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.

After a furious year of churning CMBS, repurchasing outstanding corporate debt and refinancing its bank loans, among other feats, Northstar actually ended the year with a little bit of cash. That’s the good news. The bad news is they’re going to need it.

Northstar now has about $238 million in the bank, which includes the all important figure of $138.9 million in unrestricted cash. This is discretionary cash, the kind of stuff that Hamamoto can use to expense dinners at Bobby Van’s. The remaining $99.4 million is bottled up inside Northstar’s CDOs, and the ability to profitably reinvest that cash is diminishing by the day as credit spreads tighten and the CDO reinvestment periods expire.

If you strip out all the non-GAAP AFFO noise from NAREIT, you can see the nail-biting story unfolding: Northstar’s cash flows from continuing operations have been declining rapidly. It’s true, Northstar did manage to generate $54 million in cash for all of 2009, but that’s down from $88 million in 2008 and $102 million in 2007. Obviously, an almost 50% drop in operating cash flow is not the sign of a healthy business, but the fact that Northstar is currently in an unhealthy business should also come as no surprise.

The question is, what can Northstar do about it? In the short term, the answer is not much. Northstar’s portfolio is running off, interest rates are at all time lows, and Northstar’s CDO funding model is dead. 2009 interest income of $142.2 million was $70 million less than 2008, and $150 million less than 2007. As Northstar’s asset balances decline, so too have Northstar’s advisory fees and rental income.

The lack of good options may be why NRF is attempting replace this revenue with management fees, and in the meantime Hamamoto is generating a lot of work for his accounting department with the debt buybacks and CMBS trading, but all of this is clearly a stop gap, and it’s just not enough.

Not only that, management fees are not ramping up nearly as fast as Northstar needs them to ramp up, and at the current pace, they may never ramp up. Northstar Realty Income Trust, the new non-traded REIT, has not yet been declared effective by the SEC, and Northstar can’t start raising money in earnest until that happens.

However, judging by its new Reg D offering, Northstar Income Opportunity REIT I, Northstar’s shiny new Denver broker/dealer operation isn’t knocking the cover off the ball. The first investor commitment was made on September 24th, but as of early February, Northstar Income REIT I had only raised $3.1 million in equity. This is certainly not failure, but managing $3.1 million will definitely not pay the rent at 399 Park Avenue. Furthermore, starting a broker/dealer from scratch is neither cheap nor risk free. Northstar must now comply with a whole new raft of federal and state securities laws, and be exposed to the liability that arises from selling shares to retail investors through hundreds of rowdy, independent securities brokers across the country.

On top of paying rent on the 18th floor, dinner at Bobby Van’s, and the expense of starting up a brand new broker/dealer, under its new credit facility with Wells Fargo, Northstar must make $30 million in annual amortization payments. Also, through its loan book, NRF is on the hook for $80 million in future funding commitments, of which only $51.9 million will come out of the CDOs. $50 million in operating cash flow doesn’t create a huge margin for error in a capital intensive business, so Northstar will likely have to borrow most of the remaining $28.1 million using credit facilities.

So what is Hamamoto thinking? That’s unclear, but NRF is definitely walking a tightrope, and that may explain the management and board changes at the end of Q4. Curiously, REITs have collectively raised almost $30 billion of debt and equity capital since the crisis began, and Crexus, Colony Capital and Starwood Capital were among several Mortgage REITs to raise almost $1.5 billion. Somehow, despite the stellar performance of its portfolio, NRF just barely managed to squeeze $25.7 million out of this deluge.

Some portfolio managers I know have said that Hamamoto is not part of the “REIT Mafia”, and therefore he is not always invited to the REIT fundraising parties. This may or may not be true, but I’m not sure what else could explain NRF’s decision to throw a hail mary into the cesspool of Reg D offerings and non-traded REITs.

I spent all day reading the 10K in search of an answer, and it seemed to confirm the REIT Mafia conspiracy theory, as well as the fact that NRF has chosen a particularly rocky path to circumvent it:

“we cannot currently raise large amounts of corporate equity capital at attractive levels…we hope that our reputation in the marketplace will enable us to be early in raising corporate capital when market conditions improve.”

One thing is for sure, Reg D offerings and non-traded REITs won’t do much for NRF’s reputation, so shareholders may also want to hope there is a contingency plan brewing somewhere on the 18th floor.