Newcastle’s High Yield Going Higher?

The gap between the perception of the risks in mortgage debt and the actual risks is now the exact opposite of where it was just before the credit crunch began.

Let’s see, there are a few positive things happening out there and I think I need to write about them before my prescription runs out…

First, it’s an election year and not too difficult to make a connection between the calendar and the $300 billion loan modification program housing bill that just passed. We also have 2% Fed Funds rate, and a whole slew of obscure but hugely important Fed programs aimed at restoring liquidity. These programs are unprecedented in scope, and all of it marks a big turnaround from the laissez-faire 5,000 former bear stearns employees days of “largely contained” subprime morgage defaults.

Things will turn around though, they always do, and I think Newcastle is one REIT that may be turning around sooner that some others. I sold NCT late in 2007, which sadly I cannot attribute to any unique insight. I simply got a margin call. That proved to be serendipitous, and a rare bit of good luck for me in what has been an otherwise miserable several months for NCT. In July, the stock hit $4.50.

But Newcastle is no Alesco, and I’ve been interested in developments there ever since the REIT cut its dividend to less than half its taxable income. REITs are required to pay out 90% of their taxable income to shareholders, so what were they planning to do with all that cash, assuming it wasn’t burned up with more losses? Could a special dividend be on the way?

That became an even more pertinent question this quarter, when NCT reported operating earnings (Non-GAAP) which were twice the dividend yet again, a big jump in cash, to $170 million, and $88 million in debt reduction, $57 of which was recourse. 13% of NCTs debt now remains recourse to the Company (less, on a percentage basis, than AHR), and half of that consists of recourse debt on liquid, AAA-implied agency securities.

The Company is also in a similar position to Northstar (The Mortgage REIT With $4 Billion Of Sweet CDOs) with respect to its CDO assets. As loans inside NCT’s CDOs get paid off, NCT has been busy replacing them with new assets that are yielding 2-3% more (N.B., NCT’s funding costs do not go up, because the poor sots who own the CDOs are stuck with their miserable LIBOR +50). NCT replaced $63 million of CDO assets in the second quarter, and they expect the higher yields on this $63 million alone will generate an additional .06/share annually in earnings.

The Company is also working on further debt reductions, which may occur through asset sales. By the end of the third quarter, if all goes according to plan, NCT plans to be back out in the market aggressively acquiring new assets. They see three primary opportunities, either (1) the repurchase of common stock, which may be the most accretive, (2) the continued repurchase of CDO debt, or (3) the acquisition of new mortgage assets. Obviously, with market spreads being what they are, the ability to do any one of these three things could prove to be lucrative.

That’s the good news, and everybody already knows the bad news – or at least they should. In March of 2007, NCT made a contrarian call on the single family mortgage market and announced a $1.7 billion purchase of subprime mortgages. Out of the entire portfolio, almost 40% of the mortgages were in California and Florida.

Back then, the stock was trading at $27. They eventually kicked out $400 million in mortgages – let’s hope they were in Stockton and Bakersfield – and closed on $1.3 in May, intending to securitize the loans and retain a $75 million residual. That never happened, and the value of those securities (among other things in their portfolio) clearly kept dropping. NCT was forced to raise cash by selling $1.8 billion of assets in Q1, including $770 million of agency-backed mortgages, which is the good stuff (implied AAA), and take huge write downs on much of the rest of their portfolio they couldn’t sell.

Those write downs continued in the second quarter, and in the end the write downs can also be a big driver of taxable income. The question swirling around NCT right now is how big a driver. NCT has now covered their full year dividend nut with just six months of operating earnings. The Company wouldn’t give guidance on full year taxable income, but they have consistently said that they intend to make distributions such that they meet meet the 90% requirement. Assuming NCT’s current porfolio marks are enough, if NCT can accomplish anything even close to its first and second quarter run rate in the third and fourth quarters, a special dividend gets added to the yield pot in Q4.

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