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Drive Shack Inc. - Quarter Report: 2006 September (Form 10-Q)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

or

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from ___________________ to ___________________

Commission File Number: 001-31458

Newcastle Investment Corp.
(Exact name of registrant as specified in its charter)

Maryland
81-0559116
(State or other jurisdiction of incorporation
(I.R.S. Employer Identification No.)
or organization)
 

1345 Avenue of the Americas, New York, NY
10105
(Address of principal executive offices)
(Zip Code)

(212) 798-6100
(Registrant's telephone number, including area code)

_____________________________________________________________
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o     

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer x    Accelerated filer  Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o  No x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the last practicable date.

Common stock, $0.01 par value per share: 45,699,817 shares outstanding as of November 7, 2006.


NEWCASTLE INVESTMENT CORP.
FORM 10-Q

INDEX
 
 
PAGE
   
PART I. FINANCIAL INFORMATION
 
   
Item 1. Financial Statements
 
   
Consolidated Balance Sheets as of September 30, 2006 (unaudited) and December 31, 2005
1
   
Consolidated Statements of Income (unaudited) for the three and nine months ended September 30, 2006 and 2005
2
   
Consolidated Statements of Stockholders' Equity (unaudited) for the nine months ended September 30, 2006 and 2005
3
   
Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2006 and 2005
4
 
 
Notes to Consolidated Financial Statements (unaudited)
6
   
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
15
   
Item 3. Quantitative and Qualitative Disclosures About Market Risk
32
   
Item 4. Controls and Procedures
37
   
PART II. OTHER INFORMATION
 
   
Item 1. Legal Proceedings
38
   
Item 1A. Risk Factors
38
 
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
39
   
Item 3. Defaults upon Senior Securities
39
   
Item 4. Submission of Matters to a Vote of Security Holders
39
   
Item 5. Other Information
39
   
Item 6. Exhibits
40
   
SIGNATURES
41


 
PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)


   
September 30, 2006(Unaudited)
 
December 31, 2005
 
   
 
     
Assets
         
Real estate securities, available for sale
 
$
5,369,641
 
$
4,554,519
 
Real estate related loans, net
   
1,238,418
   
615,551
 
Residential mortgage loans, net
   
863,788
   
600,682
 
Subprime mortgage loans subject to future repurchase - Note 5
   
287,546
   
-
 
Investments in unconsolidated subsidiaries
   
28,549
   
29,953
 
Operating real estate, net
   
30,271
   
16,673
 
Cash and cash equivalents
   
16,317
   
21,275
 
Restricted cash
   
183,334
   
268,910
 
Derivative assets
   
64,218
   
63,834
 
Receivables and other assets
   
43,999
   
38,302
 
   
$
8,126,081
 
$
6,209,699
 
Liabilities and Stockholders' Equity
             
 
Liabilities
             
CBO bonds payable
 
$
3,505,906
 
$
3,530,384
 
Other bonds payable
   
704,785
   
353,330
 
Notes payable
   
153,957
   
260,441
 
Repurchase agreements
   
2,197,780
   
1,048,203
 
Financing of subprime mortgage loans subject to future repurchase - Note 5
   
287,546
   
-
 
Credit facility
   
125,000
   
20,000
 
Junior subordinated notes payable (security for trust preferred)
   
100,100
   
-
 
Derivative liabilities
   
26,576
   
18,392
 
Dividends payable
   
30,152
   
29,052
 
Due to affiliates
   
9,938
   
8,783
 
Accrued expenses and other liabilities
   
27,175
   
23,111
 
     
7,168,915
   
5,291,696
 
Stockholders' Equity
             
Preferred stock, $0.01 par value, 100,000,000 shares authorized, 2,500,000
             
shares of 9.75% Series B Cumulative Redeemable Preferred Stock and 1,600,000
             
shares of 8.05% Series C Cumulative Redeemable Preferred Stock, liquidation
             
preference $25.00 per share, issued and outstanding
   
102,500
   
102,500
 
Common stock, $0.01 par value, 500,000,000 shares authorized, 43,999,817 and
             
43,913,409 shares issued and outstanding at September 30, 2006 and
             
December 31, 2005, respectively
   
440
   
439
 
Additional paid-in capital
   
784,234
   
782,735
 
Dividends in excess of earnings
   
(10,923
)
 
(13,235
)
Accumulated other comprehensive income
   
80,915
   
45,564
 
     
957,166
   
918,003
 
   
$
8,126,081
 
$
6,209,699
 
 
1

 
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(dollars in thousands, except share data)


   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
   
2006
 
2005
 
2006
 
2005
 
Revenues
                 
Interest income
 
$
140,330
 
$
88,021
 
$
378,446
 
$
254,035
 
Rental and escalation income
   
834
   
1,871
   
3,616
   
4,850
 
Gain on sale of investments, net
   
2,642
   
6,750
   
10,064
   
12,099
 
Other income, net
   
288
   
3,208
   
4,545
   
4,594
 
     
144,094
   
99,850
   
396,671
   
275,578
 
Expenses
                         
Interest expense
   
100,239
   
58,681
   
265,113
   
163,238
 
Property operating expense
   
1,041
   
594
   
2,808
   
1,827
 
Loan and security servicing expense
   
1,553
   
1,483
   
4,961
   
4,646
 
Provision for credit losses
   
2,682
   
4,091
   
5,868
   
5,990
 
Provision for losses, loans held for sale - Note 5
   
-
   
-
   
4,127
   
-
 
General and administrative expense
   
1,187
   
1,034
   
3,979
   
3,251
 
Management fee to affiliate
   
3,475
   
3,316
   
10,420
   
9,895
 
Incentive compensation to affiliate
   
3,094
   
2,416
   
8,780
   
5,271
 
Depreciation and amortization
   
290
   
182
   
767
   
453
 
     
113,561
   
71,797
   
306,823
   
194,571
 
Income before equity in earnings of unconsolidated subsidiaries
   
30,533
   
28,053
   
89,848
   
81,007
 
Equity in earnings of unconsolidated subsidiaries
   
1,506
   
1,104
   
3,916
   
4,628
 
Income taxes on related taxable subsidiaries
   
-
   
(43
)
 
-
   
(321
)
Income from continuing operations
   
32,039
   
29,114
   
93,764
   
85,314
 
Income from discontinued operations
   
(12
)
 
86
   
212
   
2,051
 
Net Income
   
32,027
   
29,200
   
93,976
   
87,365
 
Preferred dividends
   
(2,328
)
 
(1,523
)
 
(6,985
)
 
(4,570
)
Income Available For Common Stockholders
 
$
29,699
 
$
27,677
 
$
86,991
 
$
82,795
 
Net Income Per Share of Common Stock
                         
Basic
 
$
0.68
 
$
0.63
 
$
1.98
 
$
1.90
 
Diluted
 
$
0.67
 
$
0.63
 
$
1.97
 
$
1.88
 
Income from continuing operations per share of common stock, after
                         
preferred dividends
                         
Basic
 
$
0.68
 
$
0.63
 
$
1.97
 
$
1.85
 
Diluted
 
$
0.67
 
$
0.63
 
$
1.97
 
$
1.84
 
Income from discontinued operations per share of common stock
                         
Basic
 
$
(0.00
)
$
0.00
 
$
0.01
 
$
0.05
 
Diluted
 
$
(0.00
)
$
0.00
 
$
0.00
 
$
0.04
 
Weighted Average Number of Shares of
                         
Common Stock Outstanding
                         
Basic
   
43,999,817
   
43,789,819
   
43,978,625
   
43,595,411
 
Diluted
   
44,136,956
   
44,121,263
   
44,091,003
   
43,961,044
 
Dividends Declared per Share of Common Stock
 
$
0.650
 
$
0.625
 
$
1.925
 
$
1.875
 
 
2

 
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Unaudited)
FOR THE NINE MONHTS ENDED SEPTEMBER 30, 2006 AND 2005
(dollars in thousands)


 
Preferred Stock
 
Common Stock
 
Additional Paid-in
 
Dividends in Excess of
 
Accum. Other Comp.
 
Total Stock-holders'
 
 
Shares
 
Amount
 
Shares
 
Amount
 
Capital
 
 Earnings
 
Income
 
Equity
 
Stockholders' equity - December 31, 2005
 
4,100,000
 
$
102,500
   
43,913,409
 
$
439
 
$
782,735
 
$
(13,235
)
$
45,564
 
$
918,003
 
Dividends declared
 
-
   
-
   
-
   
-
   
-
   
(91,664
)
 
-
   
(91,664
)
Exercise of common stock options
 
-
   
-
   
84,000
   
1
   
1,439
   
-
   
-
   
1,440
 
Issuance of common stock to directors
 
-
   
-
   
2,408
   
-
   
60
   
-
   
-
   
60
 
Comprehensive income:
                                               
Net income
 
-
   
-
   
-
   
-
   
-
   
93,976
   
-
   
93,976
 
Net unrealized (loss) on securities
 
-
   
-
   
-
   
-
   
-
   
-
   
31,775
   
31,775
 
Reclassification of net realized (gain) on securities into earnings
 
-
   
-
   
-
   
-
   
-
   
-
   
(637
)
 
(637
)
Foreign currency translation
 
-
   
-
   
-
   
-
   
-
   
-
   
763
   
763
 
Net unrealized gain on derivatives designated as cash flow hedges
 
-
   
-
   
-
   
-
   
-
   
-
   
6,801
   
6,801
 
Reclassification of net realized (gain) on derivatives designated as cash flow hedges into earnings
 
-
   
-
   
-
   
-
   
-
   
-
   
(3,351
)
 
(3,351
)
Total comprehensive income
                                           
129,327
 
Stockholders' equity - September 30, 2006
 
4,100,000
 
$
102,500
   
43,999,817
 
$
440
 
$
784,234
 
$
(10,923
)
$
80,915
 
$
957,166
 
Stockholders' equity - December 31, 2004
 
2,500,000
 
$
62,500
   
39,859,481
 
$
399
 
$
676,015
 
$
(13,969
)
$
71,770
 
$
796,715
 
Dividends declared
 
-
   
-
   
-
   
-
   
-
   
(86,661
)
 
-
   
(86,661
)
Issuance of common stock
 
-
   
-
   
3,300,000
   
33
   
96,518
   
-
   
-
   
96,551
 
Exercise of common stock options
 
-
   
-
   
628,330
   
6
   
9,491
   
-
   
-
   
9,497
 
Issuance of common stock to directors
 
-
   
-
   
2,008
   
-
   
67
   
-
   
-
   
67
 
Comprehensive income:
                                               
Net income
 
-
   
-
   
-
   
-
   
-
   
87,365
   
-
   
87,365
 
Net unrealized (loss) on securities
 
-
   
-
   
-
   
-
   
-
   
-
   
(41,202
)
 
(41,202
)
Reclassification of net realized (gain) on securities into earnings
 
-
   
-
   
-
   
-
   
-
   
-
   
(7,157
)
 
(7,157
)
Foreign currency translation
 
-
   
-
   
-
   
-
   
-
   
-
   
(1,103
)
 
(1,103
)
Reclassification of net realized foreign currency translation into earnings
 
-
   
-
   
-
   
-
   
-
   
-
   
(626
)
 
(626
)
Net unrealized gain on derivatives designated as cash flow hedges
 
-
   
-
   
-
   
-
   
-
   
-
   
38,701
   
38,701
 
Reclassification of net realized loss on derivatives designated as cash flow hedges into earnings
 
-
   
-
   
-
   
-
   
-
   
-
   
1,657
   
1,657
 
Total comprehensive income
                                           
77,635
 
Stockholders' equity - September 30, 2005
 
2,500,000
 
$
62,500
   
43,789,819
 
$
438
 
$
782,091
 
$
(13,265
)
$
62,040
 
$
893,804
 
 
3

 
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOW (Unaudited)
(dollars in thousands)


   
Nine Months Ended September 30,
 
   
2006
 
2005
 
Cash Flows From Operating Activities
         
Net income
 
$
93,976
 
$
87,365
 
Adjustments to reconcile net income to net cash provided by (used in) operating activities
  (inclusive of amounts related to discontinued operations):
             
Depreciation and amortization
   
767
   
629
 
Accretion of discount and other amortization
   
(14,976
)
 
174
 
Equity in earnings of unconsolidated subsidiaries
   
(3,916
)
 
(4,628
)
Distributions of earnings from unconsolidated subsidiaries
   
3,916
   
4,049
 
Deferred rent
   
(1,274
)
 
(1,776
)
Gain on sale of investments
   
(10,430
)
 
(13,893
)
Unrealized gain on non-hedge derivatives and hedge ineffectiveness
   
(4,421
)
 
(6,559
)
Provision for credit losses
   
5,868
   
5,990
 
Provision for losses, loans held for sale
   
4,127
   
-
 
Purchase of loans held for sale - Note 5
   
(1,511,086
)
 
-
 
Sale of loans held for sale - Note 5
   
1,507,588
   
-
 
Non-cash directors' compensation
   
60
   
67
 
Change in:
             
Restricted cash
   
34,398
   
(117,679
)
Receivables and other assets
   
(524
)
 
(1,016
)
Due to affiliates
   
1,155
   
(2,583
)
Accrued expenses and other liabilities
   
8,757
   
61,993
 
Net cash provided by operating activities
   
113,985
   
12,133
 
Cash Flows From Investing Activities
             
Purchase of real estate securities
   
(1,116,676
)
 
(815,728
)
Proceeds from sale of real estate securities
   
306,618
   
50,082
 
Deposit on real estate securities (treated as a derivative)
   
-
   
(32,439
)
Purchase of and advances on loans
   
(1,267,511
)
 
(609,567
)
Proceeds from settlement of loans
   
-
   
1,024
 
Repayments of loan and security principal
   
417,277
   
540,749
 
Margin deposits on derivative instruments
   
(33,387
)
 
-
 
Return of margin deposits on derivative instruments
   
30,349
   
-
 
Margin deposits on total rate of return swaps (treated as derivative instruments)
   
(46,158
)
 
(39,099
)
Return of margin deposits on total rate of return swaps (treated as derivative instruments)
   
89,255
   
-
 
Proceeds from termination of derivative instruments
   
17,982
   
762
 
Proceeds from sale of derivative instrument into Securitization Trust - Note 5
   
5,623
   
-
 
Payments on settlement of derivative instruments
   
-
   
(1,112
)
Purchase and improvement of operating real estate
   
(1,314
)
 
(188
)
Proceeds from sale of operating real estate
   
-
   
52,333
 
Contributions to unconsolidated subsidiaries
   
(100
)
 
-
 
Distributions of capital from unconsolidated subsidiaries
   
1,504
   
9,122
 
Payment of deferred transaction costs
   
-
   
(38
)
Net cash used in investing activities
   
(1,596,538
)
 
(844,099
)
               
Continued on Page 5
             
 
4


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOW (Unaudited)
(dollars in thousands)


   
Nine Months Ended September 30,
   
2006
 
2005
 
Cash Flows From Financing Activities
             
Issuance of CBO bonds payable
   
-
   
442,034
 
Repayments of CBO bonds payable
   
(27,716
)
 
(7,364
)
Issuance of other bonds payable
   
631,988
   
246,547
 
Repayments of other bonds payable
   
(276,082
)
 
(98,786
)
Repayments of notes payable
   
(106,484
)
 
(327,080
)
Borrowings under repurchase agreements
   
3,300,477
   
675,500
 
Repayments of repurchase agreements
   
(2,150,900
)
 
(182,547
)
Draws under credit facility
   
393,900
   
42,000
 
Repayments of credit facility
   
(288,900
)
 
-
 
Issuance of junior subordinated notes payable
   
100,100
   
-
 
Issuance of common stock
   
-
   
97,680
 
Costs related to issuance of common stock
   
-
   
(1,129
)
Exercise of common stock options
   
1,440
   
9,497
 
Dividends paid
   
(90,564
)
 
(84,205
)
Payment of deferred financing costs
   
(9,664
)
 
(1,683
)
Net cash provided by financing activities
   
1,477,595
   
810,464
 
Net Increase (Decrease) in Cash and Cash Equivalents
   
(4,958
)
 
822,559
 
Cash and Cash Equivalents, Beginning of Period
   
21,275
   
37,911
 
Cash and Cash Equivalents, End of Period
 
$
16,317
 
$
860,470
 
Supplemental Disclosure of Cash Flow Information
             
Cash paid during the period for interest expense
 
$
248,594
 
$
153,122
 
Cash paid during the period for income taxes
 
$
244
 
$
443
 
Supplemental Schedule of Non-Cash Investing and Financing Activities
             
Common stock dividends declared but not paid
 
$
28,600
 
$
27,369
 
Preferred stock dividends declared but not paid
 
$
1,552
 
$
1,016
 
Deposits used in acquisition of real estate securities (treated as derivatives)
 
$
-
 
$
44,504
 
Foreclosure of loans
 
$
12,200
 
$
-
 
Acquisition and financing of loans subject to future repurchase
 
$
286,315
 
$
-
 
 
5


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2006
(dollars in tables in thousands, except share data)


1. GENERAL

Newcastle Investment Corp. (and its subsidiaries, "Newcastle") is a Maryland corporation that was formed in 2002. Newcastle conducts its business through three primary segments: (i) real estate securities and real estate related loans, (ii) residential mortgage loans, and (iii) operating real estate.

Newcastle is organized and conducts its operations to qualify as a real estate investment trust (“REIT”) for U.S. federal income tax purposes. As such, Newcastle will generally not be subject to U.S. federal corporate income tax on that portion of its net income that is distributed to stockholders if it distributes at least 90% of its REIT taxable income to its stockholders by prescribed dates and complies with various other requirements.

Newcastle is party to a management agreement (the "Management Agreement") with Fortress Investment Group LLC (the "Manager"), an affiliate, under which the Manager advises Newcastle on various aspects of its business and manages its day-to-day operations, subject to the supervision of Newcastle's board of directors. For its services, the Manager receives an annual management fee and incentive compensation, both as defined in the Management Agreement.

Approximately 2.9 million shares of Newcastle’s common stock were held by an affiliate of the Manager and its principals at September 30, 2006. In addition, an affiliate of the Manager held options to purchase approximately 1.2 million shares of Newcastle’s common stock at September 30, 2006.
 
The accompanying consolidated financial statements and related notes of Newcastle have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared under U.S. generally accepted accounting principles have been condensed or omitted. In the opinion of management, all adjustments considered necessary for a fair presentation of Newcastle's financial position, results of operations and cash flows have been included and are of a normal and recurring nature. The operating results presented for interim periods are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. These financial statements should be read in conjunction with Newcastle's consolidated financial statements for the year ended December 31, 2005 and notes thereto included in Newcastle’s annual report on Form 10-K filed with the Securities and Exchange Commission. Capitalized terms used herein, and not otherwise defined, are defined in Newcastle’s consolidated financial statements for the year ended December 31, 2005.

6


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2006
(dollars in tables in thousands, except share data)


2. INFORMATION REGARDING BUSINESS SEGMENTS

Newcastle conducts its business through three primary segments: real estate securities and real estate related loans, residential mortgage loans, and operating real estate.

The residential mortgage loans segment includes the securitized retained equity and bonds from the Securitization Trust described in Note 5 since they represent a first loss credit position in residential loans.

Summary financial data on Newcastle's segments is given below, together with a reconciliation to the same data for Newcastle as a whole:

   
Real Estate Securities
and Real Estate Related Loans
 
Residential Mortgage Loans
 
Operating Real Estate
 
Unallocated
 
Total
 
September 30, 2006 and the Nine Months then Ended
                     
Gross revenues
 
$
317,138
 
$
75,878
 
$
3,851
 
$
(196
)
$
396,671
 
Operating expenses
   
(2,026
)
 
(13,274
)
 
(3,006
)
 
(22,637
)
 
(40,943
)
Operating income (loss)
   
315,112
   
62,604
   
845
   
(22,833
)
 
355,728
 
Interest expense
   
(210,793
)
 
(46,696
)
 
-
   
(7,624
)
 
(265,113
)
Depreciation and amortization
   
-
   
-
   
(562
)
 
(205
)
 
(767
)
Equity in earnings of unconsolidated subsidiaries (A)
   
1,975
   
-
   
1,940
   
1
   
3,916
 
Income (loss) from continuing operations
   
106,294
   
15,908
   
2,223
   
(30,661
)
 
93,764
 
Income from discontinued operations
   
-
   
-
   
212
   
-
   
212
 
Net Income (loss)
 
$
106,294
 
$
15,908
 
$
2,435
 
$
(30,661
)
$
93,976
 
Revenue derived from non-U.S. sources:
                               
Canada
 
$
-
 
$
-
 
$
2,933
 
$
-
 
$
2,933
 
Total assets
 
$
6,820,667
 
$
1,238,856
 
$
46,255
 
$
20,303
 
$
8,126,081
 
Long-lived assets outside the U.S.:
                               
Canada
 
$
-
 
$
-
 
$
17,153
 
$
-
 
$
17,153
 
December 31, 2005
                               
Total assets
 
$
5,544,818
 
$
606,320
 
$
36,306
 
$
22,255
 
$
6,209,699
 
Long-lived assets outside the U.S.:
                               
Canada
 
$
-
 
$
-
 
$
16,673
 
$
-
 
$
16,673
 
Three Months Ended September 30, 2006
                               
Gross revenues
 
$
116,680
 
$
26,466
 
$
834
 
$
114
 
$
144,094
 
Operating expenses
   
(731
)
 
(3,608
)
 
(1,088
)
 
(7,605
)
 
(13,032
)
Operating income (loss)
   
115,949
   
22,858
   
(254
)
 
(7,491
)
 
131,062
 
Interest expense
   
(78,696
)
 
(17,777
)
 
-
   
(3,766
)
 
(100,239
)
Depreciation and amortization
   
-
   
-
   
(221
)
 
(69
)
 
(290
)
Equity in earnings of unconsolidated subsidiaries (A)
   
629
   
-
   
877
   
-
   
1,506
 
Income (loss) from continuing operations
   
37,882
   
5,081
   
402
   
(11,326
)
 
32,039
 
Income from discontinued operations
   
-
   
-
   
(12
)
 
-
   
(12
)
Net Income (loss)
 
$
37,882
 
$
5,081
 
$
390
 
$
(11,326
)
$
32,027
 
Revenue derived from non-U.S. sources:
                               
Canada
 
$
-
 
$
-
 
$
295
 
$
-
 
$
295
 
Nine Months Ended September 30, 2005
                               
Gross revenues
 
$
232,803
 
$
37,270
 
$
4,892
 
$
613
 
$
275,578
 
Operating expenses
   
(3,236
)
 
(7,472
)
 
(1,878
)
 
(18,294
)
 
(30,880
)
Operating income (loss)
   
229,567
   
29,798
   
3,014
   
(17,681
)
 
244,698
 
Interest expense
   
(140,240
)
 
(22,646
)
 
(249
)
 
(103
)
 
(163,238
)
Depreciation and amortization
   
-
   
-
   
(350
)
 
(103
)
 
(453
)
Equity in earnings of unconsolidated subsidiaries (A)
   
2,567
   
-
   
1,740
   
-
   
4,307
 
Income (loss) from continuing operations
   
91,894
   
7,152
   
4,155
   
(17,887
)
 
85,314
 
Income (loss) from discontinued operations
   
-
   
-
   
2,051
   
-
   
2,051
 
Net Income (Loss)
 
$
91,894
 
$
7,152
 
$
6,206
 
$
(17,887
)
$
87,365
 
Revenue derived from non-U.S. sources:
                               
Canada
 
$
-
 
$
-
 
$
10,269
 
$
-
 
$
10,269
 
 
continued on page 8

7

 
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2006
(dollars in tables in thousands, except share data)


   
Real Estate Securities
and Real Estate Related Loans
 
Residential Mortgage Loans
 
Operating Real Estate
 
Unallocated
 
Total
 
Three Months Ended September 30, 2005
                     
Gross revenues
 
$
85,742
 
$
11,932
 
$
1,889
 
$
287
 
$
99,850
 
Operating expenses
   
(2,460
)
 
(3,144
)
 
(618
)
 
(6,712
)
 
(12,934
)
Operating income (loss)
   
83,282
   
8,788
   
1,271
   
(6,425
)
 
86,916
 
Interest expense
   
(50,992
)
 
(7,588
)
 
2
   
(103
)
 
(58,681
)
Depreciation and amortization
   
-
   
-
   
(119
)
 
(63
)
 
(182
)
Equity in earnings of unconsolidated subsidiaries (A)
   
724
   
-
   
337
   
-
   
1,061
 
Income (loss) from continuing operations
   
33,014
   
1,200
   
1,491
   
(6,591
)
 
29,114
 
Income (loss) from discontinued operations
   
-
   
-
   
86
   
-
   
86
 
Net Income (Loss)
 
$
33,014
 
$
1,200
 
$
1,577
 
$
(6,591
)
$
29,200
 
Revenue derived from non-U.S. sources:
                               
Canada
 
$
-
 
$
-
 
$
1,917
 
$
-
 
$
1,917
 
                                 
(A) Net of income taxes on related taxable subsidiaries.
                               

Unconsolidated Subsidiaries

The following table summarizes the activity affecting the equity held by Newcastle in unconsolidated subsidiaries:

   
Operating Real Estate Subsidiary
 
Real Estate Loan Subsidiary
 
Trust Preferred Subsidiary
 
Balance at December 31, 2005
 
$
12,151
 
$
17,802
 
$
-
 
Contributions to unconsolidated subsidiaries
   
-
   
-
   
100
 
Distributions from unconsolidated subsidiaries
   
(1,734
)
 
(3,686
)
 
-
 
Equity in earnings of unconsolidated subsidiaries
   
1,940
   
1,975
   
1
 
Balance at September 30, 2006
 
$
12,357
 
$
16,091
 
$
101
 

Summarized financial information related to Newcastle’s unconsolidated subsidiaries was as follows:

 
Operating Real Estate Subsidiary (A) (B)
 

Real Estate Loan Subsidiary (A) (C)
 
   
September 30,
 
December 31,
 
September 30,
 
December 31,
 
   
2006
 
2005
 
2006
 
2005
 
Assets
 
$
78,177
 
$
77,758
 
$
32,365
 
$
35,806
 
Liabilities
   
(53,000
)
 
(53,000
)
 
-
   
-
 
Minority interest
   
(463
)
 
(455
)
 
(183
)
 
(202
)
Equity
 
$
24,714
 
$
24,303
 
$
32,182
 
$
35,604
 
Equity held by Newcastle
 
$
12,357
 
$
12,151
 
$
16,091
 
$
17,802
 
 
 
 
 Nine Months Ended September 30,
 
 Nine Months Ended September 30,
 
     
2006
 
 
2005
 
 
2006
 
 
2005
 
Revenues
 
$
6,493
 
$
8,287
 
$
3,996
 
$
5,195
 
Expenses
   
(2,541
)
 
(4,088
)
 
(25
)
 
(32
)
Minority interest
   
(72
)
 
(77
)
 
(22
)
 
(29
)
Net income
 
$
3,880
 
$
4,122
 
$
3,949
 
$
5,134
 
Newcastle's equity in net income
 
$
1,940
 
$
2,061
 
$
1,975
 
$
2,567
 

(A)  
The unconsolidated subsidiaries’ summary financial information is presented on a fair value basis, consistent with their internal basis of accounting.

(B)
Included in the operating real estate segment.

(C)
Included in the real estate securities and real estate related loans segment.
 
For information regarding the trust preferred subsidiary, which is a financing subsidiary with no material net income or cash flow, see Note 6.
 
8

 
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2006
(dollars in tables in thousands, except share data)


3. REAL ESTATE SECURITIES

The following is a summary of Newcastle’s real estate securities at September 30, 2006, all of which are classified as available for sale and are therefore marked to market through other comprehensive income.

           
Gross Unrealized
         
Weighted Average
 
Asset Type
 
Current Face Amount
 
Amortized Cost Basis
 
Gains
 
Losses
 
Carrying Value
 
Number of
Securities
 
S&P
Equivalent
Rating
 
Coupon
 
Yield
 
Maturity (Years)
 
CMBS-Conduit
 
$
1,478,808
 
$
1,427,860
 
$
37,634
 
$
(11,373
)
$
1,454,121
   
200
   
BBB-
   
5.95%
 
 
6.50%
 
 
7.22
 
CMBS- CDO
   
23,500
   
20,690
   
1,312
   
(38
)
 
21,964
   
2
   
BB
   
9.47%
 
 
11.86%
 
 
8.74
 
CMBS-Large Loan
   
618,014
   
615,712
   
8,212
   
(305
)
 
623,619
   
54
   
BBB-
   
6.94%
 
 
7.11%
 
 
2.32
 
CMBS- B-Note
   
245,567
   
233,080
   
6,035
   
(285
)
 
238,830
   
29
   
BB-
   
6.97%
 
 
7.72%
 
 
6.92
 
Unsecured REIT Debt
   
979,598
   
994,447
   
16,656
   
(11,612
)
 
999,491
   
100
   
BBB-
   
6.37%
 
 
6.00%
 
 
6.33
 
ABS-Manufactured Housing
   
91,839
   
86,526
   
1,644
   
(920
)
 
87,250
   
10
   
BB+
   
6.87%
 
 
7.74%
 
 
6.60
 
ABS-Home Equity
   
697,486
   
683,286
   
6,803
   
(902
)
 
689,187
   
121
   
BBB
   
7.09%
 
 
7.55%
 
 
2.86
 
ABS-Franchise
   
79,096
   
78,513
   
1,561
   
(1,016
)
 
79,058
   
23
   
BBB
   
7.26%
 
 
8.21%
 
 
4.93
 
Agency RMBS
   
1,091,022
   
1,097,009
   
2,511
   
(7,792
)
 
1,091,728
   
32
   
AAA
   
5.19%
 
 
5.18%
 
 
4.33
 
Subtotal/Average (A)
   
5,304,930
   
5,237,123
   
82,368
   
(34,243
)
 
5,285,248
   
571
   
BBB+
   
6.23%
 
 
6.46%
 
 
5.27
 
Retained securities (B)
   
37,555
   
34,119
   
233
   
(102
)
 
34,250
   
3
   
BBB-
   
7.71%
 
 
11.01%
 
 
3.48
 
Residual interest (B)
   
50,143
   
50,143
   
-
   
-
   
50,143
   
1
   
NR
   
0.00%
 
 
18.77%
 
 
2.78
 
Total/Average
 
$
5,392,628
 
$
5,321,385
 
$
82,601
 
$
(34,345
)
$
5,369,641
   
575
   
BBB+
   
6.19%
 
 
6.60%
 
 
5.23
 
 
(A)
The total current face amount of fixed rate securities was $4.2 billion, and of floating rate securities was $1.2 billion.
(B)
Represents the retained bonds and equity from the Securitization Trust as described in Note 5. These securities have been treated as part of the residential mortgage loan segment - see Note 2. The residual does not have a stated coupon and therefore its coupon has been treated as zero for purposes of the table.
 
Unrealized losses that are considered other than temporary are recognized currently in income. There were no such losses incurred during the nine months ended September 30, 2006. The unrealized losses on Newcastle’s securities are primarily the result of market factors, rather than credit impairment, and Newcastle believes their carrying values are fully recoverable over their expected holding period. None of the securities had principal in default as of September 30, 2006. Newcastle has performed credit analyses in relation to such securities which support its belief that the carrying values of such securities are fully recoverable over their expected holding period. Although management expects to hold these securities until their recovery, there is no assurance that such securities will not be sold or at what price they may be sold.

           
Gross Unrealized
         
Weighted Average
 
Securities in an Unrealized Loss Position
 
Current Face Amount
 
Amortized Cost Basis
 
Gains
 
Losses
 
Carrying Value
 
Number of
Securities
 
S&P
Equivalent
Rating
 
Coupon
 
Yield
 
Maturity (Years)
 
Less Than Twelve Months
 
$
603,483
 
$
589,011
 
$
-
 
$
(2,589
)
$
586,422
   
82
   
BBB-
   
7.80%
 
 
8.32%
 
 
4.37
 
Twelve or More Months
   
1,492,869
   
1,514,167
   
-
   
(31,756
)
 
1,482,411
   
178
   
A-
   
5.62%
 
 
5.30%
 
 
5.61
 
Total
 
$
2,096,352
 
$
2,103,178
 
$
-
 
$
(34,345
)
$
2,068,833
   
260
   
BBB+
   
6.25%
 
 
6.15%
 
 
5.25
 
 
As of September 30, 2006, Newcastle had $139.1 million of restricted cash held in CBO financing structures pending its investment in real estate securities and loans. As of November 7, 2006, Newcastle had approximately $100.0 million of restricted cash held in CBO financing structures pending its investment in real estate securities and loans.

9

 
NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2006
(dollars in tables in thousands, except share data)


4. REAL ESTATE RELATED LOANS, RESIDENTIAL MORTGAGE LOANS AND SUBPRIME MORTGAGE LOANS

The following is a summary of real estate related loans, residential mortgage loans and subprime mortgage loans at September 30, 2006. The loans contain various terms, including fixed and floating rates, self-amortizing and interest only. They are generally subject to prepayment.

Loan Type
 

Current
Face Amount
 
Carrying
Value
 
Loan Count
 
Wtd. Avg. Yield
 
Weighted Average Maturity
(Years) (D)
 
Delinquent Carrying Amount (E)
 
B-Notes
 
$
95,859
 
$
95,124
   
5
   
7.25
%
 
4.31
 
$
-
 
Mezzanine Loans (A)
   
729,701
   
729,509
   
15
   
8.90
%
 
2.73
   
-
 
Bank Loans
   
209,691
   
209,813
   
5
   
7.80
%
 
4.25
   
-
 
Whole Loans (A)
   
74,993
   
75,238
   
2
   
11.94
%
 
1.90
   
-
 
ICH Loans (B)
   
130,287
   
128,734
   
74
   
8.64
%
 
1.24
   
6,040
 
Total Real Estate Related Loans
 
$
1,240,531
 
$
1,238,418
   
101
   
8.74
%
 
2.90
 
$
6,040
 
                                       
Residential Loans
 
$
195,159
 
$
199,952
   
566
   
6.42
%
 
2.79
 
$
3,104
 
Manufactured Housing Loans
   
673,956
   
663,836
   
19,148
   
8.46
%
 
6.05
   
12,928
 
Total Residential Mortgage Loans
 
$
869,115
 
$
863,788
   
19,714
   
7.99
%
 
5.32
 
$
16,032
 
Subprime Mortgage Loans Subject
                                     
to Future Repurchase (C)
 
$
299,176
 
$
287,546
                         

(A)
Two of these loans have contractual exit fees. Newcastle has begun accruing the exit fee on one loan and will begin to accrue for the other if and when management believes it is probable that such exit fee will be received.

(B)
In October 2003, pursuant to FIN No. 46, Newcastle consolidated an entity which holds a portfolio of commercial mortgage loans which has been securitized. This investment, which is referred to as the ICH CMO, was previously treated as a non-consolidated residual interest in such securitization. The primary effect of the consolidation is the requirement that Newcastle reflect the gross loan assets and gross bonds payable of this entity in its financial statements.

(C)
See Note 5.

(D)
The weighted average maturities for the residential loan portfolio and the manufactured housing loan portfolio were calculated based on constant prepayment rates (CPR) of approximately 30% and 9%, respectively.

(E)
This face amount of loans is 60 or more days delinquent.

The following is a reconciliation of loss allowance.

   
Real Estate Related Loans
 
Residential Mortgage Loans
 
Balance at December 31, 2005
 
$
4,226
 
$
3,207
 
Provision for credit losses
   
605
   
5,263
 
Realized losses
   
(2,931
)
 
(2,821
)
Balance at September 30, 2006
 
$
1,900
 
$
5,649
 
10


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2006
(dollars in tables in thousands, except share data)

 
Newcastle has entered into total rate of return swaps with a major investment bank to finance certain loans whereby Newcastle receives the sum of all interest, fees and any positive change in value amounts (the total return cash flows) from a reference asset with a specified notional amount, and pays interest on such notional plus any negative change in value amounts from such asset. These agreements are recorded in Derivative Assets and treated as non-hedge derivatives for accounting purposes and are therefore marked to market through income. Net interest received is recorded to Interest Income and the mark to market is recorded to Other Income. If Newcastle owned the reference assets directly, they would not be marked to market through income. Under the agreements, Newcastle is required to post an initial margin deposit to an interest bearing account and additional margin may be payable in the event of a decline in value of the reference asset. Any margin on deposit (recorded in Restricted Cash), less any negative change in value amounts, will be returned to Newcastle upon termination of the contract.

As of September 30, 2006, Newcastle held an aggregate of $186.9 million notional amount of total rate of return swaps on 5 reference assets on which it had deposited $29.2 million of margin. These total rate of return swaps had an aggregate fair value of approximately $0.7 million, a weighted average receive interest rate of LIBOR + 2.54%, a weighted average pay interest rate of LIBOR + 0.53%, and a weighted average maturity of 1.3 years.

5. SECURITIZATION OF SUBPRIME MORTGAGE LOANS

In March 2006, Newcastle, through a consolidated subsidiary, acquired a portfolio of approximately 11,300 residential mortgage loans to subprime borrowers (the “Subprime Portfolio”) for $1.50 billion. The loans are being serviced by Centex Home Equity Company, LLC for a servicing fee equal to 0.50% per annum on the unpaid principal balance of the Subprime Portfolio. At March 31, 2006, these loans were considered “held for sale” and carried at the lower of cost or fair value. A write down of $4.1 million was recorded to Provision for Losses, Loans Held for Sale in March 2006 related to these loans, related to market factors. Furthermore, the acquisition of loans held for sale is considered an operating activity for statement of cash flow purposes. An offsetting cash inflow from the sale of such loans (as described below) was recorded as an operating cash flow in April 2006. This acquisition was initially funded with an approximately $1.47 billion repurchase agreement which bore interest at LIBOR + 0.50%. Newcastle entered into an interest rate swap in order to hedge its exposure to the risk of changes in market interest rates with respect to the financing of the Subprime Portfolio. This swap did not qualify as a hedge for accounting purposes and was therefore marked to market through income. An unrealized mark to market gain of $5.5 million was recorded to Other Income in connection with this swap in March 2006.

In April 2006, Newcastle, through Newcastle Mortgage Securities Trust 2006-1 (the “Securitization Trust”), closed on a securitization of the Subprime Portfolio. The Securitization Trust is not consolidated by Newcastle. Newcastle sold the Subprime Portfolio and the related interest rate swap to the Securitization Trust. The Securitization Trust issued $1.45 billion of debt (the “Notes”). Newcastle retained $37.6 million face amount of the low investment grade Notes and all of the equity issued by the Securitization Trust. The Notes have a stated maturity of March 25, 2036. Newcastle, as holder of the equity of the Securitization Trust, has the option to redeem the Notes once the aggregate principal balance of the Subprime Portfolio is equal to or less than 20% of such balance at the date of the transfer. The proceeds from the securitization were used to repay the repurchase agreement described above.
 
The transaction between Newcastle and the Securitization Trust qualified as a sale for accounting purposes, resulting in a net gain of approximately $40,000 being recorded in April 2006. However, 20% of the loans which are subject to future repurchase by Newcastle were not treated as being sold and are classified as “held for investment” subsequent to the completion of the securitization. Following the securitization, Newcastle held the following interests in the Subprime Portfolio, all valued at the date of securitization: (i) the $62.4 million equity of the Securitization Trust, recorded in Real Estate Securities, Available for Sale, (ii) the $33.7 million of retained bonds ($37.6 million face amount), recorded in Real Estate Securities, Available for Sale, which have been financed with a $28.0 million repurchase agreement, and (iii) subprime mortgage loans subject to future repurchase of $286.3 million and related financing in the amount of 100% of such loans.
 
11


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2006
(dollars in tables in thousands, except share data)


The key assumptions utilized in measuring the $62.4 million fair value of the equity, or residual interest, in the Securitization Trust at the date of securitization were as follows:

Weighted average life (years) of residual interest
   
3.1
 
Expected credit losses
   
5.3
%
Weighted average constant prepayment rate
   
28.0
%
Discount rate
   
18.8
%

The following table presents information on the retained interests in the securitization of the Subprime Portfolio, which include the residual interest and the retained bonds described above, and the sensitivity of their fair value to immediate 10% and 20% adverse changes in the assumptions utilized in calculating such fair value, at September 30, 2006:
 
Total securitized loans (unpaid principal balance)
 
$
1,304,950
 
Loans subject to future repurchase (carrying value)
 
$
287,546
 
Retained interests (fair value)
 
$
84,393
 
         
Weighted average life (years) of residual interest
   
2.78
 
         
Expected credit losses
   
5.3
%
Effect on fair value of retained interests of 10% adverse change
 
$
(2,533
)
Effect on fair value of retained interests of 20% adverse change
 
$
(4,681
)
         
Weighted average constant prepayment rate
   
28.0
%
Effect on fair value of retained interests of 10% adverse change
 
$
(3,507
)
Effect on fair value of retained interests of 20% adverse change
 
$
(6,005
)
         
Discount rate
   
18.8
%
Effect on fair value of retained interests of 10% adverse change
 
$
(2,393
)
Effect on fair value of retained interests of 20% adverse change
 
$
(4,695
)
 
The sensitivity analysis is hypothetical and should be used with caution. In particular, the results are calculated by stressing a particular economic assumption independent of changes in any other assumption; in practice, changes in one factor may result in changes in another, which might counteract or amplify the sensitivities. Also, changes in the fair value based on a 10% or 20% variation in an assumption generally may not be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear.

The following table summarizes principal amounts outstanding and delinquencies of the securitized loans as of September 30, 2006 and net credit losses for the period then ended:
Loan unpaid principal balance (UPB)
 
$
1,304,950
 
Delinquencies of 60 or more days (UPB)
 
$
26,020
 
Net credit losses
 
$
-
 
 
Newcastle received net proceeds of $1.41 billion from the securitization transaction completed in April 2006 and net cash inflows of $20.3 million from the retained interests subsequent to the securitization.

The weighted average yield of the retained bonds was 11.01% and the weighted average funding cost of the related repurchase agreement was 5.83% as of September 30, 2006. The loans subject to future repurchase and the corresponding financing recognize interest income and expense based on the expected weighted average coupon of the loans subject to future repurchase at the call date of 9.24%.

12


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2006
(dollars in tables in thousands, except share data)


6. RECENT ACTIVITIES

In January 2006, Newcastle closed on a three year term financing of its manufactured housing loan portfolio which provided for an initial financing amount of approximately $237.1 million. The financing bears interest at LIBOR + 1.25%. The lender received an upfront structuring fee equal to 0.75% of the initial financing amount. Newcastle entered into an interest rate swap in order to hedge its exposure to the risk of changes in market interest rates with respect to this debt. In connection with this term financing, Newcastle renewed its servicing agreement on these loans, with a portfolio company of a private equity fund advised by an affiliate of its manager, at the same terms.

In 2006, employees of the Manager exercised options to acquire 84,000 shares of Newcastle’s common stock for net proceeds of $1.4 million.

In March 2006, Newcastle foreclosed on $12.2 million of loans formerly in the ICH portfolio. The related real estate is considered held for investment.

In March 2006, Newcastle completed the placement of $100 million of trust preferred securities through its wholly owned subsidiary, Newcastle Trust I (the “Preferred Trust”). Newcastle owns all of the common stock of the Preferred Trust. The Preferred Trust used the proceeds to purchase $100.1 million of Newcastle’s junior subordinated notes. These notes represent all of the Preferred Trust’s assets. The terms of the junior subordinated notes are substantially the same as the terms of the trust preferred securities. The trust preferred securities require quarterly distributions at a fixed rate of 7.574% through April 2016 and at a floating rate of 3-month LIBOR plus 2.25% thereafter. The trust preferred securities mature in April 2036, but may be redeemed at par beginning in April 2011. Under the provisions of FIN 46R, Newcastle determined that the holders of the trust preferred securities were the primary beneficiaries of the Preferred Trust. As a result, Newcastle did not consolidate the Preferred Trust and has reflected the obligation to the Preferred Trust under the caption Junior Subordinated Notes Payable in its consolidated balance sheet and will account for its investment in the common stock of the Preferred Trust, which is reflected in Investments in Unconsolidated Subsidiaries in the consolidated balance sheet, under the equity method of accounting.

In May 2006, Newcastle entered into a new $200.0 million revolving credit facility, secured by substantially all of its unencumbered assets and its equity interests in its subsidiaries. Newcastle paid an upfront fee of 0.25% of the total commitment. The credit facility bears interest at one month LIBOR + 1.75% and matures in November 2007. The credit facility does not contain any unused fees. Newcastle simultaneously terminated its prior credit facility and recorded a loss of $0.7 million related to deferred financing costs, included in Gain on Sale of Investments, Net.

In June 2006, Newcastle entered into a warehouse agreement with a major investment bank to finance a portfolio of real estate related loans and securities prior to them being financed with a CBO. The financing bears interest at LIBOR + 0.50%. As of September 30, 2006, $695.8 million face amount of investments were financed with $572.5 million of debt, which has been classified as a Repurchase Agreement.

In July 2006, private equity funds managed by an affiliate of Newcastle’s manager completed the acquisition of a subprime home equity mortgage lender (“Subprime Servicer ” ). Newcastle’s portfolio of subprime loans, which was securitized in April, is being serviced by the Subprime Servicer for a servicing fee equal to 0.5% per annum on the unpaid principal balance of the portfolio.

In August 2006, Newcastle acquired a portfolio of approximately 13,300 manufactured housing loans for an aggregate purchase price of approximately $425.4 million. The loans, 96% of which were current or less than 30 days delinquent at the time of acquisition, are 82% fixed rate and 18% adjustable rate. Their weighted average gross coupon was 10.0% and the loans had a weighted average remaining term to maturity of 213 months at acquisition. The acquisition was funded with $391.3 million of five year notes bearing interest at one month LIBOR + 1.25%. The lender received an upfront fee of 0.5% on the initial financing amount and is entitled to expense reimbursement of up to 0.125% on the initial financing amount. Newcastle entered into interest rate swaps to hedge its exposure to the risk of changes in market interest rates with respect to this financing. The loans are serviced by a portfolio company of a private equity fund advised by an affiliate of our manager.

In November 2006, Newcastle sold 1.7 million shares of its common stock in a public offering at a price to the public of $29.42 per share, for net proceeds of approximately $49.5 million. For the purpose of compensating the Manager for its successful efforts in raising capital for Newcastle, in connection with this offering, Newcastle granted options to the Manager to purchase 170,000 shares of Newcastle’s common stock at the public offering price, which were valued at approximately $0.5 million.

13


NEWCASTLE INVESTMENT CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
SEPTEMBER 30, 2006
(dollars in tables in thousands, except share data)


7. DERIVATIVE INSTRUMENTS

The following table summarizes the notional amounts and fair (carrying) values of Newcastle's derivative financial instruments, excluding the credit derivative arrangements described in Note 4, as of September 30, 2006.
 
   
Notional Amount
 
Fair Value
 
Longest Maturity
 
Interest rate swaps, treated as hedges (A)
 
$
3,838,625
 
$
37,139
   
April 2017
 
Interest rate caps, treated as hedges (A)
   
342,351
   
1,677
   
October 2015
 
Non-hedge derivative obligations (A) (B)
   
147,500
   
(444
)
 
July 2038
 
(A)
Included in Derivative Assets or Derivative Liabilities, as applicable. Derivative Liabilities also include accrued interest.
(B)
Represents two essentially offsetting interest rate caps and two essentially offsetting interest rate swaps, each with notional amounts of $32.5 million and an interest rate cap with a notional amount of $17.5 million.

8. EARNINGS PER SHARE

Newcastle is required to present both basic and diluted earnings per share (“EPS”). Basic EPS is calculated by dividing net income available for common stockholders by the weighted average number of shares of common stock outstanding during each period. Diluted EPS is calculated by dividing net income available for common stockholders by the weighted average number of shares of common stock outstanding plus the additional dilutive effect of common stock equivalents during each period. Newcastle’s common stock equivalents are its outstanding stock options. Net income available for common stockholders is equal to net income less preferred dividends.

The following is a reconciliation of the weighted average number of shares of common stock outstanding on a diluted basis.

   
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
   
2006
 
2005
 
2006
 
2005
 
Weighted average number of shares of common stock outstanding, basic
   
43,999,817
   
43,789,819
   
43,978,625
   
43,595,411
 
Dilutive effect of stock options, based on the treasury stock method
   
137,139
   
331,444
   
112,378
   
365,633
 
Weighted average number of shares of common stock outstanding, diluted
   
44,136,956
   
44,121,263
   
44,091,003
   
43,961,044
 
 
As of September 30, 2006, Newcastle’s outstanding options were summarized as follows:
 
Held by the Manager
   
1,193,439
 
Issued to the Manager and subsequently transferred to certain of the Manager's employees
   
520,368
 
Held by the independent directors
   
14,000
 
Total
   
1,727,807
 

14


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following should be read in conjunction with the unaudited consolidated financial statements and notes included herein.

GENERAL

Newcastle Investment Corp. is a real estate investment and finance company. We invest in real estate securities, loans and other real estate related assets. In addition, we consider other opportunistic investments which capitalize on our manager’s expertise and which we believe present attractive risk/return profiles and are consistent with our investment guidelines. We seek to deliver stable dividends and attractive risk-adjusted returns to our stockholders through prudent asset selection, active management and the use of match funded financing structures, which reduce our interest rate and financing risks. Our objective is to maximize the difference between the yield on our investments and the cost of financing these investments while hedging our interest rate risk. We emphasize asset quality, diversification, match funded financing and credit risk management.

We currently own a diversified portfolio of moderately credit sensitive real estate debt investments including securities and loans. Our portfolio of real estate securities includes commercial mortgage backed securities (CMBS), senior unsecured debt issued by property REITs, real estate related asset backed securities (ABS), and agency residential mortgage backed securities (RMBS). Mortgage backed securities are interests in or obligations secured by pools of mortgage loans. We generally target investments rated A through BB, except for our agency RMBS which are generally considered AAA rated. We also own, directly and indirectly, interest in loans and pools of loans, including real estate related loans, commercial mortgage loans, residential mortgage loans, manufactured housing loans, and subprime mortgage loans. We also own, directly and indirectly, interests in operating real estate.

We employ leverage in order to achieve our return objectives. We do not have a predetermined target debt to equity ratio as we believe the appropriate leverage for the particular assets we are financing depends on the credit quality of those assets. As of September 30, 2006, our debt to equity ratio was approximately 7.4 to 1. Also, on a pro forma basis, our debt to equity ratio would be 6.6 to 1 if the trust preferred securities we issued in March 2006 were considered equity for purposes of this computation. We maintain access to a broad array of capital resources in an effort to insulate our business from potential fluctuations in the availability of capital. We utilize multiple forms of financing including collateralized bond obligations (CBOs), other securitizations, term loans, and trust preferred securities, as well as short term financing in the form of repurchase agreements and our credit facility.

We seek to match fund our investments with respect to interest rates and maturities in order to minimize the impact of interest rate fluctuations on earnings and reduce the risk of refinancing our liabilities prior to the maturity of the investments. We seek to finance a substantial portion of our real estate securities and loans through the issuance of debt securities in the form of CBOs, which are obligations issued in multiple classes secured by an underlying portfolio of securities. Our CBO financings offer us the structural flexibility to buy and sell certain investments to manage risk and, subject to certain limitations, to optimize returns.

Market Considerations

Our ability to maintain our dividends and grow our business is dependent on our ability to invest our capital on a timely basis at yields which exceed our cost of capital. The primary market factor that bears on this is credit spread.

Generally speaking, tightening credit spreads increase the unrealized gains on our current investments but reduce the yields available on potential new investments, while widening credit spreads reduce the unrealized gains on our current investments (or cause unrealized losses) but increase the yields available on potential new investments.

In the first nine months of 2006, credit spreads again tightened, reducing the yield we can earn on certain new investments. This tightening of credit spreads and declining interest rates caused the net unrealized gains on our securities and derivatives, recorded in accumulated other comprehensive income, and therefore our book value per share, to increase.

We continue to pursue opportunistic investments within our investment guidelines that offer a more attractive risk adjusted return, including our recent investments in subprime mortgage loans and other real estate related loans which we expect to produce a net, loss adjusted yield in the high teens.
 
If credit spreads widen, we expect that our new investment activities will benefit and our earnings will increase, although our net book value per share may decrease.

15


Certain aspects of these effects are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Interest Rate, Credit and Spread Risk” as well as in “Quantitative and Qualitative Disclosures About Market Risk.”

Organization

Our initial public offering occurred in October 2002. The following table presents information on shares of our common stock issued since our formation:

Year
 
Shares Issued
 
Range of Issue
Prices (1)
 
Net Proceeds (millions)
 
Formation
   
16,488,517
   
N/A
   
N/A
 
2002
   
7,000,000
 
 
$13.00
 
 
$80.0
 
2003
   
7,886,316
 
 
$20.35-$22.85
 
 
$163.4
 
2004
   
8,484,648
 
 
$26.30-$31.40
 
 
$224.3
 
2005
   
4,053,928
 
 
$29.60
 
 
$108.2
 
Nine Months Ended 2006
 
 
86,408
   
N/A
 
 
$1.4
 
September 30, 2006
 
 
43,999,817
         
 
 
November 2006
   
1,700,000
 
 
$29.42
   
$49.5
 
 
(1)
Excludes prices of shares issued pursuant to the exercise of options and shares issued to Newcastle's independent directors.

As of September 30, 2006, approximately 2.9 million shares of our common stock were held by an affiliate of our manager and its principals. In addition, an affiliate of our manager held options to purchase approximately 1.2 million shares of our common stock at September 30, 2006.

We are organized and conduct our operations to qualify as a REIT for U.S. federal income tax purposes. As such, we will generally not be subject to U.S. federal corporate income tax on that portion of our income that is distributed to stockholders if we distribute at least 90% of our REIT taxable income to our stockholders by prescribed dates and comply with various other requirements.

We conduct our business by investing in three primary business segments: (i) real estate securities and real estate related loans, (ii) residential mortgage loans and (iii) operating real estate.

Revenues attributable to each segment are disclosed below (unaudited) (in thousands).

For the Nine Months Ended September 30,
 
Real Estate Securities and Real Estate Related Loans
 
Residential Mortgage Loans
 
Operating Real Estate
 
Unallocated
 
Total
 
2006
 
$
317,138
 
$
75,878
 
$
3,851
 
$
(196
)
$
396,671
 
2005
 
$
232,803
 
$
37,270
 
$
4,892
 
$
613
 
$
275,578
 
 
16

 
APPLICATION OF CRITICAL ACCOUNTING POLICIES

Management's discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP"). The preparation of financial statements in conformity with GAAP requires the use of estimates and assumptions that could affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses. Actual results could differ from these estimates. The following is a summary of our accounting policies that are most effected by judgments, estimates and assumptions.

Variable Interest Entities

In December 2003, Financial Accounting Standards Board Interpretation (“FIN”) No. 46R “Consolidation of Variable Interest Entities” was issued as a modification of FIN 46. FIN 46R clarified the methodology for determining whether an entity is a variable interest entity (“VIE”) and the methodology for assessing who is the primary beneficiary of a VIE. VIEs are defined as entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. A VIE is required to be consolidated by its primary beneficiary, and only by its primary beneficiary, which is defined as the party who will absorb a majority of the VIE’s expected losses or receive a majority of the expected residual returns as a result of holding variable interests.

Prior to FIN 46R, we consolidated our existing CBO transactions (the “CBO Entities”) because we own the entire equity interest in each of them, representing a substantial portion of their capitalization, and we control the management and resolution of their assets. We have determined that certain of the CBO Entities are VIEs and that we are the primary beneficiary of each of these VIEs and therefore continue to consolidate them. We have also determined that the application of FIN 46R did not result in a change in our accounting for any other entities which were previously consolidated. However, it did cause us to consolidate one entity which was previously not consolidated, ICH CMO, as described below under “Liquidity and Capital Resources.” Furthermore, as a result of FIN 46R, we are precluded from consolidating our wholly owned subsidiary which has issued trust preferred securities as described in “Liquidity and Capital Resources” below. We will continue to analyze future CBO entities, as well as other investments, pursuant to the requirements of FIN 46R. These analyses require considerable judgment in determining the primary beneficiary of a VIE since they involve subjective probability weighting of subjectively determined possible cash flow scenarios. The result could be the consolidation of an entity acquired or formed in the future that would otherwise not have been consolidated or the non-consolidation of such an entity that would otherwise have been consolidated.

Valuation and Impairment of Securities

We have classified our real estate securities as available for sale. As such, they are carried at fair value with net unrealized gains or losses reported as a component of accumulated other comprehensive income. Fair value is based primarily upon broker quotations, as well as counterparty quotations, which provide valuation estimates based upon reasonable market order indications or a good faith estimate thereof. These quotations are subject to significant variability based on market conditions, such as interest rates and credit spreads. Changes in market conditions, as well as changes in the assumptions or methodology used to determine fair value, could result in a significant increase or decrease in our book equity. We must also assess whether unrealized losses on securities, if any, reflect a decline in value which is other than temporary and, accordingly, write the impaired security down to its value through earnings. For example, a decline in value is deemed to be other than temporary if it is probable that we will be unable to collect all amounts due according to the contractual terms of a security which was not impaired at acquisition, or if we do not have the ability and intent to hold a security in an unrealized loss position until its anticipated recovery (if any). Temporary declines in value generally result from changes in market factors, such as market interest rates and credit spreads, or from certain macroeconomic events, including market disruptions and supply changes, which do not directly impact our ability to collect amounts contractually due. We continually evaluate the credit status of each of our securities and the collateral supporting our securities. This evaluation includes a review of the credit of the issuer of the security (if applicable), the credit rating of the security, the key terms of the security (including credit support), debt service coverage and loan to value ratios, the performance of the pool of underlying loans and the estimated value of the collateral supporting such loans, including the effect of local, industry and broader economic trends and factors. These factors include loan default expectations and loss severities, which are analyzed in connection with a particular security’s credit support, as well as prepayment rates. The result of this evaluation is considered in relation to the amount of the unrealized loss and the period elapsed since it was incurred. Significant judgment is required in this analysis.

17

 
Revenue Recognition on Securities

Income on these securities is recognized using a level yield methodology based upon a number of cash flow assumptions that are subject to uncertainties and contingencies. Such assumptions include the rate and timing of principal and interest receipts (which may be subject to prepayments and defaults). These assumptions are updated on at least a quarterly basis to reflect changes related to a particular security, actual historical data, and market changes. These uncertainties and contingencies are difficult to predict and are subject to future events, and economic and market conditions, which may alter the assumptions. For securities acquired at a discount for credit losses, the net income recognized is based on a “loss adjusted yield” whereby a gross interest yield is recorded to Interest Income, offset by a provision for probable, incurred credit losses which is accrued on a periodic basis to Provision for Credit Losses. The provision is determined based on an evaluation of the credit status of securities, as described in connection with the analysis of impairment above.

Valuation of Derivatives

Similarly, our derivative instruments are carried at fair value pursuant to Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities," as amended. Fair value is based on counterparty quotations. To the extent they qualify as cash flow hedges under SFAS No. 133, net unrealized gains or losses are reported as a component of accumulated other comprehensive income; otherwise, they are reported currently in income. To the extent they qualify as fair value hedges, net unrealized gains or losses on both the derivative and the related portion of the hedged item are reported currently in income. Fair values of such derivatives are subject to significant variability based on many of the same factors as the securities discussed above. The results of such variability could be a significant increase or decrease in our book equity and/or earnings.

Impairment of Loans

We purchase, directly and indirectly, real estate related, commercial mortgage and residential mortgage loans, including manufactured housing loans and subprime mortgage loans, to be held for investment. We periodically evaluate each of these loans or loan pools for possible impairment. Impairment is indicated when it is deemed probable that we will be unable to collect all amounts due according to the contractual terms of the loan, or, for loans acquired at a discount for credit losses, when it is deemed probable that we will be unable to collect as anticipated. Upon determination of impairment, we would establish a specific valuation allowance with a corresponding charge to earnings. We continually evaluate our loans receivable for impairment. Our residential mortgage loans, including manufactured housing loans, are aggregated into pools for evaluation based on like characteristics, such as loan type and acquisition date. Individual loans are evaluated based on an analysis of the borrower’s performance, the credit rating of the borrower, debt service coverage and loan to value ratios, the estimated value of the underlying collateral, the key terms of the loan, and the effect of local, industry and broader economic trends and factors. Pools of loans are also evaluated based on similar criteria, including trends in defaults and loss severities for the type and seasoning of loans being evaluated. This information is used to estimate specific impairment charges on individual loans as well as provisions for estimated unidentified incurred losses on pools of loans. Significant judgment is required both in determining impairment and in estimating the resulting loss allowance.

Revenue Recognition on Loans

Income on these loans is recognized similarly to that on our securities and is subject to similar uncertainties and contingencies, which are also analyzed on at least a quarterly basis. For loan pools acquired at a discount for credit losses, the net income recognized is based on a “loss adjusted yield” whereby a gross interest yield is recorded to Interest Income, offset by a provision for probable, incurred credit losses which is accrued on a periodic basis to Provision for Credit Losses. The provision is determined based on an evaluation of the loans as described under “Impairment of Loans” above. A rollforward of the provision is included in Note 4 to our consolidated financial statements.

Impairment of Operating Real Estate

We own operating real estate held for investment. We review our operating real estate for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Upon determination of impairment, we would record a write-down of the asset, which would be charged to earnings. Significant judgment is required both in determining impairment and in estimating the resulting write-down. To date, we have determined that no write-downs have been necessary on the operating real estate in our portfolio. In addition, when operating real estate is classified as held for sale, it must be recorded at the lower of its carrying amount or fair value less costs of sale. Significant judgment is required in determining the fair value of such properties.

Accounting Treatment for Certain Investments Financed with Repurchase Agreements

We owned $491.0 million of assets purchased from particular counterparties which are financed via $413.6 million of repurchase agreements with the same counterparties at September 30, 2006. Currently, we record such assets and the related financings gross on our balance sheet, and the corresponding interest income and interest expense gross on our income statement. In addition, if the asset is a security, any change in fair value is reported through other comprehensive income (since it is considered “available for sale”).

18

 
However, in a transaction where assets are acquired from and financed under a repurchase agreement with the same counterparty, the acquisition may not qualify as a sale from the seller’s perspective; in such cases, the seller may be required to continue to consolidate the assets sold to us, based on their “continuing involvement” with such investments. The result is that we may be precluded from presenting the assets gross on our balance sheet as we currently do, and may instead be required to treat our net investment in such assets as a derivative.

If it is determined that these transactions should be treated as investments in derivatives, the interest rate swaps entered into by us to hedge our interest rate exposure with respect to these transactions would no longer qualify for hedge accounting, but would, as the underlying asset transactions, also be marked to market through the income statement.

This potential change in accounting treatment does not affect the economics of the transactions but does affect how the transactions are reported in our financial statements. Our cash flows, our liquidity and our ability to pay a dividend would be unchanged, and we do not believe our taxable income would be affected. Our net income and net equity would not be materially affected. In addition, this would not affect Newcastle’s status as a REIT or cause it to fail to qualify for its Investment Company Act exemption. This issue has been submitted to accounting standard setters for resolution. If we were to change our current accounting treatment for these transactions, our total assets and total liabilities would each be reduced by approximately $414.4 million at September 30, 2006.
 
19


RESULTS OF OPERATIONS

The following table summarizes the changes in our results of operations from the three and nine months ended September 30, 2005 to the three and nine months ended September 30, 2006 (dollars in thousands):

   
Period to Period Change
 
Period to Period Percent Change
     
   
Nine Months Ended September 30, 2006/2005
 
Three Months Ended September 30, 2006/2005
 
Nine Months Ended September 30, 2006/2005
 
Three Months Ended September 30, 2006/2005
 
Explanation
 
Interest income
 
$
124,411
 
$
52,309
   
49.0
%
 
59.4
%
 
(1)
 
Rental and escalation income
   
(1,234
)
 
(1,037
)
 
(25.4
%)
 
(55.4
%)
 
(2)
 
Gain on sale of investments
   
(2,035
)
 
(4,108
)
 
(16.8
%)
 
(60.9
%)
 
(3)
 
Other income
   
(49
)
 
(2,920
)
 
(1.1
%)
 
(91.0
%)
 
(4)
 
                                 
Interest expense
   
101,875
   
41,558
   
62.4
%
 
70.8
%
 
(1)
 
Property operating expense
   
981
   
447
   
53.7
%
 
75.3
%
 
(2)
 
Loan and security servicing expense
   
315
   
70
   
6.8
%
 
4.7
%
 
(1)
 
Provision for credit losses
   
(122
)
 
(1,409
)
 
(2.0
%)
 
(34.4
%)
 
(5)
 
Provision for losses, loans held for sale
   
4,127
   
-
   
N/A
   
N/A
   
(6)
 
General and administrative expense
   
728
   
153
   
22.4
%
 
14.8
%
 
(7)
 
Management fee to affiliate
   
525
   
159
   
5.3
%
 
4.8
%
 
(8)
 
Incentive compensation to affiliate
   
3,509
   
678
   
66.6
%
 
28.1
%
 
(8)
 
Depreciation and amortization
   
314
   
108
   
69.4
%
 
59.3
%
 
(9)
 
Equity in earnings of unconsolidated subsidiaries
   
(391
)
 
445
   
(9.1
%)
 
41.9
%
 
(10)
 
Income from continuing operations
 
$
8,450
 
$
2,925
   
9.9
%
 
10.0
%
     

(1)
Changes in interest income and expense are primarily related to our acquisition and disposition during the periods of interest bearing assets and related financings, as follows:

   
Nine Months Ended September 30, 2006/2005
 
Three Months Ended September 30, 2006/2005
 
 
 
Period to Period Increase (Decrease)
 
Period to Period Increase (Decrease)
 
 
 
Interest Income
 
Interest Expense
 
Interest Income
 
Interest Expense
 
Real estate security and loan portfolios (A)
 
$
44,938
 
$
35,284
 
$
19,788
 
$
14,235
 
Agency RMBS
   
19,016
   
18,216
   
6,730
   
6,523
 
Other real estate related loans
   
33,502
   
11,190
   
12,179
   
3,864
 
Subprime mortgage loan portfolio
   
31,467
   
22,523
   
10,078
   
7,144
 
Credit facility and junior subordinated notes
   
-
   
7,523
   
-
   
3,665
 
Manufactured housing loan portfolio (D)
   
7,715
   
4,675
   
6,042
   
4,398
 
Other (B)
   
7,175
   
13,031
   
2,706
   
5,018
 
Other real estate related loans (C)
   
(13,898
)
 
(7,418
)
 
(3,713
)
 
(1,935
)
Residential mortgage loan portfolio (C)
   
(5,504
)
 
(3,149
)
 
(1,501
)
 
(1,354
)
   
$
124,411
 
$
101,875
 
$
52,309
 
$
41,558
 
 
(A)  
Represents the collateral for our most recent CBO financings.

(B)  
Primarily due to increasing interest rates on floating rate assets and liabilities owned during the entire period.

(C)  
These loans received paydowns during the period which served to offset the amounts listed above.

(D)  
Primarily due to the acquisition of a manufactured housing loan pool in the third quarter of 2006.

Changes in loan and security servicing expense are also primarily due to these acquisitions and paydowns.

(2)
These changes are primarily the result of the effect of the termination of a lease (including the acceleration of lease termination income), the inception of a new lease (including the associated free rent period), foreign currency fluctuations, and the acquisition of a $12.2 million portfolio of properties through foreclosure in the first quarter of 2006.

(3)
This change is primarily a result of the volume of sales of real estate securities. Sales of real estate securities are based on a number of factors including credit, asset type and industry and can be expected to increase or decrease from time to time. Periodic fluctuations in the volume of sales of securities is dependent upon, among other things, management’s assessment of credit risk, asset concentration, portfolio balance and other factors. In addition, this item includes a $0.7 million loss recorded in connection with the refinancing of our credit facility in the second quarter of 2006.

(4)
This change is primarily the result of investments financed with total rate of return swaps which we treat as non-hedge derivatives and mark to market through the income statement, which is offset by the $5.5 million gain recorded in the first half of 2006 on the derivative used to hedge the interim financing of our subprime mortgage loans, which did not qualify as a hedge for accounting purposes. This gain was offset by the loss described in (6) below.
 
20

 
(5)
The change for the nine months is primarily due to less impairment recorded with respect to the ICH loans which is offset by an increase as a result of the acquisition of manufactured housing and residential mortgage loan pools at a discount related to credit. The change for the three months is primarily due to the impairment recorded with respect to ICH loans in the third quarter of 2005.

6)
This change represents the unrealized loss on our pool of subprime mortgage loans which was considered held for sale at March 31, 2006. This loss was related to market factors and was offset by the gain described in (4) above.

(7)
The increase in general and administrative expense is primarily a result of increased professional fees.

(8)
The increase in management fees is a result of our increased size resulting from our equity issuances. The increase in incentive compensation is primarily a result of increased funds from operations, as described below under “Funds from Operations”.

(9)
The increase in depreciation is primarily due to the acquisition of new information systems and the acquisition of a $12.2 million portfolio of properties through foreclosure in the first quarter of 2006.

(10)
The decrease in earnings from unconsolidated subsidiaries for the nine months ended September 30, 2006 is primarily the result of a decrease in earnings from an LLC which owns franchise loans. During the periods presented, our investment in this LLC decreased due to return of capital distributions resulting in a corresponding reduction in earnings. The increase for the three months ended September 30, 2006 is primarily due to an income tax refund to a taxable subsidiary.
 
21


LIQUIDITY AND CAPITAL RESOURCES

Liquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain investments, and other general business needs. Additionally, to maintain our status as a REIT under the Internal Revenue Code, we must distribute annually at least 90% of our REIT taxable income. Our primary sources of funds for liquidity consist of net cash provided by operating activities, borrowings under loans, and the issuance of debt and equity securities. Additional sources of liquidity include investments that are readily saleable prior to their maturity. Our debt obligations are generally secured directly by our investment assets.

We expect that our cash on hand and our cash flow provided by operations, as well as our credit facility, will satisfy our liquidity needs with respect to our current investment portfolio over the next twelve months. However, we currently expect to seek additional capital in order to grow our investment portfolio. We have an effective shelf registration statement with the SEC which allows us to issue various types of securities, such as common stock, preferred stock, depository shares, debt securities and warrants, from time to time, up to an aggregate of $750 million, of which approximately $261 million remained available as of November 1, 2006.

We expect to meet our long-term liquidity requirements, specifically the repayment of our debt obligations, through additional borrowings and the liquidation or refinancing of our assets at maturity. We believe that the value of these assets is, and will continue to be, sufficient to repay our debt at maturity under either scenario. Our ability to meet our long-term liquidity requirements relating to capital required for the growth of our investment portfolio is subject to obtaining additional equity and debt financing. Decisions by investors and lenders to enter into such transactions with us will depend upon a number of factors, such as our historical and projected financial performance, compliance with the terms of our current credit arrangements, industry and market trends, the availability of capital and our investors’ and lenders’ policies and rates applicable thereto, and the relative attractiveness of alternative investment or lending opportunities. We maintain access to a broad array of capital resources in an effort to insulate our business from potential fluctuations in the availability of capital.

Our ability to execute our business strategy, particularly the growth of our investment portfolio, depends to a significant degree on our ability to obtain additional capital. Our core business strategy is dependent upon our ability to finance our real estate securities, loans and other real estate related assets with match funded debt at rates that provide a positive net spread. If spreads for such liabilities widen or if demand for such liabilities ceases to exist, then our ability to execute future financings will be severely restricted. Furthermore, in an environment where spreads are tightening, if spreads tighten on the assets we purchase to a greater degree than they tighten on the liabilities we issue, our net spread will be reduced.

We expect to meet our short-term liquidity requirements generally through our cash flow provided by operations and our credit facility, as well as investment specific borrowings. In addition, at September 30, 2006 we had an unrestricted cash balance of $16.3 million and an undrawn balance of $75.0 million on our credit facility. Our cash flow provided by operations differs from our net income due to five primary factors: (i) accretion of discount or premium on our real estate securities and loans (including the accrual of interest and fees payable at maturity), discount on our debt obligations, deferred financing costs and interest rate cap premiums, and deferred hedge gains and losses, (ii) gains and losses from sales of assets financed with CBOs, (iii) depreciation and straight-lined rental income of our operating real estate, (iv) the provision for credit losses recorded in connection with our loan assets, and (v) unrealized gains or losses on our non-hedge derivatives, particularly our total return swaps. Proceeds from the sale of assets which serve as collateral for our CBO financings, including gains thereon, are required to be retained in the CBO structure until the related bonds are retired and are therefore not available to fund current cash needs.

Our match funded investments are financed long-term and their credit status is continuously monitored; therefore, these investments are expected to generate a generally stable current return, subject to interest rate fluctuations. See “Quantitative and Qualitative Disclosures About Market Risk -- Interest Rate Exposure” below. Our remaining investments, generally financed with short term repurchase agreements, are also subject to refinancing risk upon the maturity of the related debt. See “Debt Obligations” below.

With respect to our operating real estate, we expect to incur expenditures of approximately $3.2 million relating to tenant improvements, in connection with the inception of leases, and capital expenditures during the twelve months ending September 30, 2007.

As described below, under “Interest Rate, Credit and Spread Risk,” we are subject to margin calls in connection with our assets financed with repurchase agreements. We do not expect these potential margin calls to materially affect our financial condition or results of operations.
 
22


Debt Obligations

The following tables present certain information regarding our debt obligations and related hedges as of September 30, 2006 (unaudited) (dollars in thousands):
 
Debt Obligation/Collateral
Month
Issued
 
Current
Face
Amount
 
Carrying
Value
 
 
Unhedged Weighted
Average
Funding Cost
 
Final Stated Maturity
 
Weighted Average
Funding
Cost (1)
 
Weighted Average Maturity
(Years)
 
Face
Amount
of Floating Rate Debt
 
Collateral
Carrying
Value
 
Collateral Weighted Average Maturity
(Years)
 
Face
Amount
of Floating Rate Collateral
 
Aggregate
Notional
Amount of
Current Hedges
 
CBO Bonds Payable
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate securities
 
Jul 1999
 
$
398,970
 
$
396,060
 
 6.58% (2)
 
 
Jul 2038
   
5.12
%
 
2.25
 
$
303,970
 
$
545,452
   
4.26
 
$
-
 
$
262,732
 
Real estate securities and loans
 
Apr 2002
   
444,000
   
441,500
 
6.51% (2)
 
 
Apr 2037
   
6.80
%
 
3.70
   
372,000
   
499,025
   
5.47
   
59,849
   
296,000
 
Real estate securities and loans
 
Mar 2003
   
472,000
   
468,808
 
6.26% (2)
 
 
Mar 2038
   
5.36
%
 
5.55
   
427,800
   
516,387
   
4.77
   
133,771
   
285,060
 
Real estate securities and loans
 
Sep 2003
   
460,000
   
456,098
 
6.07% (2)
 
 
Sep 2038
   
5.88
%
 
6.11
   
442,500
   
506,289
   
4.58
   
135,545
   
207,500
 
Real estate securities and loans
 
Mar 2004
   
414,000
   
410,887
 
5.96% (2)
 
 
Mar 2039
   
5.40
%
 
5.86
   
382,750
   
446,737
   
4.87
   
184,946
   
177,300
 
Real estate securities and loans
 
Sep 2004
   
454,500
   
451,011
 
5.94% (2)
 
 
Sep 2039
   
5.51
%
 
6.44
   
442,500
   
498,845
   
5.17
   
227,746
   
209,261
 
Real estate securities and loans
 
Apr 2005
   
447,000
   
442,741
 
5.79% (2)
 
 
Apr 2040
   
5.53
%
 
7.42
   
439,600
   
490,338
   
6.15
   
186,386
   
243,079
 
Real estate securities
 
Dec 2005
   
442,800
   
438,801
 
5.70% (2)
 
 
Dec 2050
   
5.48
%
 
8.73
   
436,800
   
509,724
   
7.62
   
115,574
   
341,506
 
 
     
3,533,270
   
3,505,906
 
 
       
5.64
%
 
5.80
   
3,247,920
   
4,012,797
   
5.39
   
1,043,817
   
2,022,438
 
Other Bonds Payable
           
 
                                 
ICH loans (3)
 
(3)
 
 
106,084
   
106,084
 
6.77% (2)
 
 
Aug 2030
   
6.77
%
 
1.05
   
1,987
   
128,734
   
1.24
   
1,987
   
-
 
Manufactured housing loans
 
Jan 2006
   
218,635
   
217,000
 
LIBOR+1.25%
 
 
Jan 2009
   
6.14
%
 
1.71
   
218,635
   
241,833
   
6.29
   
5,317
   
213,350
 
Manufactured housing loans
 
Aug 2006
   
384,518
   
381,701
 
LIBOR+1.25%
 
 
Aug 2011
   
6.94
%
 
3.39
   
384,518
   
422,002
   
5.90
   
76,523
   
384,081
 
 
     
709,237
   
704,785
 
 
       
6.67
%
 
2.52
   
605,140
   
792,569
   
5.27
   
83,827
   
597,431
 
Notes Payable
           
 
                                 
Residential mortgage loans (4)
 
Nov 2004
   
153,957
   
153,957
 
LIBOR+0.16%
 
 
Nov 2007
   
5.67
%
 
0.84
   
153,957
   
172,902
   
2.79
   
168,807
   
-
 
 
     
153,957
   
153,957
 
 
       
5.67
%
 
0.84
   
153,957
   
172,902
   
2.79
   
168,807
   
-
 
Repurchase Agreements (4) (10)
           
 
                                 
Agency RMBS (5)
 
Rolling
   
1,059,670
   
1,059,670
 
LIBOR+ 0.13%
 
 
Oct 2006
   
5.09
%
 
0.08
   
1,059,670
   
1,091,728
   
4.33
   
-
   
1,016,135
 
Real estate securities and loans (6)
 
Jun 2006
   
572,509
   
572,509
 
LIBOR+ 0.50%
 
 
Dec 2006
   
5.83
%
 
0.25
   
572,509
   
691,562
   
4.17
   
616,841
   
63,590
 
Real estate securities
 
Rolling
   
283,139
   
283,139
 
LIBOR+ 0.44%
 
 
Various (8)
 
 
5.79
%
 
0.08
   
283,139
   
335,851
   
6.20
   
187,941
   
139,031
 
Real estate related loans
 
Rolling
   
257,115
   
257,115
 
LIBOR+ 0.63%
 
 
Oct 2006
   
5.97
%
 
0.08
   
257,115
   
352,798
   
1.79
   
352,965
   
-
 
Residential mortgage loans
 
Rolling
   
25,347
   
25,347
 
LIBOR+ 0.43%
 
 
Dec 2006
   
5.79
%
 
0.23
   
25,347
   
27,050
   
2.81
   
26,352
   
-
 
 
     
2,197,780
   
2,197,780
 
 
     
5.48
%
 
0.13
   
2,197,780
   
2,498,989
   
4.18
   
1,184,099
   
1,218,756
 
Credit facility (7)
 
May 2006
   
125,000
   
125,000
 
LIBOR+ 1.75%
 
 
Nov 2007
   
7.10
%
 
1.09
   
125,000
   
-
   
-
   
-
   
-
 
Junior subordinated notes payable
 
Mar 2006
   
100,100
   
100,100
 
7.574% (9)
 
 
Apr 2036
   
7.62
%
 
29.50
   
-
   
-
   
-
   
-
   
-
 
Subtotal debt obligations
     
6,819,344
   
6,787,528
 
 
       
5.75
%
 
3.78
 
$
6,329,797
 
$
7,477,257
   
4.90
 
$
2,480,550
 
$
3,838,625
 
Financing on subprime mortgage
                                               
loans subject to future repurchase (11)
 
Apr 2006
   
299,176
   
287,546
                                     
Total debt obligations
   
$
7,118,520
 
$
7,075,074
                                     
 
(1)
Includes the effect of applicable hedges.
(2)
Weighted average, including floating and fixed rate classes.
(3)
See "Liquidity and Capital Resources" below regarding the consolidation of ICH CMO.
(4)
Subject to potential mandatory prepayments based on collateral value.
(5)
A maximum of $1.125 billion is available until November 2006.
(6)
A maximum of $700 million is available under this warehouse agreement for the accumulation of collateral for the next CBO financing.
(7)
A maximum of $200 million can be drawn.
(8)
The longest maturity is November 2006.
(9)
LIBOR + 2.25% after April 2016.
(10)
The counterparties on our repurchase agreements include: Bank of America Securities LLC ($1,128 million), Bear Stearns Mortgage Capital Corporation ($256 million), Credit Suisse ($637 million), Deutsche Bank AG ($177 million).
(11)
See "Liquidity and Capital Resources" below.

23

 
Our debt obligations existing at September 30, 2006 (gross of $43.4 million of discounts) had contractual maturities as follows (unaudited) (in thousands):

Period from October 1, 2006 through December 31, 2006
 
$
2,197,780
 
2007
   
278,957
 
2008
   
-
 
2009
   
218,635
 
2010
   
-
 
2011
   
384,518
 
Thereafter
   
4,038,630
 
Total
 
$
7,118,520
 

Certain of the debt obligations included above are obligations of our consolidated subsidiaries which own the related collateral. In some cases, including the CBO and Other Bonds Payable, such collateral is not available to other creditors of ours.

Two classes of CBO bonds, with an aggregate $718.0 million face amount, were issued subject to remarketing procedures and related agreements whereby such bonds are remarketed and sold on a periodic basis. $395.0 million of these bonds are fully insured by a third party with respect to the timely payment of interest and principal thereon.

In October 2003, pursuant to FIN No. 46R, we consolidated an entity which holds a portfolio of commercial mortgage loans which has been securitized. This investment, which we refer to as ICH, was previously treated as a non-consolidated residual interest in such securitization. The primary effect of the consolidation is the requirement that we reflect the gross loan assets and gross bonds payable of this entity in our financial statements.

In January 2006, we closed on a term financing of our manufactured housing loan portfolio which provided for an initial financing amount of approximately $237.1 million. The lender received an upfront structuring fee equal to 0.75% on the initial financing amount and is entitled to expense reimbursement of up to 0.125% on the initial financing amount. We entered into an interest rate swap in order to hedge our exposure to the risk of changes in market interest rates with respect to this debt.

In March 2006, a consolidated subsidiary of ours acquired a portfolio of approximately 11,300 subprime mortgage loans (the “Subprime Portfolio”) for $1.50 billion. This acquisition was initially funded with an approximately $1.47 billion repurchase agreement.

In April 2006, Newcastle Mortgage Securities Trust 2006-1 (the “Securitization Trust”) closed on a securitization of the Subprime Portfolio. We do not consolidate the Securitization Trust. We sold the Subprime Portfolio to the Securitization Trust. The Securitization Trust issued $1.45 billion of debt (the “Notes”). The Notes have a stated maturity of March 25, 2036. We, as holder of the equity of the Securitization Trust, have the option to redeem the Notes once the aggregate principal balance of the Subprime Portfolio is equal to or less than 20% of such balance at the date of the transfer. The proceeds from the securitization were used to repay the repurchase agreement described above.

The transaction between us and the Securitization Trust qualified as a sale for accounting purposes. However, 20% of the loans which are subject to future repurchase by us were not treated as being sold. Following the securitization, we held the following interests in the Subprime Portfolio, all valued at the date of securitization: (i) the $62.4 million equity of the Securitization Trust, (ii) the $33.7 million of retained bonds ($37.6 million face amount), which have been financed with a $28.0 million repurchase agreement, and (iii) subprime mortgage loans subject to future repurchase of $286.3 million and related financing in the amount of 100% of such loans.

In March 2006, we completed the placement of $100.0 million of trust preferred securities through our wholly owned subsidiary, Newcastle Trust I (the “Preferred Trust”). We own all of the common stock of the Preferred Trust. The Preferred Trust used the proceeds to purchase $100.1 million of our junior subordinated notes. These notes represent all of the Preferred Trust’s assets. The terms of the junior subordinated notes are substantially the same as the terms of the trust preferred securities. The trust preferred securities may be redeemed at par beginning in April 2011. We do not consolidate the Preferred Trust; as a result, we have reflected the obligation to the Preferred Trust under the caption Junior Subordinated Notes Payable.

In May 2006, we entered into a new $200.0 million revolving credit facility, secured by substantially all of our unencumbered assets and our equity interests in our subsidiaries. We paid an upfront fee of 0.25% of the total commitment. The credit facility bears interest at one month LIBOR + 1.75% and matures in November 2007. We will not incur any unused fees. We simultaneously terminated our prior credit facility and recorded an expense of $0.7 million related to deferred financing costs.

In August 2006, we completed our acquisition of a manufactured housing loan portfolio and closed on a five year term financing for an initial financing amount of approximately $391.3 million bearing interest rate at one month LIBOR+1.25%. The lender received an upfront structuring fee equal to 0.5% on the initial financing amount and is entitled to expense reimbursement of up to 0.125% on the initial financing amount. We entered into interest rate swaps in order to hedge our exposure to the risk of changes in market interest rates with respect to this debt. 
 
In November 2006, we priced our ninth CBO financing to term finance $950 million portfolio of real estate securities and loans. We have agreed to issue, through a consolidated subsidiary of ours, $807.5 million of investment grade debt in the offering, which is expected to close on November 16, 2006. At closing, the investment grade debt will have an initial weighted average spread over LIBOR of 0.48% and a weighted average life of 7 years. Approximately 69%, or $560.5 million, of the investment grade debt is rated AAA.

24

 
Our debt obligations contain various customary loan covenants. Such covenants do not, in management’s opinion, materially restrict our investment strategy or ability to raise capital. We are in compliance with all of our loan covenants as of September 30, 2006.

Other

We have entered into arrangements with a major investment bank to finance certain loans whereby we receive the sum of all interest, fees and any positive change in value amounts (the total return cash flows) from a reference asset with a specified notional amount, and pay interest on such notional plus any negative change in value amounts from such asset. These agreements are recorded in Derivative Assets and treated as non-hedge derivatives for accounting purposes and are therefore marked to market through income. Net interest received is recorded to Interest Income and the mark to market is recorded to Other Income. If we owned the reference assets directly, they would not be marked to market. Under the agreements, we are required to post an initial margin deposit to an interest bearing account and additional margin may be payable in the event of a decline in value of the reference asset. Any margin on deposit, less any negative change in value amounts, will be returned to us upon termination of the contract.

As of September 30, 2006, we held an aggregate of $186.9 million notional amount of total rate of return swaps on 5 reference assets on which we had deposited $29.2 million of margin. These total rate of return swaps had an aggregate fair value of approximately $0.7 million, a weighted average receive interest rate of LIBOR + 2.54%, a weighted average pay interest rate of LIBOR + 0.53%, and a weighted average maturity of 1.3 years.
 
Stockholders’ Equity

Common Stock

The following table presents information on shares of our common stock issued since December 31, 2005:
 
Period
 
Shares Issued
 
Range of Issue Prices (1)
 
Net Proceeds (millions)
 
Options Granted
to Manager
Nine Months 2006
 
 86,408
 
 N/A
 
$1.4
 
 N/A
 
(1)
Excludes prices of shares issued pursuant to the exercise of options and shares issued to our independent directors.

At September 30, 2006, we had 43,899,817 shares of common stock outstanding.

As of September 30, 2006, our outstanding options were summarized as follows:

Held by the Manager
   
1,193,439
 
Issued to the Manager and subsequently transferred to certain of the manager’s employees
   
520,368
 
Held by the independent directors
   
14,000
 
Total
   
1,727,807
 
 
In November 2006, we sold 1.7 million shares of our common stock in a public offering at a price to the public at $29.42 per share for net proceeds of approximately $49.5 million. For the purpose of compensating the Manager for its successful efforts in raising capital for us, in connection with this offering, we granted options to the Manager to purchase 170,000 shares of our common stock at the public offering price, which were valued at approximately $0.5 million.

Preferred Stock

In March 2003, we issued 2.5 million shares ($62.5 million face amount) of 9.75% Series B Cumulative Redeemable Preferred Stock (the “Series B Preferred”). In October 2005, we issued 1.6 million shares ($40.0 million face amount) of 8.05% Series C Cumulative Redeemable Preferred Stock (the “Series C Preferred”). The Series B Preferred and Series C Preferred have a $25 liquidation preference, no maturity date and no mandatory redemption. We have the option to redeem the Series B Preferred beginning in March 2008 and the Series C Preferred beginning in October 2010.

25


Other Comprehensive Income

During the nine months ended September 30, 2006, our accumulated other comprehensive income changed due to the following factors (in thousands):
 
Accumulated other comprehensive income, December, 31, 2005
 
$
45,564
 
Net unrealized (loss) on securities
   
31,775
 
Reclassification of net realized (gain) on securities into earnings
   
(637
)
Foreign currency translation
   
763
 
Net unrealized gain on derivatives designated as cash flow hedges
   
6,801
 
Reclassification of net realized (gain) on derivatives designated as cash flow hedges into earnings
   
(3,351
)
Accumulated other comprehensive income, September 30, 2006
 
$
80,915
 
 
Our book equity changes as our real estate securities portfolio and derivatives are marked-to-market each quarter, among other factors. The primary causes of mark-to-market changes are changes in interest rates and credit spreads. During the period, increasing interest rates and tightening credit spreads resulted in a net increase in unrealized gains on our real estate securities and derivatives. In an environment of widening credit spreads and increasing interest rates, we believe our new investment activities would benefit. While such an environment would likely result in a decrease in the fair value of our existing securities portfolio and, therefore, reduce our book equity and ability to realize gains on such existing securities, it would not directly affect our earnings or our cash flow or our ability to pay dividends.

Common Dividends Paid
 
Declared for the Period Ended
 
Paid
 
Amount Per Share
 
March 31, 2006
   
April 28, 2006
 
$0.625
 
June 30, 2006
   
July 28, 2006
 
$0.650
 
September 30, 2006
   
October 31, 2006
 
$0.650
 
 
Cash Flow

Net cash flow provided by operating activities increased to $114.0 million for the nine months ended September 30, 2006 from $12.1 million for the nine months ended September 30, 2005. This change primarily resulted from the increase in restricted cash, offset by the acquisition and settlement of our investments as described above.

Investing activities (used) ($1,596.5 million) and ($844.1 million) during the nine months ended September 30, 2006 and 2005, respectively. Investing activities consisted primarily of investments made in certain real estate securities, loans and other real estate related assets, net of proceeds from the sale or settlement of investments.

Financing activities provided $1,477.6 million and $810.5 million during the nine months ended September 30, 2006 and 2005, respectively. The equity issuances, borrowings and debt issuances described above served as the primary sources of cash flow from financing activities. Offsetting uses included the payment of related deferred financing costs, the purchase of hedging instruments, the payment of dividends, and the repayment of debt as described above.

See the consolidated statements of cash flows included in our consolidated financial statements included herein for a reconciliation of our cash position for the periods described herein.

INTEREST RATE, CREDIT AND SPREAD RISK

We are subject to interest rate, credit and spread risk with respect to our investments.

Our primary interest rate exposures relate to our real estate securities, loans, floating rate debt obligations, interest rate swaps, and interest rate caps. Changes in the general level of interest rates can affect our net interest income, which is the difference between the interest income earned on interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities and hedges. Changes in the level of interest rates also can affect, among other things, our ability to acquire real estate securities and loans at attractive prices, the value of our real estate securities, loans and derivatives, and our ability to realize gains from the sale of such assets.

Our general financing strategy focuses on the use of match funded structures. This means that we seek to match the maturities of our debt obligations with the maturities of our investments to minimize the risk that we have to refinance our liabilities prior to the maturities of our assets, and to reduce the impact of changing interest rates on our earnings. In addition, we generally match fund interest rates on our investments with like-kind debt (i.e., fixed rate assets are financed with fixed rate debt and floating rate assets are financed with floating rate debt), directly or through the use of interest rate swaps, caps or other financial instruments, or through a combination of these strategies, which allows us to reduce the impact of changing interest rates on our earnings. See “Quantitative and Qualitative Disclosures About Market Risk - Interest Rate Exposure” below.
 
26

 
Real Estate Securities

Interest rate changes may also impact our net book value as our real estate securities and related hedge derivatives are marked to market each quarter. Our loan investments and debt obligations are not marked to market. Generally, as interest rates increase, the value of our fixed rate securities decreases, and as interest rates decrease, the value of such securities will increase. In general, we would expect that over time, decreases in the value of our real estate securities portfolio attributable to interest rate changes will be offset to some degree by increases in the value of our swaps, and vice versa. However, the relationship between spreads on securities and spreads on swaps may vary from time to time, resulting in a net aggregate book value increase or decline. Our real estate securities portfolio is largely financed to maturity through long term CBO financings that are not redeemable as a result of book value changes. Accordingly, unless there is a material impairment in value that would result in a payment not being received on a security, changes in the book value of our securities portfolio will not directly affect our recurring earnings or our ability to pay dividends.

The commercial mortgage and asset backed securities we invest in are generally junior in right of payment of interest and principal to one or more senior classes, but benefit from the support of one or more subordinate classes of securities or other form of credit support within a securitization transaction. The senior unsecured REIT debt securities we invest in reflect comparable credit risk. Credit risk refers to each individual borrower’s ability to make required interest and principal payments on the scheduled due dates. We believe, based on our due diligence process, that these securities offer attractive risk-adjusted returns with long term principal protection under a variety of default and loss scenarios. While the expected yield on these securities is sensitive to the performance of the underlying assets, the more subordinated securities or other features of the securitization transaction, in the case of commercial mortgage and asset backed securities, and the issuer's underlying equity and subordinated debt, in the case of senior unsecured REIT debt securities, are designed to bear the first risk of default and loss. We further minimize credit risk by actively monitoring our real estate securities portfolio and the underlying credit quality of our holdings and, where appropriate, repositioning our investments to upgrade the credit quality on our investments. While we have not experienced any significant credit losses, in the event of a significant rising interest rate environment and/or economic downturn, loan and collateral defaults may increase and result in credit losses that would adversely affect our liquidity and operating results.

Our real estate securities are also subject to spread risk. Our fixed rate securities are valued based on a market credit spread over the rate payable on fixed rate U.S. Treasuries of like maturity. In other words, their value is dependent on the yield demanded on such securities by the market based on their credit relative to U.S. Treasuries. Excessive supply of such securities combined with reduced demand will generally cause the market to require a higher yield on such securities, resulting in the use of a higher (or “wider”) spread over the benchmark rate (usually the applicable U.S. Treasury security yield) to value such securities. Under such conditions, the value of our real estate securities portfolio would tend to decline. Conversely, if the spread used to value such securities were to decrease (or “tighten”), the value of our real estate securities portfolio would tend to increase. Our floating rate securities are valued based on a market credit spread over LIBOR and are affected similarly by changes in LIBOR spreads. Such changes in the market value of our real estate securities portfolio may affect our net equity, net income or cash flow directly through their impact on unrealized gains or losses on available-for-sale securities, and therefore our ability to realize gains on such securities, or indirectly through their impact on our ability to borrow and access capital. If the value of our securities subject to repurchase agreements were to decline, it could affect our ability to refinance such securities upon the maturity of the related repurchase agreements, adversely impacting our rate of return on such securities. See “ Quantitative and Qualitative Disclosures About Market Risk - Credit Spread Exposure” below.

Furthermore, shifts in the U.S. Treasury yield curve, which represents the market’s expectations of future interest rates, would also affect the yield required on our real estate securities and therefore their value. This would have similar effects on our real estate securities portfolio and our financial position and operations to a change in spreads.

Loans

Similar to our real estate securities portfolio, we are subject to credit and spread risk with respect to our real estate related, commercial mortgage and residential mortgage loan portfolios. However, unlike our real estate securities portfolio, our loans generally do not benefit from the support of junior classes of securities, but rather bear the first risk of default and loss. We believe that this credit risk is mitigated through our due diligence process and continual reviews of the borrower’s payment history, delinquency status, and the relationship of the loan balance to the underlying property value.

Our loan portfolios are also subject to spread risk. Our floating rate loans are valued based on a market credit spread to LIBOR. The value of the loans is dependent upon the yield demanded by the market based on their credit relative to LIBOR. The value of our floating rate loans would tend to decline should the market require a higher yield on such loans, resulting in the use of a higher spread over the benchmark rate (usually the applicable LIBOR yield). Our fixed rate loans are valued based on a market credit spread over U.S. Treasuries and are effected similarly by changes in U.S. Treasury spreads. If the value of our loans subject to repurchase agreements were to decline, it could affect our ability to refinance such loans upon the maturity of the related repurchase agreements.

Any credit or spread losses incurred with respect to our loan portfolios would affect us in the same way as similar losses on our real estate securities portfolio as described above, except that our loan portfolios are not marked to market. Accordingly, unless there is a material impairment in value that would result in a payment not being received on a loan, changes in the value of our loan portfolio will not directly affect our recurring earnings or ability to pay dividends.
 
27

 
Statistics as of September 30, 2006

The face amount of our total portfolio was $8.1 billion, which includes real estate securities and related loans (including agency RMBS) of $6.7 billion, residential mortgage loans of $0.9 billion, as well as other real estate related assets.

$5.7 billion of the real estate securities and related loans were rated by third parties or implied AAA (agency RMBS) with an average rating of BBB+, $1.0 billion of the real estate securities and real estate related loans (mezzanine loans, B-notes and real estate loans) were non-rated but had a weighted average loan to value ratio of 71.0%. Our average investment size in the real estate securities and related loan portfolio was $9.8 million, with our largest single investment being $123.1 million at September 30, 2006. The weighted average credit spread on this portfolio (i.e. the yield premium on our investments over the comparable U.S. Treasury rate or LIBOR) was 2.55%. Furthermore, our real estate securities are supported by pools of underlying loans. For instance, our CMBS investments had over 22,000 underlying loans. We expect this diversification helps to minimize the risk of capital loss, and will also enhance the terms of our financing structures.

Our residential mortgage loan portfolio was characterized by high credit quality borrowers with a weighted average FICO score of 706 at origination. Approximately $168.8 million of the unpaid principal balance of the $195.2 residential mortgage loan portfolio was held in securitized form, of which over 96.0% of the principal balance was rated investment grade.

Our loan portfolios are diversified by geographic location and by borrower. Our residential and manufactured housing loans were well diversified with 566 loans and 19,148 loans, respectively. We believe that this diversification also helps to minimize the risk of capital loss.
 
28

 
Margin

Certain of our investments are financed through repurchase agreements or total return swaps which are subject to margin calls based on the value of such investments. Margin calls resulting from decreases in value related to rising interest rates are substantially offset by our ability to make margin calls on our interest rate derivatives. We maintain adequate cash reserves or availability on our credit facility to meet any margin calls resulting from decreases in value related to a reasonably possible (in the opinion of management) widening of credit spreads. Funding a margin call on our credit facility would have a dilutive effect on our earnings, however we would not expect this to be material.

OFF-BALANCE SHEET ARRANGEMENTS

As of September 30, 2006, we had one material off-balance sheet arrangement.

·  
In April 2006, we securitized our portfolio of subprime mortgage loans. 80% of this transaction was treated as an off-balance sheet financing as described in “Liquidity and Capital Resources.”

We also had the following arrangements which do not meet the definition of off-balance sheet arrangements, but do have some of the characteristics of off-balance sheet arrangements.

·  
We are party to total rate of return swaps which are treated as non-hedge derivatives. For further information on these investments, see “Liquidity and Capital Resources.”

·  
We have made investments in three unconsolidated subsidiaries. See Note 2 to our consolidated financial statements.

In each case, our exposure to loss is limited to the carrying (fair) value of our investment, except for the total rate of return swaps where our exposure to loss is limited to their fair value plus their notional amount.

CONTRACTUAL OBLIGATIONS

During the first nine months of 2006, we had all of the material contractual obligations referred to in our annual report on Form 10-K for the year ended December 31, 2005, as well as the following:

Contract Category
Change
 
Repurchase agreements
We financed certain newly acquired loans and securities with repurchase agreements. We also entered into a warehouse agreement (structured in the form of a repurchase agreement) related to our next CBO financing.
 
Other bonds payable
One portfolio of manufactured housing loans was refinanced. We also entered into a term financing in connection with the purchase of a second manufactured housing loan portfolio.
 
Credit facility
We replaced our prior credit facility.
 
Junior subordinated notes payable
We issued the junior subordinated notes payable in connection with the issuance of trust preferred securities by our unconsolidated, wholly owned subsidiary.
 
Interest rate swaps, treated as hedges
Certain floating rate debt issuances, including those described above as well as an anticipated issuance, as well as certain assets, were hedged with interest rate swaps.
 
Loan servicing agreements
We renewed the agreement related to our manufactured housing loan portfolio at the same terms, and entered into an agreement related to our subprime mortgage loan portfolio.
 
Securitization
We entered into the securitization of our subprime mortgage loan portfolio.
 

The terms of these contracts are described under “Quantitative and Qualitative Disclosures About Market Risk” below.

INFLATION
 
We believe that our risk of increases in the market interest rates on our floating rate debt as a result of inflation is largely offset by our use of match funding and hedging instruments as described above. See "Quantitative and Qualitative Disclosure About Market Risk -- Interest Rate Exposure" below.

29


FUNDS FROM OPERATIONS

We believe FFO is one appropriate measure of the operating performance of real estate companies. We also believe that FFO is an appropriate supplemental disclosure of operating performance for a REIT due to its widespread acceptance and use within the REIT and analyst communities.  Furthermore, FFO is used to compute our incentive compensation to the Manager. FFO, for our purposes, represents net income available for common stockholders (computed in accordance with GAAP), excluding extraordinary items, plus depreciation of operating real estate, and after adjustments for unconsolidated subsidiaries, if any. We consider gains and losses on resolution of our investments to be a normal part of our recurring operations and therefore do not exclude such gains and losses when arriving at FFO. Adjustments for unconsolidated subsidiaries, if any, are calculated to reflect FFO on the same basis. FFO does not represent cash generated from operating activities in accordance with GAAP and therefore should not be considered an alternative to net income as an indicator of our operating performance or as an alternative to cash flow as a measure of liquidity and is not necessarily indicative of cash available to fund cash needs. Our calculation of FFO may be different from the calculation used by other companies and, therefore, comparability may be limited.

Funds from Operations (FFO) is calculated as follows (unaudited) (in thousands):

   
For the Nine
Months Ended
September 30, 2006
 
For the Three
Months Ended
September 30, 2006
 
Income available for common stockholders
 
$
86,991
 
$
29,699
 
Operating real estate depreciation
   
562
   
221
 
Funds from Operations (FFO)
 
$
87,553
 
$
29,920
 

Funds from Operations was derived from our segments as follows (unaudited) (in thousands):

   
Book Equity at
September 30, 2006
 
Average Invested Common Equity for the Nine Months Ended September 30, 2006(2)
 
FFO for the Nine Months Ended
September 30, 2006
 
Return on
Invested
Common Equity (ROE) (3)
 
Real estate securities and real estate related loans
 
$
956,109
 
$
872,745
 
$
106,294
   
16.2
%
Residential mortgage loans
   
135,641
   
104,031
   
15,908
   
20.4
%
Operating real estate
   
46,783
   
45,920
   
2,997
   
8.7
%
Unallocated (1)
   
(360,674
)
 
(232,168
)
 
(37,646
)
 
N/A
 
Total (2)
   
777,859
 
$
790,528
 
$
87,553
   
14.8
%
Preferred stock
   
102,500
                   
Accumulated depreciation
   
(4,108
)
                 
Accumulated other comprehensive income
   
80,915
                   
Net book equity
 
$
957,166
                   
 
 
 
Book Equity at
September 30, 2006
 
 Average Invested Common Equity for the Three Months Ended September 30, 2006(2)
 
 FFO for the Three Months Ended
September 30, 2006
 
 Return on
Invested
Common Equity (ROE) (3)
 
Real estate securities and real estate related loans
 
$
956,109
 
$
921,822
 
$
37,882
   
16.4
%
Residential mortgage loans
   
135,641
   
121,687
   
5,081
   
16.7
%
Operating real estate
   
46,783
   
46,690
   
611
   
5.2
%
Unallocated (1)
   
(360,674
)
 
(309,056
)
 
(13,654
)
 
N/A
 
Total (2)
   
777,859
 
$
781,143
 
$
29,920
   
15.3
%
Preferred stock
   
102,500
                   
Accumulated depreciation
   
(4,108
)
                 
Accumulated other comprehensive income
   
80,915
                   
Net book equity
 
$
957,166
                   
 
(1)
Unallocated FFO represents ($6,985) and ($2,328) of preferred dividends, ($7,624) and ($3,766) of interest on our credit facility and junior subordinated notes payable, and ($23,037) and ($7,560) of corporate general and administrative expenses, management fees and incentive compensation for the nine and three months ended September 30, 2006, respectively.
 
(2)
Invested common equity is equal to book equity excluding preferred stock, accumulated depreciation and accumulated other comprehensive income.
 
(3)
FFO divided by average invested common equity, annualized.
 
30

 
RELATED PARTY TRANSACTIONS

As of December 31, 2005, we owned an aggregate of approximately $48.5 million of securities of Global Signal Trust I and II, special purpose vehicles established by Global Signal Inc., which were purchased in private placements from underwriters in January 2004 and April 2005. Our CEO and chairman of our board of directors is the chairman of the board of Global Signal, Inc. and private equity funds managed by an affiliate of our manager own a significant portion of Global Signal Inc.’s common stock. In February 2006, we purchased from an underwriter $91.0 million face amount of BBB- and BB+ rated securities of Global Signal Trust III, a special purpose vehicle established by Global Signal, Inc. Pursuant to an underwritten 144A offering, approximately $1,550.0 million of Global Signal Trust III securities were issued in 8 classes, rated AAA through BB+, of which the BBB- and BB+ classes aggregated $188.3 million. The balance of the BBB- and BB+ securities were sold on identical terms to third parties. A portion of the proceeds were used to repay Global Signal, Inc. debt, including $31.5 million of the Global Signal Trust I securities we owned, and to fund the prepayment penalty associated with this debt.

In January 2005, we entered into a servicing agreement with a portfolio company of a private equity fund advised by an affiliate of our manager for them to service a portfolio of manufactured housing loans, which was acquired at the same time. As compensation under the servicing agreement, the portfolio company will receive, on a monthly basis, a net servicing fee equal to 1.00% per annum on the unpaid principal balance of the loans being serviced. In January 2006, we closed on a new term financing of this portfolio. In connection with this term financing, we renewed our servicing agreement at the same terms.

In April 2006, we securitized our portfolio of subprime residential mortgage loans and, through the Securitization Trust, entered into a servicing agreement with a subprime home equity mortgage lender (“Subprime Servicer”) to service this portfolio. In July 2006, private equity funds managed by an affiliate of our manager completed the acquisition of the Subprime Servicer. As compensation under the servicing agreement, the Subprime Servicer will receive, on a monthly basis, a net servicing fee equal to 0.5% per annum on the unpaid principal balance of the portfolio. The outstanding unpaid principal balance of this portfolio was approximately $1.30 billion at September 30, 2006.

In August 2006, we acquired a portfolio of manufactured housing loans for an aggregate purchase price of $425.4 million. The loans are being serviced by a portfolio company of a private equity fund advised by an affiliate of our manager. As compensation under the servicing agreement, the servicer will receive, on a monthly basis, a net servicing fee equal to 0.625% per annum on the unpaid principal balance of the portfolio plus an incentive fee if the performance of the loans meets certain thresholds. The outstanding unpaid principal balance of this portfolio was approximately $419.9 million at September 30, 2006.

In September 2006, we were co-lenders with two private investment funds managed by an affiliate of our manager in a new real estate related loan of $250.1 million. The loan is secured by a first mortgage interest on a parcel of land in Arizona. We own a 20% interest in the loan and the private investment funds own an 80% interest in the loan. Major decisions require the unanimous approval of the holders of interests in the loan, while other decisions require the approval of a majority of holders of interests in the loan. Newcastle and our affiliated investment funds are each entitled to transfer all or any portion of their respective interests in the loan to third parties. In October 2006, we and the private investment funds sold, on a pro-rata basis, a $125.0 million senior participation interest in the loan to an unaffiliated third party resulting in a 20% interest in the junior participation interest in the loan. Our investment in this loan was approximately $50.2 million at September 30, 2006.

As of September 30, 2006, we held total investments of $193.8 million face amount of real estate securities and related loans issued by affiliates of our manager and earned approximately $8.9 million of interest on such investments for the nine months ended September 30, 2006.

31

 
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the exposure to loss resulting from changes in interest rates, credit spreads, foreign currency exchange rates, commodity prices and equity prices. The primary market risks that we are exposed to are interest rate risk and credit spread risk. These risks are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. All of our market risk sensitive assets, liabilities and related derivative positions are for non-trading purposes only. For a further understanding of how market risk may affect our financial position or operating results, please refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations − Application of Critical Accounting Policies.”

Interest Rate Exposure

Our primary interest rate exposures relate to our real estate securities, loans, floating rate debt obligations, interest rate swaps, and interest rate caps. Changes in the general level of interest rates can affect our net interest income, which is the difference between the interest income earned on interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities and hedges. Changes in the level of interest rates also can affect, among other things, our ability to acquire real estate securities and loans at attractive prices, the value of our real estate securities, loans and derivatives, and our ability to realize gains from the sale of such assets. While our strategy is to utilize interest rate swaps, caps and match funded financings in order to limit the effects of changes in interest rates on our operations, there can be no assurance that our profitability will not be adversely affected during any period as a result of changing interest rates. In the event of a significant rising interest rate environment and/or economic downturn, loan and collateral defaults may increase and result in credit losses that would adversely affect our liquidity and operating results. As of September 30, 2006, a 100 basis point increase in short term interest rates would increase our earnings by approximately $0.6 million per annum.

A period of rising interest rates as we are currently experiencing negatively impacts our return on certain investments, particularly our floating rate residential mortgage loans. Although these loans are financed with floating rate debt, the interest rate on the debt resets prior to, and in some cases more frequently than, the interest rate on the assets, causing a decrease in return on equity during a period of rising interest rates. When interest rates stabilize, we expect these investments will return to their historical returns on equity. 

Interest rate changes may also impact our net book value as our real estate securities and related hedge derivatives are marked to market each quarter. Our loan investments and debt obligations are not marked to market. Generally, as interest rates increase, the value of our fixed rate securities decreases, and as interest rates decrease, the value of such securities will increase. In general, we would expect that over time, decreases in the value of our real estate securities portfolio attributable to interest rate changes will be offset to some degree by increases in the value of our swaps, and vice versa. However, the relationship between spreads on securities and spreads on swaps may vary from time to time, resulting in a net aggregate book value increase or decline. Our real estate securities portfolio is largely financed to maturity through long-term CBO financings that are not redeemable as a result of book value changes. Accordingly, unless there is a material impairment in value that would result in a payment not being received on a security, changes in the book value of our portfolio will not directly affect our recurring earnings or our ability to pay dividends. As of September 30, 2006, a 100 basis point change in short term interest rates would impact our net book value by approximately $60.8 million.

Our general financing strategy focuses on the use of match funded structures. This means that we seek to match the maturities of our debt obligations with the maturities of our investments to minimize the risk that we have to refinance our liabilities prior to the maturities of our assets, and to reduce the impact of changing interest rates on our earnings. In addition, we generally match fund interest rates on our investments with like-kind debt (i.e., fixed rate assets are financed with fixed rate debt and floating rate assets are financed with floating rate debt), directly or through the use of interest rate swaps, caps, or other financial instruments, or through a combination of these strategies, which allows us to reduce the impact of changing interest rates on our earnings. Our financing strategy is dependent on our ability to place the match funded debt we use to finance our investments at rates that provide a positive net spread. If spreads for such liabilities widen or if demand for such liabilities ceases to exist, then our ability to execute future financings will be severely restricted.

Interest rate swaps are agreements in which a series of interest rate flows are exchanged with a third party (counterparty) over a prescribed period. The notional amount on which swaps are based is not exchanged. In general, our swaps are “pay fixed” swaps involving the exchange of floating rate interest payments from the counterparty for fixed interest payments from us. This can effectively convert a floating rate debt obligation into a fixed rate debt obligation.
 
Similarly, an interest rate cap or floor agreement is a contract in which we purchase a cap or floor contract on a notional face amount. We will make an up-front payment to the counterparty for which the counterparty agrees to make future payments to us should the reference rate (typically one- or three-month LIBOR) rise above (cap agreements) or fall below (floor agreements) the “strike” rate specified in the contract. Should the reference rate rise above the contractual strike rate in a cap, we will earn cap income; should the reference rate fall below the contractual strike rate in a floor, we will earn floor income. Payments on an annualized basis will equal the contractual notional face amount multiplied by the difference between the actual reference rate and the contracted strike rate.
 
32


While a REIT may utilize these types of derivative instruments to hedge interest rate risk on its liabilities or for other purposes, such derivative instruments could generate income that is not qualified income for purposes of maintaining REIT status. As a consequence, we may only engage in such instruments to hedge such risks within the constraints of maintaining our standing as a REIT. We do not enter into derivative contracts for speculative purposes nor as a hedge against changes in credit risk.

Our hedging transactions using derivative instruments also involve certain additional risks such as counterparty credit risk, the enforceability of hedging contracts and the risk that unanticipated and significant changes in interest rates will cause a significant loss of basis in the contract. The counterparties to our derivative arrangements are major financial institutions with high credit ratings with which we and our affiliates may also have other financial relationships. As a result, we do not anticipate that any of these counterparties will fail to meet their obligations. There can be no assurance that we will be able to adequately protect against the foregoing risks and will ultimately realize an economic benefit that exceeds the related amounts incurred in connection with engaging in such hedging strategies.

Credit Spread Exposure

Our real estate securities are also subject to spread risk. Our fixed rate securities are valued based on a market credit spread over the rate payable on fixed rate U.S. Treasuries of like maturity. In other words, their value is dependent on the yield demanded on such securities by the market based on their credit relative to U.S. Treasuries. Excessive supply of such securities combined with reduced demand will generally cause the market to require a higher yield on such securities, resulting in the use of higher (or “wider”) spread over the benchmark rate (usually the applicable U.S. Treasury security yield) to value such securities. Under such conditions, the value of our real estate securities portfolio would tend to decline. Conversely, if the spread used to value such securities were to decrease (or “tighten”), the value of our real estate securities portfolio would tend to increase. Our floating rate securities are valued based on a market credit spread over LIBOR and are affected similarly by changes in LIBOR spreads. Such changes in the market value of our real estate securities portfolio may affect our net equity, net income or cash flow directly through their impact on unrealized gains or losses on available-for-sale securities, and therefore our ability to realize gains on such securities, or indirectly through their impact on our ability to borrow and access capital.

Furthermore, shifts in the U.S. Treasury yield curve, which represents the market’s expectations of future interest rates, would also effect the yield required on our real estate securities and therefore their value. This would have similar effects on our real estate securities portfolio and our financial position and operations to a change in spreads.

Our loan portfolios are also subject to spread risk. Our floating rate loans are valued based on a market credit spread to LIBOR. The value of the loans is dependent upon the yield demanded by the market based on their credit relative to LIBOR. The value of our floating rate loans would tend to decline should the market require a higher yield on such loans, resulting in the use of a higher spread over the benchmark rate (usually the applicable LIBOR yield). Our fixed rate loans are valued based on a market credit spread over U.S. Treasuries and are effected similarly by changes in U.S. Treasury spreads. If the value of our loans subject to repurchase agreements were to decline, it could affect our ability to refinance such loans upon the maturity of the related repurchase agreements.

Any decreases in the value of our loan portfolios due to spread changes would affect us in the same way as similar changes to our real estate securities portfolio as described above, except that our loan portfolios are not marked to market.

As of September 30, 2006, a 25 basis point movement in credit spreads would impact our net book value by approximately $62.3 million, but would not directly affect our earnings or cash flow.

Margin

Certain of our investments are financed through repurchase agreements or total return swaps which are subject to margin calls based on the value of such investments. Margin calls resulting from decreases in value related to rising interest rates are substantially offset by our ability to make margin calls on our interest rate derivatives. We maintain adequate cash reserves or availability on our credit facility to meet any margin calls resulting from decreases in value related to a reasonably possible (in the opinion of management) widening of credit spreads. Funding a margin call on our credit facility would have a dilutive effect on our earnings, however we would not expect this to be material.
 
33

 
Fair Values

Fair values for a majority of our investments are readily obtainable through broker quotations. For certain of our financial instruments, fair values are not readily available since there are no active trading markets as characterized by current exchanges between willing parties. Accordingly, fair values can only be derived or estimated for these instruments using various valuation techniques, such as computing the present value of estimated future cash flows using discount rates commensurate with the risks involved. However, the determination of estimated future cash flows is inherently subjective and imprecise. We note that minor changes in assumptions or estimation methodologies can have a material effect on these derived or estimated fair values, and that the fair values reflected below are indicative of the interest rate and credit spread environments as of September 30, 2006 and do not take into consideration the effects of subsequent interest rate or credit spread fluctuations.

We note that the values of our investments in real estate securities, loans and derivative instruments, primarily interest rate hedges on our debt obligations, are sensitive to changes in market interest rates, credit spreads and other market factors. The value of these investments can vary, and has varied, materially from period to period.

Interest Rate and Credit Spread Risk

We held the following interest rate and credit spread risk sensitive instruments at September 30, 2006 (unaudited) (dollars in thousands):

   
Carrying Value
 
Principal Balance or Notional Amount
 
Weighted Average Yield/Funding Cost
 
Weighted Average Maturity
 
Fair Value
 
Assets:
                     
Real estate securities, available for sale (1)
 
$
5,369,641
 
$
5,392,628
   
6.61
%
 
(1)
 
$
5,369,641
 
Real estate related loans (2)
   
1,238,418
   
1,240,531
   
8.74
%
 
(2)
 
 
1,243,434
 
Residential mortgage loans (3)
   
863,788
   
869,115
   
7.99
%
 
(3)
 
 
883,420
 
Subprime mortgage loans subject to future repurchase (4)
   
287,546
   
299,176
   
(4
)
 
(4)
 
 
287,546
 
Interest rate caps, treated as hedges (5)
   
1,677
   
342,351
   
N/A
   
(5)
 
 
1,677
 
Total return swaps (6)
   
659
   
186,883
   
N/A
   
(6)
 
 
659
 
Liabilities:
                     
 
     
CBO bonds payable (7)
   
3,505,906
   
3,533,270
   
5.64
%
 
(7)
 
 
3,563,789
 
Other bonds payable (8)
   
704,785
   
709,237
   
6.67
%
 
(8)
 
 
705,531
 
Notes payable (9)
   
153,957
   
153,957
   
5.67
%
 
(9)
 
 
153,957
 
Repurchase agreements (10)
   
2,197,780
   
2,197,780
   
5.48
%
 
(10)
 
 
2,197,780
 
Financing of subprime mortgage loans
                     
 
       
subject to future repurchase (4)
   
287,546
   
299,176
   
(4
)
 
(4)
 
 
287,546
 
Credit facility (11)
   
125,000
   
125,000
   
7.10
%
 
(11)
 
 
125,000
 
Junior subordinated notes payable (12)
   
100,100
   
100,100
   
7.62
%
 
(12)
 
 
101,672
 
Interest rate swaps, treated as hedges (13)
   
(37,139
)
 
3,838,625
   
N/A
   
(13)
 
 
(37,139
)
Non-hedge derivatives (14)
   
444
   
147,500
   
N/A
   
(14)
 
 
444
 
 
(1)
These securities contain various terms, including fixed and floating rates, self-amortizing and interest only. Their weighted average maturity is 5.23 years. The fair value of these securities is estimated by obtaining third party broker quotations, if available and practicable, and counterparty quotations.

(2)
Represents the following loans:
 
Loan Type
 
Current
Face
Amount
 
 Carrying
Value
 
Weighted Avg.
Yield
 
 Weighted Average
Maturity (Years)
 
Floating Rate Loans as a % of Face Amount
 
Fair Value
 
B-Notes
 
$
95,859
 
$
95,124
   
7.25
%
 
4.31
   
54.8
%
$
97,815
 
Mezzanine Loans
   
729,701
   
729,509
   
8.90
%
 
2.73
   
100.0
%
 
730,632
 
Bank Loans
   
209,691
   
209,813
   
7.80
%
 
4.25
   
100.0
%
 
211,014
 
Whole Loans
   
74,993
   
75,238
   
11.94
%
 
1.90
   
100.0
%
 
75,239
 
ICH Loans
   
130,287
   
128,734
   
8.64
%
 
1.24
   
1.5
%
 
128,734
 
   
$
1,240,531
 
$
1,238,418
   
8.74
%
 
2.90
   
86.2
%
$
1,243,434
 
 
34


The ICH loans were valued by discounting expected future cash flows by the loans’ effective rate at acquisition. The rest of the loans were valued by obtaining third party broker quotations, if available and practicable, and counterparty quotations.

(3)
This aggregate portfolio of residential loans consists of a portfolio of floating rate residential mortgage loans, two portfolios of substantially fixed rate manufactured housing loans, and the $195.2 million portfolio of residential mortgage loans has a weighted average maturity of 2.79 years. The $674.0 million manufactured housing loan portfolios have a weighted average maturity of 6.05 years. The residential mortgage loans and manufactured housing loans were valued by reference to current market interest rates and credit spreads.

(4)
Thesetwo items, related to the securitization of subprime mortgage loans, are equal and offsetting. They each yield 9.24% and are further described under “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources”.

(5)
Represents cap agreements as follows:

Notional Balance
 
Effective Date
 
Maturity Date
 
Capped Rate
 
Strike Rate
 
Fair Value
 
$
262,732
   
Current
   
March 2009
   
1-Month LIBOR
   
6.50
%
$
59
 
 
18,000
   
January 2010
   
October 2015
   
3-Month LIBOR
   
8.00
%
 
253
 
 
8,619
   
December 2010
   
June 2015
   
3-Month LIBOR
   
7.00
%
 
492
 
 
53,000
   
May 2011
   
September 2015
   
1-Month LIBOR
   
7.50
%
 
873
 
$
342,351
                         
$
1,677
 

The fair value of these agreements is estimated by obtaining counterparty quotations.

(6)
Represents total rate of return swaps which are treated as non-hedge derivatives. The fair value of these agreements, which is included in Derivative Assets, is estimated by obtaining counterparty quotations. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources” for a further discussion of these swaps.

(7)
These bonds were valued by discounting expected future cash flows by a rate calculated based on current market conditions for comparable financial instruments, including market interest rates and credit spreads. The weighted average maturity of the CBO bonds payable is 5.80 years. The CBO bonds payable amortize principal prior to maturity based on collateral receipts, subject to reinvestment requirements.

(8)
The ICH bonds amortize principal prior to maturity based on collateral receipts and have a weighted average maturity of 1.05 years. These bonds were valued by discounting expected future cash flows by a rate calculated based on current market conditions for comparable financial instruments, including market interest rates and credit spreads. The manufactured housing loan bonds amortize principal prior to maturity based on collateral receipts and have a weighted average maturity of 2.78. These bonds were valued by reference to current market interest rates and credit spreads.

(9)
The residential mortgage loan financing has a weighted average maturity of 0.84 years and is subject to adjustment monthly based on the market value of the loan portfolio. This financing was valued by reference to current market interest rates and credit spreads.

(10)
These agreements bear floating rates of interest, which reset monthly or quarterly to a market credit spread, and we believe that, for similar financial instruments with comparable credit risks, the effective rates approximate market rates. Accordingly, the carrying amounts outstanding are believed to approximate fair value. These agreements have a weighted average maturity of 0.13 years.

(11)
The credit facility has a weighted average maturity of 1.09 years. This facility was valued at par because management believes it could currently enter a similar arrangement under similar terms.

(12)
These notes have a weighted average maturity of 29.5 years. These notes were valued by discounting expected future cash flows by a rate calculated based on current market conditions for comparable financial instruments, including market interest rates and credit spreads. The credit spread used was obtained from a broker quotation.
 
35


(13)
Represents current swap agreements as follows:
 
Year of Maturity
 
Weighted Average Maturity
 
Aggregate Notional Amount
 
 
Weighted Average Fixed Pay Rate
 
Aggregate Fair Value
 
                     
Agreements which receive 1-Month LIBOR:
                           
                             
2009
   
May2009
 
$
343,377
*
   
3.28%
 
$
(10,491
)
2010
   
Jun 2010
   
425,626
     
4.37%
 
 
(6,460
)
2011
   
May 2011
   
524,864
     
5.30%
 
 
3,647
 
2013
   
Jun 2013
   
14,057
     
5.28%
   
150
 
2014
   
Dec 2014
   
9,052
     
5.27%
   
108
 
2015
   
Jul 2015
   
784,627
     
4.92%
   
(7,532
)
2016
   
Apr 2016
   
597,431
     
5.22%
   
3,796
 
2017
   
Apr 2017
   
8,745
     
5.33%
   
92
 
 
                 
 
       
Agreements which receive 3-Month LIBOR:
                           
                             
2011
   
Apr 2011
   
337,000
     
5.81%
   
8,694
 
2013
   
Mar 2013
   
295,140
     
3.97%
 
 
(15,148
)
2014
   
Jun 2014
   
357,911
     
4.21%
   
(18,045
)
2016
   
May 2016
   
140,795
     
5.55%
   
4,050
 
         
$
3,838,625
         
$
(37,139
)
 
* $262,732 of this notional receives 1-Month LIBOR only up to 6.50%
 
The fair value of these agreements is estimated by obtaining counterparty quotations. A positive fair value represents a liability. We have recorded $60.7 million of gross interest rate swap assets and $23.6 million of liabilities.

(14)
These are two essentially offsetting interest rate caps and two essentially offsetting interest rate swaps, each with notional amounts of $32.5 million and an interest rate cap with a notional balance of $17.5 million. The maturity date of the purchased swap is July 2009; the maturity date of the sold swap is July 2014, the maturity date of the $32.5 million caps is July 2038 and the maturity date of the $17.5 million cap is July 2009. The fair value of these agreements is estimated by obtaining counterparty quotations. A positive fair value represents a liability; therefore, we have a net non-hedge derivative asset.
 
36


ITEM 4. CONTROLS AND PROCEDURES

(a)
Disclosure Controls and Procedures. The Company's management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report. The Company’s disclosure controls and procedures are designed to provide reasonable assurance that information is recorded, processed, summarized and reported accurately and on a timely basis. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective.

(b)  
Internal Control Over Financial Reporting. There have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

37

 
PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The Company is not party to any material legal proceedings.

Item 1A. Risk Factors

There have been no material changes from the risk factors previously disclosed in the registrant’s Form 10-K for the year ended December 31, 2005.

CAUTIONARY STATEMENTS

The information contained in this quarterly report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our company. We urge you to carefully review and consider the various disclosures made by us in this report and in our other filings with the Securities and Exchange Commission (“SEC”), including our annual report on Form 10-K for the year ended December 31, 2005, that discuss our business in greater detail.

This report contains certain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements relate to, among other things, the operating performance of our investments, the stability of our earnings, and our financing needs. Forward-looking statements are generally identifiable by use of forward-looking terminology such as "may," "will," "should," "potential," "intend," "expect," "endeavor," "seek," "anticipate," "estimate," "overestimate," "underestimate," "believe," "could," "project," "predict," "continue" or other similar words or expressions. Forward-looking statements are based on certain assumptions, discuss future expectations, describe future plans and strategies, contain projections of results of operations or of financial condition or state other forward-looking information. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Although we believe that the expectations reflected in such forward-looking statements are based on reasonable assumptions, our actual results and performance could differ materially from those set forth in the forward-looking statements. These forward-looking statements involve risks, uncertainties and other factors that may cause our actual results in future periods to differ materially from forecasted results. Factors which could have a material adverse effect on our operations and future prospects include, but are not limited to, our ability to take advantage of opportunities in additional asset classes at attractive risk-adjusted prices, our ability to deploy capital accretively, the risks that default and recovery rates on our loan portfolios exceed our underwriting estimates, the relationship between yields on assets which are paid off and yields on assets in which such monies can be reinvested, the relative spreads between the yield on the assets we invest in and the cost of financing, changes in economic conditions generally and the real estate and bond markets specifically; adverse changes in the financing markets we access affecting our ability to finance our real estate securities portfolios in general or particular real estate related assets, or in a manner that maintains our historic net spreads; changes in interest rates and/or credit spreads, as well as the success of our hedging strategy in relation to such changes; the quality and size of the investment pipeline and the rate at which we can invest our cash, including cash inside our CBOs; impairments in the value of the collateral underlying our real estate securities, real estate related loans and residential mortgage loans and the relation of any such impairments to our judgments as to whether changes in the market value of our securities, loans or real estate are temporary or not and whether circumstances bearing on the value of such assets warrant changes in carrying values; legislative/regulatory changes; completion of pending investments; the availability and cost of capital for future investments; competition within the finance and real estate industries; and other risks detailed from time to time in our SEC reports. Readers are cautioned not to place undue reliance on any of these forward-looking statements, which reflect our management's views as of the date of this report. The factors noted above could cause our actual results to differ significantly from those contained in any forward-looking statement. For a discussion of our critical accounting policies, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Application of Critical Accounting Policies."

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We are under no duty to update any of the forward-looking statements after the date of this report to conform these statements to actual results.

In addition, risks relating to our management and business, which are described in our SEC reports include, specifically, (1) the following risks relating to our management: (i) We are dependent on our manager and may not find a suitable replacement if our manager terminates the management agreement. Furthermore, we are dependent on the services of certain key employees of our manager and the loss of such services could temporarily adversely affect our operations; (ii) There are conflicts of interest inherent in our relationship with our manager insofar as our manager and its affiliates manage and invest in other pooled investment vehicles (investment funds, private investment funds, or businesses) that invest in real estate securities, real estate related loans and operating real estate and whose investment objectives overlap with our investment objectives. Our management agreement with our manager does not limit or restrict our manager or its affiliates from managing other investment vehicles that invest in investments which meet our investment objectives. Certain investments appropriate for Newcastle may also be appropriate for one or more of these other investment vehicles and our manager or its affiliates may determine to make a particular investment through another investment vehicle rather than through Newcastle. It is possible that
 
38

 
we may not be given the opportunity to participate at all in certain investments made by our affiliates that meet our investment objectives; and (iii) Our investment strategy may evolve, in light of existing market conditions and investment opportunities, to continue to take advantage of opportunistic investments in real estate related assets, which may involve additional risks depending upon the nature of such assets and our ability to finance such assets on a short or long term basis; and (2) the following risks relating to our business: (i) Although we seek to match fund our investments to limit refinance risk, in particular with respect to a substantial portion of our investments in real estate securities and loans, we do not employ this strategy with respect to certain of our investments, which increases refinance risks for and, therefore, the yield of these investments; (ii) We may not be able to match fund our investments with respect to maturities and interest rates, which exposes us to the risk that we may not be able to finance or refinance our investments on economically favorable terms; (iii) Prepayment rates can increase, adversely affecting yields on certain of our loans; (iv) The real estate related loans and other direct and indirect interests in pools of real estate properties or loans that we invest in may be subject to additional risks relating to the privately negotiated structure and terms of the transaction, which may result in losses to us; and (v) We finance certain of our investments with debt subject to margin calls based on a decrease in the value of such investments, which could adversely impact our liquidity.
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults upon Senior Securities

None. 

Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information
 
None.
 
39


Item 6. Exhibits

3.1
Articles of Amendment and Restatement (incorporated by reference to the Registrant's Registration Statement on Form S-11 (File No. 333-90578), Exhibit 3.1).

3.2
Articles Supplementary Relating to the Series B Preferred Stock (incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q for the period ended March 31, 2003, Exhibit 3.3).

3.3
Articles Supplementary Relating to the Series C Preferred Stock (incorporated by reference to the Registrant’s Report on Form 8-K, Exhibit 3.3, filed on October 25, 2005).

3.4
Amended and Restated By-laws (incorporated by reference to the Registrant's Registration Statement on Form 8-K, Exhibit 3.1, filed on May 5, 2006).

4.1
Rights Agreement between the Registrant and American Stock Transfer and Trust Company, as Rights Agent, dated October 16, 2002 (incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q for the period ended September 30, 2002, Exhibit 4.1).

10.1
Amended and Restated Management and Advisory Agreement by and among the Registrant and Fortress Investment Group LLC, dated June 23, 2003 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 (File No. 333-106135), Exhibit 10.1).

10.2
Newcastle Investment Corp. Nonqualified Stock Option and Incentive Award Plan Amended and Restated Effective as of February 11, 2004 (incorporated by reference to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2005, Exhibit 10.2).

31.1
Certification of Chief Executive Officer as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2
Certification of Chief Financial Officer as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
32.2
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
40

 
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized:
 
     
 
NEWCASTLE INVESTMENT CORP.
 
(Registrant)
 
 
 
 
 
 
  By:   /s/ Wesley R. Edens
 

Name: Wesley R. Edens
Title: Chairman of the Board
  Chief Executive Officer
Date: November 9, 2006
 
   
 
 
 
 
 
 
  By:   /s/ Debra A. Hess
 

Name: Debra A. Hess
Title: Chief Financial Officer
Date: November 9, 2006
 
41