Rithm Capital Corp. quarterly report, Q2 FY2015

Business Context and Reporting Period

New Residential Investment Corp. (now Rithm Capital Corp.; NYSE: NRZ) filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2015. The company was an externally managed REIT focused primarily on excess mortgage servicing rights (MSRs), servicer advances, residential mortgage-backed securities, residential mortgage loans and consumer loans.

The most significant event was the April 6, 2015 acquisition of substantially all of Home Loan Servicing Solutions, Ltd. (HLSS) assets and assumed liabilities for total preliminary consideration of approximately $1.49 billion, including $434.1 million of New Residential common stock, $622.0 million of cash, $385.2 million of seller financing and contingent consideration of up to $50.0 million.

Key Financial Metrics

Metric	Three months ended June 30	Six months ended June 30
Interest income	$178.2 million, versus $92.7 million	$262.6 million, versus $164.1 million
Net interest income	$96.3 million, versus $56.1 million	$146.7 million, versus $88.6 million
Net income	$79.3 million, versus $182.2 million	$121.1 million, versus $239.1 million
Net income attributable to common stockholders	$75.1 million, versus $123.5 million	$111.1 million, versus $172.3 million
Diluted EPS	$0.37, versus $0.88	$0.63, versus $1.28
Core earnings	$92.2 million, versus $56.4 million	$155.6 million, versus $98.1 million
Net cash provided by operating activities	Not separately provided	$517.3 million, versus $30.0 million

Net interest margin percentage is not presented as a consolidated metric. Net interest income after impairment was $90.9 million for the quarter and $139.2 million for the six-month period. Total impairment was $5.4 million for the quarter and $7.5 million for the six-month period, including $1.7 million of six-month other-than-temporary impairment on securities and $5.7 million of valuation provisions on loans and REO.

Total assets increased to $14.39 billion from $8.09 billion at December 31, 2014.
Total equity increased to $3.10 billion from $1.85 billion; common stockholders’ equity was $2.86 billion.
Cash and cash equivalents were $432.0 million, with restricted cash of $134.7 million.
Repurchase agreements were $2.40 billion and notes payable were $7.88 billion, for total debt carrying value of approximately $10.29 billion.
Available financing was reported at approximately $5.28 billion, subject to eligible collateral and applicable borrowing conditions.
The quarterly dividend declared was $0.45 per share; dividends declared for the first six months totaled $0.83 per share.

Portfolio and Leverage

Excess MSRs were carried at $1.50 billion directly and $216.1 million through equity-method investees. Direct and indirect interests referenced underlying mortgage loan UPB of approximately $415.4 billion.
Servicer advances were carried at $8.18 billion, compared with $3.27 billion at December 31, 2014, primarily reflecting the HLSS acquisition. The portfolio had a weighted-average yield of 5.6% and weighted-average life of 4.3 years.
Real estate securities totaled $1.91 billion, consisting of $994.0 million of Agency RMBS and $913.9 million of Non-Agency RMBS.
Residential mortgage loans totaled $565.8 million, including $523.0 million held for sale and $42.7 million held for investment. REO totaled $25.3 million.
Consumer loans were held through equity-method investees with no carrying value for New Residential’s investment after prior distributions exceeded its basis, although the underlying consumer loan companies reported $1.88 billion of consumer loan assets.
Net interest spreads were 2.60% for Agency RMBS and 2.92% for Non-Agency RMBS at June 30, 2015.

Material Changes Versus the Prior Comparable Period

Interest income increased 92% for the quarter and 60% for the six months, primarily from the expanded MSR, servicer advance and real estate loan portfolios following the HLSS transaction.
Net interest income increased 72% for the quarter and 66% for the six months, but higher interest expense and materially lower fair-value gains and realized investment gains reduced reported net income.
Net income attributable to common stockholders declined 39% for the quarter and 36% for the six months. Diluted EPS declined to $0.37 and $0.63, respectively, partly reflecting lower earnings and substantial share issuance.
Other income declined to $37.7 million from $177.9 million for the quarter and to $49.9 million from $212.9 million for the six months. The principal drivers were lower servicer advance fair-value gains, lower MSR fair-value gains and lower securities settlement gains.
General and administrative expense increased to $21.2 million from $5.4 million for the quarter and to $29.8 million from $7.4 million for the six months, reflecting HLSS integration, employee-related costs, legal expenses and higher professional fees.
Common shares outstanding increased to approximately 230.4 million from 141.4 million at year-end 2014, due principally to HLSS consideration, public offerings and option exercises.
Operating cash flow increased substantially, while investing cash flow was positive at $419.4 million and financing cash flow was negative at $717.7 million.

Guidance, Outlook, Commentary and Risks

Management did not provide formal earnings guidance. Management expected cash on hand, operating cash flow and the ability to roll repurchase agreements to satisfy anticipated liquidity needs for the current portfolio over the following twelve months, but cautioned that liquidity could deteriorate rapidly if assumptions regarding asset values, financing access, margin requirements or cash flows prove incorrect.

Management viewed the market for MSRs and related servicing assets as attractive, but noted increasing competition, higher pricing, regulatory and GSE approval delays, and uncertainty regarding future transaction returns.
Second-quarter credit spreads widened, adversely affecting securities and loan valuations. A 25-basis-point increase in credit spreads was estimated to reduce net book value by approximately $89.6 million.
An immediate 100-basis-point increase in short-term interest rates was estimated to reduce next-twelve-month cash flows by approximately $28.0 million and increase net book value by approximately $281.8 million; these sensitivities assumed a static portfolio and are not forecasts.
The company had approximately $2.4 billion of repurchase agreement margin exposure. Near-term contractual debt maturities totaled approximately $3.16 billion through December 31, 2015 and $4.78 billion during 2016.
Principal risks included prepayment and delinquency assumptions in Level 3 MSR and servicer advance valuations, non-recoverability or delayed recovery of advances, interest-rate and credit-spread volatility, margin calls, refinancing risk, illiquidity and counterparty concentration.
Nationstar, Ocwen and Springleaf were important counterparties or servicers. Ocwen faced servicing-rating downgrades, regulatory scrutiny, alleged defaults and potential servicing termination risks that could affect the acquired HLSS assets, financing and cash flows.
The company assumed significant HLSS-related liabilities and contingencies. It had not accrued losses for certain litigation because management did not believe losses were probable and reasonably estimable.
The New Merger with HLSS remained subject to HLSS shareholder approval and other conditions. Failure to complete it could leave the company responsible for certain HLSS expenses and liabilities.
Disclosure controls and procedures were not effective at quarter-end because of a material weakness involving management’s review and validation of valuation-model assumptions for acquired assets. Remediation was in progress.
The filing corrected the classification of certain mortgage-loan purchases and sales in the prior-period cash-flow statement, moving gross inflows of $249.7 million and gross outflows of $247.1 million from investing to operating activities. Management concluded the prior presentation was not materially misstated.

Most Important Facts an Investor Should Verify

Whether the HLSS acquisition delivers the expected recurring cash flows and whether the New Merger is completed.
The recoverability, timing and financing of the $8.18 billion servicer advance portfolio, particularly under adverse Ocwen or Nationstar servicing developments.
Progress in remediating the material weakness over acquired-asset valuation models and whether additional control deficiencies arise.
Near-term debt maturities, repurchase-agreement rollovers, margin requirements and available eligible collateral.
The sensitivity of MSR fair values to prepayment speeds, discount rates, delinquencies and recapture rates.
Potential liabilities from HLSS-related class actions, derivative litigation, SEC inquiries and assumed contingencies.
Maintenance of REIT qualification and the company’s ability to fund required distributions while meeting debt and operating obligations.
Whether reported core earnings are supported by recurring cash generation rather than fair-value changes, asset sales or other unusual items.