Business Context and Reporting Period
Rithm Capital Corp. was then named New Residential Investment Corp. and was spun off from Newcastle Investment Corp. on May 15, 2013. The company operated as an externally managed REIT focused on excess mortgage servicing rights (Excess MSRs), Agency and Non-Agency RMBS, residential mortgage loans, and consumer loans. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2013.
Results for periods before the spin-off were prepared on a carve-out basis and may not reflect the results, expenses, financing, or cash flows the company would have had as an independent public company.
Financial Performance and Position
| Metric | Three months ended June 30 | Six months ended June 30 |
|---|---|---|
| Interest income | $23.0 million, versus $4.5 million | $39.2 million, versus $6.5 million |
| Interest expense | $2.7 million, versus none | $3.6 million, versus none |
| Net interest income | $20.3 million, up 354.3% | $35.6 million, up 447.0% |
| OTTI on securities | $3.8 million | $3.8 million |
| Other income | $98.2 million, versus $3.5 million | $101.0 million, versus $4.7 million |
| Net income | $109.2 million, versus $6.5 million | $122.3 million, versus $9.2 million |
| Basic EPS | $0.43, versus $0.03 | $0.48, versus $0.04 |
| Dividend declared per share | $0.07 | $0.07 |
Other income included Excess MSR fair-value gains of $41.8 million for the quarter and $43.7 million for the six months; fair-value gains on Excess MSR equity-method investments of $20.1 million and $21.1 million; and consumer-loan equity-method earnings of $36.2 million for both periods. These amounts make reported earnings highly sensitive to valuation assumptions and investment timing.
- Comprehensive income was $96.7 million for the quarter and $126.0 million for the six months. Second-quarter other comprehensive income was a loss of $12.5 million, primarily reflecting unrealized securities losses.
- Core earnings, a non-GAAP measure, were $37.5 million for the quarter and $50.2 million for the six months, compared with $3.0 million and $4.4 million, respectively. Core earnings exclude fair-value changes, impairment, and other realized or unrealized investment gains and losses, with adjustments for consumer-loan earnings.
- At June 30, 2013, total assets were $2.74 billion, stockholders’ equity was $1.25 billion, and cash and cash equivalents were $209.7 million.
- Key investments included $1.76 billion of real estate securities, $271.4 million of directly held Excess MSRs, $183.2 million of Excess MSR equity-method investments, $280.8 million of consumer-loan equity-method investments, and $33.6 million of residential mortgage loans.
- Direct and equity-method Excess MSR investments had approximately $454.6 million of carrying value and were linked to mortgage pools with aggregate unpaid principal balances of approximately $153.8 billion.
- Repurchase-agreement liabilities were $1.47 billion, with a weighted-average funding cost of approximately 0.85% and an average maturity of approximately 0.1 years. The agreements were generally subject to margin calls and had full recourse to the company.
- Six-month operating cash flow was $18.1 million, investing cash flow was negative $178.3 million, and financing cash flow was $369.9 million. Ending cash was $209.7 million.
Material Changes Versus the Prior Comparable Period
- The portfolio expanded substantially from December 31, 2012: total assets increased from $534.9 million to $2.74 billion, while repurchase-agreement debt increased from $150.9 million to $1.47 billion.
- Real estate securities increased from $289.8 million to $1.76 billion, primarily due to purchases and approximately $1.0 billion of Agency ARM RMBS contributed in kind by Newcastle.
- The company added consumer-loan and Excess MSR equity-method investments during 2013. The consumer-loan investment generated $36.2 million of equity-method earnings during the six months.
- Interest income rose primarily because of newly acquired real estate securities and Excess MSRs; interest expense increased because of repurchase-agreement financing.
- Operating expenses increased to $10.6 million for the six months from $2.1 million, including $2.3 million of management fees and $0.9 million of incentive compensation payable to the affiliate manager after the spin-off.
- The company became an independent NYSE-listed REIT under the symbol NRZ and had 253.0 million common shares outstanding at June 30, 2013.
Guidance, Outlook, Commentary, Risks, and Unusual Items
Management described opportunities from continued bank sales of mortgage servicing rights and from acquiring Non-Agency RMBS at potentially attractive risk-adjusted yields. It expected to continue co-investing with Nationstar and indicated that additional Excess MSR closings occurred after quarter-end. Management stated that cash on hand and operating cash flow were expected to meet anticipated liquidity needs for the next twelve months, including financing obligations, potential margin calls, and operating expenses.
- Subsequent to quarter-end, the company invested approximately $53 million, $12 million, and $65 million in additional Excess MSR interests related to Pools 10 and 9. These transactions covered aggregate underlying UPB of approximately $43.0 billion, $4.0 billion, and $34.7 billion, respectively.
- On August 1, 2013, a subsidiary entered into a one-year, $350 million maximum borrowing facility collateralized by Non-Agency RMBS. The facility was not subject to margin calls but included financial covenants and interest spreads ranging from 2.25% to 3.50% over LIBOR.
- On August 1, 2013, the management agreement was amended so incentive compensation would use core earnings rather than GAAP results for relevant Excess MSR and consumer-loan performance. The company stated that this reduced second-quarter incentive compensation, primarily by excluding unrealized Excess MSR gains.
- Excess MSRs were valued using Level 3 discounted-cash-flow models. Values depend materially on prepayment, delinquency, recapture, servicing-spread, and discount-rate assumptions. A 10% increase in the discount rate was estimated to reduce Excess MSR fair value by approximately $19.2 million.
- All Excess MSR investments were serviced by Nationstar, creating substantial counterparty and servicer-concentration risk. Consumer loans were or were expected to be serviced by Springleaf, an affiliate of the external manager.
- Non-Agency RMBS carried a weighted-average rating of CC and had $629.5 million of fair value. The portfolio was exposed to defaults, delinquencies, foreclosure delays, credit-spread widening, valuation uncertainty, and potential impairment.
- The company relied heavily on short-term repurchase agreements. Failure of counterparties to renew financing, increased haircuts, margin calls, or declines in collateral values could create rapid liquidity pressure.
- The company intended to qualify as a REIT and maintain an exemption from registration under the Investment Company Act. Failure to satisfy the applicable requirements could result in corporate-level taxes, forced asset sales, loss of the exemption, or other adverse consequences.
- No material litigation was reported as of June 30, 2013, and management concluded that disclosure controls and procedures were effective.
Important Facts for Investors to Verify
- Whether the company can sustain earnings and dividends after excluding substantial fair-value gains and other non-cash or non-recurring items.
- The sensitivity of Excess MSR valuations and cash flows to prepayment speeds, delinquencies, recapture rates, discount rates, and Nationstar servicing performance.
- The renewal terms, haircuts, margin requirements, and counterparty concentration of repurchase agreements and other financing arrangements.
- The performance, delinquency, loss, and cash-flow distribution restrictions of the consumer-loan joint ventures, including their $2.0 billion of asset-backed debt.
- The effect of the spin-off and carve-out accounting on comparisons with 2012 and on the company’s ongoing standalone expense structure.
- Compliance with REIT qualification requirements and the Investment Company Act exemption, including the treatment of Excess MSRs and consumer-loan investments.
- The company’s ability to close and finance announced Excess MSR commitments and to diversify away from Nationstar and other affiliated counterparties.