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.

In case you missed it, the Federal Reserve just threw some gasoline on the housing inferno. This month, the Fed confirmed that it will no longer make open market purchases of mortgage backed securities after March 31st, and underwater homeowners are going to miss that money. This particular Fed program was one of a number of extraordinary, emergency measures meant to reverse the near meltdown of the U.S. financial system, and through it the Fed pumped nearly $1.25 trillion into the mortgage backed securities market over the past twelve months.

The program was officially intended to lower home-loan mortgage rates, and that’s exactly what it did. Brian Sack, head of the NY Fed’s money market desk, estimated that it lowered rates on agency mortgage backed securities by a full point, and that a separate program targeting government securities lowered rates on the 10 year Treasury by at least half a point. Home mortgage rates dutifully followed suit, dropping from almost 6% at the end of 2008 to below 4.5% today:

When this unprecedented government market manipulation comes to an end, and it is coming to an end now, single family mortgage rates will go right back to where they came from. As that happens home ownership will become even less affordable, and that means home prices are likely to drop even further.

But there’s much more….

As the Fed begins to unwind its historic intervention, it faces a second wave of toxic mortgage maturities that could be even more damaging than the last wave of subprime mortgages. These are the 3 and 5 year Option ARM mortgages, and they were the credit bubble’s absolute creme de la creme.

If you didn’t manage to get a piece of the action in Option ARMs, these were the mortgages given to credit-worthy borrowers who could not afford their monthly mortgage payment using a normal ARM (in other words, they paid too much for their home), and the Fed is waiving goodbye just as these Option ARMs get set to explode:

Not only did these loans require zero principal repayments, they also allowed borrowers the option of skipping scheduled interest payments altogether. As these loans reset in 2010 and 2011, that option goes away and principal amortization payments will kick in, adding hundreds of dollars to a borrower’s monthly mortgage nut.

And, with the Fed pulling the plug on its mortgage buying program, these loans will reset at rates that are far higher than the initial “teaser” rate. Sadly, this may spell doom for borrowers who used these loans to fund overpriced home purchases in 2006-2007, especially in high-priced markets along the coasts.

And there’s even more….

Terminating these programs are the Fed’s first tentative steps in a “tightening cycle like no other in its history”, according to Sacks. In a speech last week to the National Association for Business Economics, Sacks noted that the Fed faces “extraordinary challenge with this exit, given the historic steps that have been taken with the Fed’s balance sheet.”

He candidly admitted that the Federal Reserve’s largesse over the past two years has been so massive and so broad that tightening will need to be implemented on a scale that the Fed has “never before attempted”. He also said that the Fed will be operating in a framework that has not been fully tested in U.S. markets. What he did not say is that the Fed needs to take these steps, and fast, in order to prevent something even worse: inflation and yet another asset price bubble.

Unfortunately, there is no asset price bubble brewing in single family housing.  Despite a glimmer of hope in the number of borrowers who had fallen behind in their payments in Q4, a record 15 percent of all homeowners with a mortgage had still missed at least one payment, and nearly half those borrowers were at least three months delinquent. 

Three month’s delinquent is the point at which foreclosure proceedings commence, and this latter figure is more than double its typical level.  The Fed has now run out of time, and its efforts to re-inflate housing are coming to an end in favor of fighting even more damaging inflation in the broader economy.  This is not good news if you’re an underwater homeowner, and it looks house prices are going to get a lot worse before they get better.