Newcastle Investment Corp., (NCT) a Mortgage REIT managed by Fortress Investment Group, will continue to contribute management fees to FIG’s income statement for at least another year. But whether NCT makes it out of 2010 is an another question. Newcastle is suffering from a host of balance sheet issues, including a portfolio full of CDOs that are struggling to meet their O/C tests and an inability to raise fresh capital.
Newcastle is externally managed by Fortress, and Fortress owns 2.3% of the Newcastle common, so it’s no surprise that one of the first moves Fortress made was to threaten the preferred holders with de-listing unless they agreed to convert into common at about $0.20 on the dollar (cheers: Richard52). However, it turned out that the preferred holders, who were primarily retail investors with limited ability to organize, ultimately prevailed. Their ace in the hole was the right to appoint two members to NCT’s Fortress-sponsored board if NCT failed to pay their dividends for six consecutive quarters. Last week, after two previous attempts to strong-arm the preferred holders and about one month before six consecutive quarters would have elapsed, Fortress and NCT both blinked.
However, with those pesky preferred shareholders now finally out of the way, NCT still faces an incredibly difficult task. After the preferred redemption, which will cost Newcastle $27 million in cash (in addition to the issuance of 9.1 million in new common shares), Newcastle will be left with about $31.5 million in unrestricted cash. (As February 17th, Newcastle had $58.8 million of unrestricted cash available, down from $68.3 million at year end.) This is not a healthy cash cushion for a highly leveraged company that’s in the business of manufacturing net interest income, even if most of that leverage is now non-recourse.
The reason is that in 2010 Newcastle, like Northstar, is going to have an increasingly difficult time managing its CDO overcollateralization tests (see “CDOs Explained“) . However, because its ability to manage the tests is even more limited, Newcastle appears to be at even greater risk than Northstar. NCT’s CDO re-investment periods are not only coming to an end, eliminating Newcastle’s ability to rebalance the CDO asset cushions, but NCT’s CDO trustee also recently notified NCT that it can no longer repurchase individual CDO notes without the approval of senior noteholders (see “CDO Buybacks Explained, Step By Step“).
With at least $1.1 billion of CDO assets under negative watch for possible downgrade by at least one of the rating agencies as of January 31st, and with CDOs IV, V, VI and VII already out of in compliance with their applicable over collateralization tests as of February 17, 2010, NCT’s margin for error is slight. To the extent Newcastle fails to meet its O/C tests on any of the remaining $1.1 billion in CDOs under watch, interest income on those CDOs would be diverted away from the junior noteholders (NCT is a junior noteholder) to the senior noteholders, and NCT’s precariously low cash position would quickly become even more precarious. In certain cases, NCT could also be replaced as Collateral Manager, which would further jeopardize its cash flow.
Certainly, retiring the preferred shares (and paying off the accrued dividend liability) is the first step in recapitalizing the company, but it’s not the last. Newcastle still needs to raise additional capital to eliminate its remaining non-recourse debt, to defuse its ticking CDO time bombs, and to re-invest in new debt instruments that are accretive. The latter third of this proposition is the life blood of a company like Newcastle, and without that NCT’s prospects remain exceptionally unexciting.