risks
The filing does not provide formal earnings or dividend guidance. Management described continued opportunities in MSRs, servicer advances, Non-Agency RMBS, call rights and distressed residential loans, but cautioned that competition for Excess MSRs had increased, pricing had risen and regulatory and GSE approval processes had become more extensive.
- Management reported that the fair value of Excess MSRs increased by approximately $51.2 million in the third quarter and that the portfolio’s weighted-average discount rate declined from 12.0% to 10.0%.
- As of September 30, 2014, the Agency RMBS net interest spread was 1.56%, compared with 1.17% at June 30, 2014; the Non-Agency RMBS spread was 3.84%, compared with 5.28% at June 30, 2014.
- A 100-basis-point increase in short-term interest rates was estimated to reduce annual earnings by approximately $9.1 million and reduce the real estate-securities segment’s net book value by approximately $7.8 million. A 25-basis-point credit-spread movement was estimated to affect that segment’s net book value by approximately $10.6 million.
- Key risks include valuation uncertainty for Level 3 assets, prepayment and delinquency assumptions, non-recovery or delayed recovery of servicer advances, mortgage-servicer performance, concentration in Nationstar and Springleaf, repurchase-agreement margin calls, refinancing risk, credit losses, illiquidity and changing housing or credit-market conditions.
- The company’s ability to maintain REIT status and its exclusion from registration under the Investment Company Act is material. Failure could result in corporate-level taxes, operational restrictions, forced asset sales or loss of the company’s NYSE listing.
- No material litigation was reported as of the filing date. Management concluded that disclosure controls and procedures were effective and reported no material change in internal control over financial reporting.
Unusual and Subsequent Items
- The company completed a one-for-two reverse stock split on October 17, 2014; share counts and EPS for all periods were presented retrospectively.
- On October 3, 2014, the consumer-loan companies refinanced approximately $1.5 billion of asset-backed notes with a new securitization of approximately $2.6 billion. New Residential received approximately $337.8 million, reduced its investment basis to zero and recognized an approximately $73.8 million gain. It used $125.0 million to repay its consumer-loan repurchase agreement.
- On October 3, 2014, the company securitized $463.6 million of performing mortgage-loan UPB, recognized an approximately $1.2 million gain and used proceeds to repay $423.2 million of repurchase financing.
- Subsequent to quarter-end, the company committed to purchase approximately $386.8 million of primarily reperforming mortgage loans for approximately $357.9 million and purchased two pools of non-performing loans with aggregate UPB of approximately $254.9 million for approximately $188.8 million.
Investor Verification Checklist
- Reconcile reported net income and core earnings to recurring cash generation, given the material contribution from fair-value marks and realized gains.
- Review the valuation assumptions and sensitivities for Excess MSRs and servicer advances, especially prepayment, delinquency, recapture, discount rates and advance recoveries.
- Assess debt maturities, repurchase-agreement rollovers, collateral haircuts, margin-call exposure and the availability of financing capacity.
- Monitor Nationstar’s servicing performance, regulatory matters, financial condition and ability to recover advances.
- Evaluate the credit quality and liquidation assumptions for PCI loans, Non-Agency RMBS, REO and consumer loans.
- Verify the accounting and economic effect of the October consumer-loan refinancing and the resulting suspension of equity-method earnings recognition until cumulative earnings exceed cumulative distributions.
- Confirm continuing REIT qualification, taxable REIT subsidiary exposure, dividend coverage and compliance with Investment Company Act exclusions.
- Consider the comparability limitations caused by the May 2013 spin-off and the October 2014 reverse stock split.