$1.6 $1.6 $2.1 $2.1 $2.3 $2.3 $2.8 $2.8 $3.6 $3.6 $4.1 $4.1 $4.2 $4.2 $4.7 $4.7 $4.9 $4.9 $5.3 $5.3 $5.7 $5.7 $5.9 $5.9 $6.2 $6.2 $6.8 $6.8 $7.1 $7.1 $8.1 $8.1 $8.6 $8.6 ’02’02 ’02’02 ’03’03 ’03’03 ’04’04 ’04’04 ’05’05 ’05’05 ’06’06 ’06’06 Newcastle Investment Corp. 2 0 0 6 a n n u a l r e p o r t CORPORATE INFORMATION BOARD OF DIRECTORS CORPORATE OFFICERS CORPORATE HEADQUARTERS wesley r. edens Chairman of the Board Chairman and Chief Executive Officer Fortress Investment Group LLC kevin j. finnerty(1) Founder and Managing Partner F.I.Capital Management stuart a. mcfarland(1) Chairman Federal City Bancorp, Inc. david k. mckown(1) Senior Advisor Eaton Vance Management peter m. miller(1) Managing Director Dresdner Kleinwort Wasserstein Securities LLC kenneth m. riis Managing Director FIG LLC kenneth m. riis Chief Executive Officer and President jonathan ashley Chief Operating Officer debra a. hess Chief Financial Officer phillip j. evanski Chief Investment Officer erik p. nygaard Chief Information Officer randal a. nardone Secretary lilly h. donohue Assistant Secretary (1) Member of Audit Committee, Nominating and Corporate Governance Committee and Compensation Committee Newcastle Investment Corp. submitted a timely CEO certification to the New York Stock Exchange (NYSE) in 2006 pursuant to NYSE Listed Company Manual Section 303A.12(a) stating that its CEO was not aware of any violations of the NYSE corporate governance listing standards. Newcastle Investment Corp. filed timely CEO and CFO certifications with the Securities and Exchange Commission pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 regarding Newcastle’s annual report on Form 10-K for the year ended December 31, 2006. These certifications were filed as exhibits 31.1 and 31.2 to such Form 10-K. forward-looking statements 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 and financing needs. Forward-looking statements are generally identifiable by use of forward-looking ter- minology 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 reason- able 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, changes in economic conditions generally and the real estate and bond markets specifically, changes in the financing markets we access that affect our ability to finance our real estate securities portfolios in general or particular real estate related assets, changes in interest rates and/or credit spreads and the success of our hedging strategy in relation to such changes, the availability and cost of capital for future investments, the rate at which we can invest our cash in suitable investments and legislative/regulatory changes (including in respect of rules applicable to REITs) as well as other risks detailed from time to time in our SEC reports. You should not place undue reliance on forward-looking statements contained in this report. Such forward- looking statements speak only as of the date of this report. We expressly disclaim any obligation to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or change in events, conditions or circumstances on which any statement is based. m o c . n o s i d d a w w w . n o s i d d A y b n g i s e D newcastle investment corp. c/o Fortress Investment Group LLC 1345 Avenue of the Americas, 46th Floor New York, NY 10105 (212) 798-6100 legal counsel Skadden, Arps, Slate, Meagher & Flom LLP Four Times Square New York, NY 10036-6522 independent auditors Ernst & Young LLP Five Times Square New York, NY 10036-6530 stock transfer agent and registrar American Stock Transfer & Trust Company 59 Maiden Lane Plaza Level New York, NY 10038 (800) 937-5449 stock exchange listing Newcastle Investment Corp.’s common stock is listed on the New York Stock Exchange (symbol: NCT) annual meeting of stockholders May 17, 2007, 9:00 a.m. PDT Sheraton Suites San Diego at Symphony Hall 701 A Street San Diego, CA 92101 investor information services Lilly H. Donohue Director, Investor Relations Newcastle Investment Corp. c/o Fortress Investment Group LLC 1345 Avenue of the Americas, 46th Floor New York, NY 10105 Tel: (212) 798-6118 Fax: (212) 798-6060 email: ldonohue@fortressinv.com newcastle investment corp. web site http://www.newcastleinv.com April 2007 printed on recycled paper Newcastle Investment Corp. is a real estate investment and finance company. The Company invests in a diversified portfolio of real estate debt and other real estate related assets with a disciplined approach to financing and managing its assets. The Company, which is taxed as a real estate investment trust, seeks to deliver strong dividends and superior risk-adjusted returns in varying interest rate and credit cycles. Newcastle is listed on the New York Stock Exchange under the symbol NCT. $1.6 $2.1 $2.1 $2.3 $2.3 $2.8 $2.8 $3.6 $3.6 $4.1 $4.1 $4.2 $4.2 $4.7 $4.7 $4.9 $4.9 $5.3 $5.3 $5.7 $5.7 $5.9 $5.9 $6.2 $6.2 $6.8 $6.8 $7.1 $7.3 $8.1 $8.1 $8.6 $8.6 ’02’02 ’03’03 2003 ’04’04 2004 ’05’05 2005 ’06’06 2006 total assets ($ in billion) OVER THE PAST 4 YEARS (DECEMBER 31, 2002 TO DECEMBER 31, 2006) ASSETS GREW 446% OR 53% ANNUALLY TOTAL RETURN TO SHAREHOLDERS OF 179% OR 29% ANNUALLY P.02 _ 2 0 0 6 a n n u a l r e p o r t newcastle FINANCIAL HIGHLIGHTS BALANCE SHEET DATA Real estate securities, available for sale Real estate related loans, net Residential mortgage loans, net Total assets Debt obligations Preferred stock Common stockholders’ equity $ 5,581,228 1,568,916 809,097 8,604,392 7,504,731 102,500 899,480 OPERATING DATA Funds from Operations (FFO)(A) FFO per common share, diluted(A) Income available for common stockholders Net income per common share, diluted Weighted average number of common shares outstanding, diluted $ $ $ $ 119,421 2.69 118,609 2.67 44,417 Dividends declared for the year ended Book value per common share $ 19.68 December 31, 2006 $ 2.615 (A) Refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for description of Funds from Operations (FFO). $350 $300 $250 $200 $150 $100 $50 $0 IP O D ec 02 Ju ne 03 D ec 03 Ju ne 04 D ec 04 Ju ne 05 D ec 05 Ju ne 06 D ec 06 Newcastle Investment Corporation NAREIT All Russel 2000 NAREIT Mortgage S & P 500 * $100 invested on 10/10/02 in stock or on 9/30/02 in index-including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2007, Standard & Poor's, a division of The McGraw-Hill Companies, Inc. All rights reserved. www.researchdatagroup.com/S&P.htm newcastle 2006 annual report _ P.03 2006 KEY EVENTS D I V I D E N D 10.4% INCREASE JUNE: INCREASED QUARTERLY DIVIDEND FROM $0.625 PER SHARE TO $0.65 PER SHARE DECEMBER: INCREASED QUARTERLY DIVIDEND FROM $0.65 PER SHARE TO $0.69 PER SHARE I N V E S T M E N T S $5 BILLION ACQUIRED JANUARY–DECEMBER: PURCHASED $3.0 BILLION OF REAL ESTATE SECURITIES AND RELATED LOANS MARCH: ACQUIRED $1.5 BILLION PORTFOLIO OF 11,300 SUBPRIME RESIDENTIAL MORTGAGE LOANS AUGUST: PURCHASED $435 MILLION PORTFOLIO OF 13,300 MANUFACTURED HOUSING LOANS F I N A N C I N G S $3 BILLION FINANCED JANUARY: ENTERED INTO 3-YEAR $237 MILLION TERM FINANCING FOR MANUFACTURED HOUSING LOAN PORTFOLIO APRIL: ISSUED $1.4 BILLION OF INVESTMENT GRADE DEBT TO TERM FINANCE THE $1.5 BILLION MORTGAGE LOAN PORTFOLIO AUGUST: FINANCED ACQUISITION OF MANUFACTURED HOUSING LOANS WITH $390 MILLION OF 5-YEAR TERM DEBT NOVEMBER: COMPLETED NINTH COLLATERALIZED DEBT OBLIGATION TO FINANCE $950 MILLION OF ASSETS C A P I T A L M A R K E T S $250 MILLION OF NEW CAPITAL MARCH: ISSUED $100 MILLION OF TRUST PREFERRED SECURITIES WITH A 30-YEAR TERM MAY: INCREASED REVOLVING CREDIT FACILITY FROM $100 MILLION TO $200 MILLION OCTOBER: ISSUED 1.7 MILLION COMMON SHARES FOR NET PROCEEDS OF APPROXIMATELY $50 MILLION P.04 _ 2 0 0 6 a n n u a l r e p o r t newcastle DEAR SHAREHOLDERS 2006 was a tremendous year for Newcastle. We reaped the rewards from the prior year’s focus on credit and portfolio diversification as we continued to generate high returns on our existing portfolio and invested new capital resulting in earnings and dividend growth. This year, we again established Newcastle as a premier real estate debt investor. In 2006, we delivered exceptional results for our shareholders. While our 39% total return to shareholders (stock price appreciation and increased dividends) was one of the most visible signs of our success, we also reached many important milestones during the past year. Newcastle recorded its highest levels of earnings and dividends per share. We also had our most active investment year, a meaningful driver to our ability to grow. OU R R E S U LT S A N D OU R C O N S I S T E N T S T R AT E G Y Our financial performance for 2006 included the following highlights: (cid:1) We grew net income to $118.6 million, a record for our Company. (cid:1) We paid total dividends of $2.615 per share and increased our quarterly dividend twice in the year to $0.69 per share, a 10.4% increase from the fourth quarter 2005. (cid:1) We generated a 14.9% return on invested equity. (cid:1) We purchased $5 billion of new assets in 158 different investments. Our performance confirms that our strategy is geared towards results. We built a credit business on a simple principle – create long-term shareholder value and generate stable earnings by investing in real estate debt with moderate credit risk while miti- gating interest rate and refinancing risks. Our goal is to achieve a mid-teens return on equity by investing in assets financed in a way that limits our exposure to changes in interest rates with a focus on matching the maturity of our assets and liabilities. Despite our markets in 2006, which were characterized by tighten- ing credit spreads, rising interest rates and a flatter treasury yield curve, our portfolio generated an average net interest spread of 1.45% and we yet again delivered a mid-teens return on invested equity – highlighting the continued stability of our business. OUR RECORD INVESTMENT ACTIVITIES Throughout the year, we demonstrated our growth and ability to source attractive investments across the credit markets as we bene- fited from the broad investment experience of our manager, Fortress. We purchased a record $5 billion of new assets, nearly dou- ble our 2005 investment activity, resulting in the deployment of over $500 million of capital. The majority of this capital was invested in commercial real estate debt (60%), with the remaining capital invested in residential debt (30%) and corporate bank loans (10%). 2006 CAPITAL ALLOCATION COMMERCIAL DEBT INVESTMENTS In the year we purchased $1.8 billion of commercial debt in 91 dif- ferent investments. As the commercial real estate debt markets continue to grow and evolve, an increasing amount of below investment grade debt on high quality commercial real estate is structured as mezzanine loans and subordinate first mortgage loans or B-Notes. In 2006, we benefited from the growth of these markets through the purchase of $1.1 billion of mezzanine loans and B-Notes, a 309% increase over 2005. This portfolio has a very attractive risk return profile yielding an average asset spread of 2.62% with an average loan to value of 66%. Mezza nine loan and B-Note investments represented approximately 44%, or $230 mil- lion dollars, of our total capital deployment in the year. OPPORTUNISTIC DEBT INVESTMENTS One of our competitive strengths is our proven ability to invest opportunistically in the credit markets. We are not reliant on a small or niche group of assets to generate growth for our share- holders. Since we have the experience and ability to invest in a wide range of real estate credit, we are able to take advantage of opportunities as they arise and invest in assets offering superior risk adjusted returns. For example, in March 2006, we purchased $1.5 billion of subprime residential mortgage loans at an attractive price and sold the loans through a securitization resulting in an initial $67 million capital investment that generated over a 20% return on average invested equity. We also purchased a $435 million portfolio of 13,300 seasoned man- ufactured housing loans. The loans were to borrowers with good credit scores (average FICO of 705) and good payment histories. We term financed these loans and initially invested $37 million of capi- tal that generated an 18% return on average invested equity. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.05 Corporate Bank Loans 10% Agency RMBS 4% ABS 6% Commercial Mezzanine Loans 31% Residential Loans 20% Other 1% Other Real Estate Loans 6% CMBS 7% REIT Debt 2% Commercial B-Notes 13% Key to both of these acquisitions was the ability to underwrite the risk, structure the appropriate financing and utilize an experi- enced loan servicer to mitigate loss. We succeeded on all fronts and look forward to sourcing more opportunities like these in 2007. S U S TA I N I NG OU R M O M E N T U M We’ve enjoyed tremendous growth – for those of you who pur- chased shares in our IPO in October 2002 and reinvested the dividends, you would have earned a compounded annual return of 35% and a total return of over 250% through December 2006. In that time, we have grown our dividend an average of 11% per year to $2.76 per share. Looking forward, our goal is to continue to pro- duce strong earnings and dividend growth which should position shareholders well. Through the talents of our people and Fortress, our manager, Newcastle has assembled a solid $8.6 billion diversified invest- ment portfolio and is poised to achieve significant market share growth in the years to come. On behalf of everyone at Newcastle, we thank you for your continued confidence and support as we remain committed to our business and building our future. kenneth m. riis Chief Executive Officer and President P.06 _ 2 0 0 6 a n n u a l r e p o r t newcastle OUR STRATEGY D I V E R S I F I E D P O R T F O L I O M A T C H I N T E R E S T R A T E S A N D M A T U R I T I E S O N G O I N G C R E D I T S U R V E I L L A N C E } } } I N V E S T Newcastle’s core business strategy is to invest in a diverse portfolio (primarily commercial backed) of real estate debt and other real estate related assets. M ATC H F U N D The Company seeks to match fund its assets with respect to interest rates and maturities in order to minimize the impact of interest rate fluctuations on earnings, and to reduce the risk of refinancing its liabilities prior to the maturities of its assets. MANAGE ASSETS Newcastle actively manages its credit exposure through portfolio diversification and ongoing asset surveillance and selection. selected financial data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 08 management’s discussion and analysis of financial condition and results of operations . . . . . . . . . . . . . 10 consolidated balance sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 consolidated statements of income . . . . . . . . . . . . . . . . . . . . . . . . 38 consolidated statements of stockholders’ equity . . . . . . . . . . . . 39 consolidated statements of cash flows . . . . . . . . . . . . . . . . . . . . . 41 notes to consolidated financial statement . . . . . . . . . . . . . . . . . . 43 report of independent registered public accounting firm . . . . . . . 75 report on internal control over financial reporting of independent registered public accounting firm . . . . . . . . . . . . 76 management’s report on internal control over financial reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 common stock prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 P.8 _ 2 0 0 6 a n n u a l r e p o r t newcastle selected financial data (in thousands, except per share data) The selected historical consolidated financial information set forth below as of December 31, 2006, 2005, 2004, 2003 and 2002 and for the years ended December 31, 2006, 2005, 2004, 2003 and 2002 has been derived from our audited historical consolidated financial statements. The information below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and notes thereto included in “Financial Statements and Supplementary Data.” selected consolidated financial information 2006 year ended december 31, 2004 2003 2005 Operating Data Revenues Interest income Other income Expenses Interest expense Other expense Income before equity in earnings of unconsolidated subsidiaries Equity in earnings of unconsolidated subsidiaries, net Income from continuing operations Income from discontinued operations Net income Preferred dividends and related accretion Income available for common stockholders Net income per share of common stock, diluted Income from continuing operations per share of common stock, after preferred dividends, diluted Weighted average number of shares of common stock outstanding, diluted Dividends declared per share of common stock – NCT Dividends declared per share of common stock – predecessor Balance Sheet Data Real estate securities, available for sale Real estate related loans, net Residential mortgage loans, net Operating real estate, net Cash and cash equivalents Total assets Debt Total liabilities Common stockholders’ equity Preferred stock Supplemental Balance Sheet Data Common shares outstanding Book value per share of common stock 2002(1) $73,620 18,716 92,336 44,238 18,197 62,435 29,901 362 30,263 1,232 31,495 (1,162) $30,333 $ 1.68 $530,006 22,603 552,609 374,269 56,608 430,877 121,732 5,968 127,700 223 127,923 (9,314) $118,609 $ 2.67 $348,516 29,697 378,213 226,446 42,529 268,975 109,238 5,609 114,847 2,108 116,955 (6,684) $110,271 $ 2.51 $225,761 23,908 249,669 136,398 29,259 165,657 84,012 9,957 93,969 4,446 98,415 (6,094) $ 92,321 $ 2.46 $133,183 18,901 152,084 76,877 20,828 97,705 54,379 862 55,241 877 56,118 (4,773) $ 51,345 $ 1.96 $ 2.67 $ 2.46 $ 2.34 $ 1.93 $ 1.61 44,417 $ 2.615 43,986 $ 2.500 37,558 $ 2.425 26,141 $ 1.950 18,090 $ 0.850 $ 1.200 2006 2005 as of december 31, 2004 2003 2002 $5,581,228 1,568,916 809,097 29,626 5,371 8,604,392 7,504,731 7,602,412 899,480 102,500 $4,554,519 615,551 600,682 16,673 21,275 6,209,699 5,212,358 5,291,696 815,503 102,500 $3,369,496 591,890 654,784 57,193 37,911 4,932,720 4,021,396 4,136,005 734,215 62,500 $2,192,727 402,784 586,237 102,995 60,403 3,550,299 2,924,552 3,010,936 476,863 62,500 $1,025,010 26,417 258,198 113,652 45,463 1,574,828 1,217,007 1,288,326 284,241 – 45,714 19.68 $ 43,913 18.57 $ 39,859 18.42 $ 31,375 15.20 $ 23,489 12.10 $ (1) Includes the operations of our predecessor through the date of commencement of our operations, July 12, 2002. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.9 2006 year ended december 31, 2004 2003 2005 2002 Other Data Cash Flow provided by (used in): Operating activities Investing activities Financing activities Funds from Operations (FFO)(1) $ 16,322 (1,963,058) 1,930,832 119,421 $ 98,763 (1,334,746) 1,219,347 104,031 $ 90,355 (1,332,164) 1,219,317 86,201 $ 38,454 (1,659,026) 1,635,512 54,380 $ 21,919 (683,053) 675,237 37,633 (1) 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 operat- ing 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 our manager. FFO, for our purposes, represents net income available for common stockholders (computed in accordance with GAAP), excluding extraordinary items, plus depre- ciation of our 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 our 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. Calculation of Funds From Operations (FFO): Income available for common stockholders Operating real estate depreciation Accumulated depreciation on operating real estate sold Other(1) Funds from operations (FFO) (1) Related to an investment retained by our predecessor. 2006 $118,609 812 – – $119,421 year ended december 31, 2004 2003 2005 $110,271 702 (6,942) – $104,031 $92,321 2,199 (8,319) – $86,201 $51,345 3,035 – – $54,380 2002 $30,333 7,994 (2,847) 2,153 $37,633 P.10 _ 2 0 0 6 a n n u a l r e p o r t newcastle management’s discussion and analysis of financial condition and results of operations The following should be read in conjunction with our consoli- dated financial statements and notes thereto included in “Financial Statements and Supplementary Data.” 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 stock- holders through prudent asset selection, active management and the use of match funded financing structures, when appropriate, which reduces our interest rate and financing risks. Our objective is to maximize the difference between the yield on our invest- ments 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 sen- sitive real estate debt investments including securities and loans. Our portfolio of real estate securities includes commercial mort- gage 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 gener- ally considered AAA rated. We also own, directly and indirectly, interests in loans and pools of loans, including real estate related loans, commercial mortgage loans, residential mortgage loans, manufactured housing loans and subprime residential 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 December 31, 2006, our debt to equity ratio was approximately 7.5 to 1. On a pro forma basis, our debt to equity ratio would have been 6.7 to 1 if the trust preferred securities we issued in March 2006 were considered equity for purposes of this computa- tion. Also, on a pro forma basis, our debt to equity ratio would have been 6.9 to 1 after adjustment for the common stock issued in January 2007. 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 securitiza- tions, term loans, credit facility and trust preferred securities, as well as short-term financing in the form of repurchase agree- ments and asset backed commercial paper. 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 lia- bilities 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 man- age 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 unreal- ized gains on our current investments and reduce our financing costs, but reduce the yields available on potential new invest- ments, while widening credit spreads reduce the unrealized gains on our current investments (or cause unrealized losses) and increase our financing costs, but increase the yields available on potential new investments. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.11 In 2004 credit spreads on real estate securities tightened to histori- cal lows, before widening in 2005. In 2006, these spreads tightened once again. This tightening of credit spreads and increasing inter- est 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 on a net basis from December 31, 2003 to December 31, 2006. In addition, trends in market interest rates continue to also affect our operations, although to a lesser degree due to our match funded financing strategy. Interest rates had been historically low throughout 2004, before rising in 2005 and continuing to increase in 2006. Interest rates, as well as property values and other factors, influ- ence the prepayment rates on our investments. Higher prepayment rates can hinder our ability to deploy capital in a timely manner, thereby reducing our return on equity, which occurred in 2005. We continue to pursue opportunistic investments within our investment guidelines that offer a more attractive risk adjusted return, including investments in subprime mortgage loans and manufactured housing loans which we expect to generate a net, loss adjusted yield in the high teens. If credit spreads widen and interest rates continue to increase, we expect that our new investment activities will benefit and our earn- ings will increase, although our net book value per share and the ability to realize gains from existing investments may decrease. 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.” formation and organization We were formed in 2002 as a subsidiary of Newcastle Investment Holdings Corp. (referred to herein as Holdings). Prior to our initial public offering, Holdings contributed to us certain assets and liabilities in exchange for approximately 16.5 million shares of our common stock. Our operations commenced in July 2002. In May 2003, Holdings distributed to its stockholders all of the shares of our common stock that it held, and it no longer owns any of our common equity. The following table presents information on shares of our com- mon stock issued since our formation: year Formation 2002 2003 2004 2005 2006 December 31, 2006 January 2007 range of issue prices per share(1) net proceeds (millions) shares issued N/A 16,488,517 7,000,000 $13.00 7,886,316 $20.35–$22.85 8,484,648 $26.30–$31.40 $29.60 4,053,928 1,800,408 $29.42 45,713,817 2,420,000 $31.30 N/A $80.0 $163.4 $224.3 $108.2 $51.2 $75.0 (1) Excludes price of shares issued pursuant to the exercise of options and of shares issued to Newcastle’s independent directors. As of December 31, 2006, approximately 2.9 million of our shares of common stock were held by our manager, through its affiliates, and principals of Fortress. In addition, our manager, through its affili- ates, held options to purchase approximately 1.3 million shares of our common stock at December 31, 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 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. P.12 _ 2 0 0 6 a n n u a l r e p o r t newcastle Our discontinued operations include the operations of properties which have been sold or classified as Real Estate Held for Sale pursuant to SFAS No. 144. For more information on these properties, see Note 6 of our consolidated financial statements which appear in “Financial Statements and Supplementary Data.” Net proceeds from the sales of such properties have been redeployed to other investments which better meet our strategic objectives. Revenues attributable to each segment are disclosed below (unaudited) (in thousands). real estate securities residential mortgage loans and real estate related loans operating real estate unallocated $441,965 $321,889 $225,236 $105,621 $48,844 $19,135 $5,117 $6,772 $4,745 $ (94) $708 $553 total $552,609 $378,213 $249,669 for the year ended December 31, 2006 December 31, 2005 December 31, 2004 taxation We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended (the “Code”), and we intend to continue to operate in such a manner. Our current and continuing qualification as a REIT depends on our ability to meet various tax law requirements, including, among others, requirements relating to the sources of our income, the nature of our assets, the composition of our stockholders, and the timing and amount of distributions that we make. As a REIT, we will generally not be subject to U.S. federal corporate income tax on our net income that is currently distributed to stockholders. We may, however, nevertheless be subject to certain state, local and foreign income and other taxes, and to U.S. federal income and excise taxes and penalties in certain situations, including taxes on our undistributed income. In addition, our stockholders may be subject to state, local or foreign taxation in various jurisdictions, including those in which they or we transact business or reside. The state, local and foreign tax treatment of us and our stockholders may not conform to the U.S. federal income tax treatment. If, in any taxable year, we fail to satisfy one or more of the various tax law requirements, we could fail to qualify as a REIT. In addition, if Newcastle Investment Holdings failed to qualify as a REIT and we are treated as a successor to Newcastle Investment Holdings, this could cause us to likewise fail to qualify as a REIT. If we fail to qualify as a REIT for a particular tax year, our income in that year would be subject to U.S. federal corporate income tax (including any applicable alternative minimum tax), and we may need to bor- row funds or liquidate certain investments in order to pay the applicable tax, and we would not be compelled by the Code to make distributions. Unless entitled to relief under certain statu- tory provisions, we would also be disqualified from treatment as a REIT for the four taxable years following the year during which qualification is lost. Although we currently intend to operate in a manner designed to qualify as a REIT, it is possible that future economic, market, legal, tax or other developments may cause us to fail to qualify as a REIT, or may cause our board of directors to revoke the REIT election. 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 prepara- tion 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. Man - age ment believes that the estimates and assumptions utilized in the preparation of the consolidated financial statements are pru- dent and reasonable. Actual results have been in line with Management’s estimates and judgements used in applying each of the accounting policies described below. A summary of our sig- nificant accounting policies is presented in Note 2 to our consolidated financial statements, which appear in “Financial Statements and Supplementary Data.” The following is a summary of our accounting policies that are most affected by judgments, estimates and assumptions. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.13 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, which became effective in the first quarter of 2004, clarified the method- ology for determining whether an entity is a variable interest entity (“VIE”) and the methodology for assessing who is the pri- mary 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 consol- idated by its primary beneficiary, and only 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 resid- ual returns as a result of holding variable interests. Prior to the adoption of FIN 46R, we consolidated our existing CBO transactions (the “CBO Entities”) because we owned the entire equity interest in each of them, representing a substantial portion of their capitalization, and we controlled 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 have therefore continued 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.” 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 deter- mining the primary beneficiary of a VIE since they involve estimated probability weighting of subjectively determined possi- ble 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 compre- hensive income. Fair value is based primarily upon broker quotations, as well as counterparty quotations, which provide val- uation 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 inter- est 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 tem- porary 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 macro- economic 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, if necessary, 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 sup- port), 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 eval- uation is considered in relation to the amount of the unrealized loss and the period elapsed since it was incurred. Significant judg- ment is required in this analysis. 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 assump- tions 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 P.14 _ 2 0 0 6 a n n u a l r e p o r t newcastle 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. A rollforward of the provision, if any, is included in Note 4 to our con- solidated financial statements in “Financial Statements and Supplementary Data.” 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 esti- mated 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. valuation of derivatives revenue recognition on loans Similarly, our derivative instruments are carried at fair value pur- suant to Statement of Financial Accounting Standards (“SFAS”) No. 133 “Accounting for Derivative Instruments and Hedging Activities,” as amended. Fair value is based on counterparty quota- tions. 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 dis- cussed above. The results of such variability could be a significant increase or decrease in our book equity and/or earnings. Income on these loans is recognized similarly to that on our secu- rities and is subject to similar uncertainties and contingencies, which are also analyzed on at least a quarterly basis. For loans 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 5 to our consolidated financial statements in “Financial Statements and Supplementary Data.” impairment of operating real estate impairment of loans We purchase, directly and indirectly, real estate related, commer- cial mortgage and residential mortgage loans, including manufactured housing loans, to be held for investment. We must periodically evaluate each of these loans or loan pools for possi- ble impairment. Impairment is indicated when it is deemed probable that we will be unable to collect all amounts due accord- ing 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 impair- ment, 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 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 impair- ment, 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. 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 $305.7 million of assets purchased from particular coun- terparties which are financed via $243.7 million of repurchase newcastle 2 0 0 6 a n n u a l r e p o r t _ P.15 agreements with the same counterparties at December 31, 2006. Currently, we record such assets and the related financings as gross on our balance sheet, and the corresponding interest income and interest expense as 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 consid- ered “available for sale”). However, in a transaction where assets are acquired from and financed under a repurchase agreement with the same counter- party, 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 invest- ments 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 eco- nomics 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. We understand that this issue has been sub- mitted 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 $244.3 million and $287.9 million at December 31, 2006 and 2005, respectively. results of operations We raised a significant amount of capital in offerings in each of these years, resulting in additional capital being deployed to our invest- ments which, in turn, caused changes to our results of operations. The following table summarizes the changes in our results of operations from year-to-year (dollars in thousands): Interest income Rental and escalation income Gain on sale of investments Other income Interest expense Property operating expense Loan and security servicing expense Provision for credit losses Provision for losses, loans held for sale General and administrative expense Management fee to affiliate Incentive compensation to affiliate Depreciation and amortization Equity in earnings of unconsolidated subsidiaries, net Income from continuing operations year-to-year increase (decrease) year-to-year percent change explanation 2006/2005 2005/2004 2006/2005 2005/2004 2006/2005 2005/2004 $181,490 (1,786) (7,965) 2,657 147,823 1,442 951 1,017 4,127 787 693 4,618 444 359 $ 12,853 $122,755 1,903 1,991 1,895 90,048 (212) 2,936 8,421 – (438) 2,705 (332) 190 (4,348) $ 20,878 52.1% (26.9)% (39.2)% 96.8% 65.3% 61.0% 15.9% 12.1% N/A 18.9% 5.2% 60.5% 69.3% 6.4% 11.2% 54.4% 40.1% 10.9% 222.9% 66.0% (8.2)% 96.0% N/A N/A (9.5)% 25.5% (4.2)% 42.1% (43.7)% 22.2% (1) (2) (3) (4) (1) (2) (1) (5) (6) (7) (8) (8) (9) (1) (2) (3) (4) (1) (2) (1) (5) (6) (7) (8) (8) (9) (10) (10) (1) Changes in interest income and expense are primarily due to our acquisition and disposition during these periods of interest bearing assets and related financings, as follows: P.16 _ 2 0 0 6 a n n u a l r e p o r t newcastle year-to-year increase interest income 2006/2005 interest expense 2006/2005 Real estate security and loan portfolios(A) Agency RMBS Other real estate related loans Subprime mortgage loan portfolio Credit facility and junior subordinated notes Manufactured housing loan portfolio(B) Other(C) Residential mortgage loan portfolio(D) Other real estate related loans(D) $ 68,911 25,738 42,899 41,478 – 17,323 9,375 (6,934) (17,300) $181,490 $ 52,174 24,695 15,342 29,671 11,305 11,313 16,908 (4,557) (9,028) $147,823 (A)Represents our CBO financings and the acquisition of the related collateral in the respective years. (B)Primarily due to the acquisition of a manufactured housing loan pool in the third quarter of 2006. (C)Primarily due to increasing interest rates on floating rate assets and liabilities owned during the period. Changes in loan and security servicing expenses 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)These changes are 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. (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 mort- gage loans, which did not qualify as a hedge for accounting purposes. This gain was offset by the loss described in (6) below. (5) The increase from 2004 to 2005 is primarily the result of the acquisition of manufac- tured housing and residential mortgage loan pools at a discount for credit quality and $2.9 million of impairment recorded with respect to the ICH loans in 2005. The increase from 2005 to 2006 is primarily due to the acquisition of manufactured housing loans at a discount for credit quality which is offset by less impairment recorded with respect to the ICH loans. (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 mar- ket factors and was offset by the gain described in (4) above. (D)These loans received paydowns during the period which served to offset the (7) The changes in general and administrative expense are primarily increases as a amounts listed above. year-to-year increase interest income 2005/2004 interest expense 2005/2004 Real estate security and loan portfolios(A) Agency RMBS Residential mortgage loan portfolio Manufactured housing loan portfolio Other real estate related loans Other(B) ABS – manufactured housing portfolio(C) ICH loan portfolio(C) Other real estate related loans(C) $ 61,251 18,350 1,147 27,717 20,878 3,181 (2,777) (3,963) (3,029) $122,755 $48,213 16,981 5,727 13,164 3,809 7,023 (426) (3,655) (788) $90,048 (A)Represents our CBO financings and the acquisition of the related collateral in the respective years. (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. result of our increased size, offset by decreased professional fees in 2005. (8)The increases in management fees are a result of our increased size resulting from our equity issuances during these periods. The changes in incentive compensation are primarily a result of our increased earnings, offset by FFO losses recorded with respect to the sale of properties during 2004 and 2005. (9)The increase in depreciation is primarily due to the implementation of new infor- mation systems and the acquisition of a $12.2 million portfolio of properties through foreclosure in the first quarter of 2006. (10)The change from 2004 to 2005 is related to an interest in an LLC which held a port - folio of convenience and retail gas stores that was acquired with the intent to sell. All sales were completed in 2005. The change from 2005 to 2006 is the result of a small improvement in operating performance. Note that the amounts shown are net of income taxes on related taxable subsidiaries. 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 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 newcastle 2 0 0 6 a n n u a l r e p o r t _ P.17 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 addi- tional 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, pre- ferred stock, depository shares, debt securities and warrants, from time to time, up to an aggregate of $750 million, of which approxi- mately $185 million remained available as of February 16, 2007. We expect to meet our long-term liquidity requirements, specifi- cally 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 con- tinue 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 portfo- lio 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 alterna- tive 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 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 exe- cute 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 lia- bilities 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 December 31, 2006, we had an unrestricted cash balance of $5.4 mil- lion and an undrawn balance of $106.2 million on our credit facility. Our cash flow provided by operations differs from our net income due to several 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 obliga- tions, 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, particu- larly our total rate of return swaps, as described below. Proceeds from the sale of assets which serve as collateral for our CBO financ- ings, 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. As of December 31, 2006 we had $123.9 million of restricted cash held in CBO financing struc- tures pending its investment in real estate securities and loans. Our match funded investments are financed long term and their credit status is continuously monitored; therefore, these invest- ments are expected to generate a generally stable current return, subject to limited 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 and asset backed commercial paper, 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 $2.4 million relating to tenant improvements in connection with the inception of leases and cap- ital expenditures during the year ending December 31, 2007. With respect to one of our real estate related loans, we were com- mitted to fund up to an additional $6.6 million at December 31, 2006, subject to certain conditions to be met by the borrower. 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 or total rate of return swaps. 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 do not expect these potential margin calls to materially affect our financial con- dition or results of operations. P.18 _ 2 0 0 6 a n n u a l r e p o r t newcastle debt obligations The following table presents certain information regarding our debt obligations and related hedges as of December 31, 2006 (unaudited) (dollars in thousands): debt obligation/collateral CBO Bonds Payable Real estate securities Real estate securities and loans Real estate securities and loans Real estate securities and loans Real estate securities and loans Real estate securities and loans Real estate securities and loans Real estate securities Real estate securities and loans Other Bonds Payable ICH loans(3) Manufactured housing loans Manufactured housing loans Notes Payable Residential mortgage loans(4) Repurchase Agreements(4) (7) Real estate securities Real estate related loans Residential mortgage loans Repurchase Agreements subject to ABCP Facility(8) Agency RMBS month issued Jul 1999 Apr 2002 Mar 2003 Sep 2003 Mar 2004 Sep 2004 Apr 2005 Dec 2005 Nov 2006 (3) Jan 2006 Aug 2006 current face amount $ 398,366 444,000 472,000 460,000 414,000 454,500 447,000 442,800 807,500 4,340,166 101,925 213,172 364,794 679,891 unhedged weighted average funding cost 6.94%(2) 6.42%(2) 6.23%(2) 6.08%(2) 5.93%(2) 5.91%(2) 5.81%(2) 5.85%(2) 5.98%(2) 6.78%(2) LIBOR + 1.25% LIBOR + 1.25% carrying value $ 395,646 441,660 468,944 456,250 411,014 451,137 442,870 438,894 807,409 4,313,824 101,925 211,738 362,181 675,844 Nov 2004 128,866 128,866 LIBOR + 0.16% Rolling Rolling Rolling 181,059 553,944 25,343 760,346 181,059 553,944 25,343 760,346 LIBOR + 0.41% LIBOR + 0.69% LIBOR + 0.43% Dec 2006 1,143,749 1,143,749 5.41% Credit facility(5) Junior subordinated notes payable Subtotal debt obligations Financing on subprime mortgage loans subject to future repurchase(8) Total debt obligations May 2006 Mar 2006 Apr 2006 93,800 100,100 7,246,918 299,176 $7,546,094 93,800 100,100 7,216,529 288,202 $7,504,731 LIBOR + 1.75% 7.80%(6) (1) Including the effect of applicable hedges. (2)Weighted average, including floating and fixed rate classes. (3)See “Business – Our Investing Activities – Real Estate Related Loans” above. (4)Subject to potential mandatory prepayments based on collateral value. (5) A maximum of $200 million can be drawn. (6)LIBOR + 2.25% after April 2016. (7) The counterparties on our repurchase agreements include: Bear Stearns Mortgage Capital Corporation ($270.6 million), Credit Suisse ($216.2 million), Deutsche Bank AG ($181.7 million) and other ($91.8 million). (8)See “Liquidity and Capital Resources” below. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.19 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 Jul 2038 Apr 2037 Mar 2038 Sep 2038 Mar 2039 Sep 2039 Apr 2040 Dec 2050 Nov 2052 Aug 2030 Jan 2009 Aug 2011 Nov 2007 Jan 2007 Jan 2007 Mar 2007 Jan 2007 Nov 2007 Apr 2036 5.50% 6.78% 5.35% 5.88% 5.38% 5.49% 5.53% 5.57% 5.92% 5.73% 6.78% 6.14% 6.87% 6.63% 5.68% 5.62% 6.02% 5.79% 5.92% 4.97% 7.08% 7.72% 5.76% 1.99 3.45 5.30 5.85 5.61 6.19 7.16 8.48 7.06 5.83 1.04 1.46 3.07 2.26 0.74 0.08 0.08 0.23 0.08 0.08 $ 303,366 372,000 427,800 442,500 382,750 442,500 439,600 436,800 799,900 4,047,216 1,986 213,172 364,794 579,952 $ 544,469 498,754 515,335 505,450 446,749 499,389 491,398 512,249 930,293 4,944,086 121,834 237,133 399,125 758,092 128,866 145,819 181,059 553,944 25,343 760,346 207,374 718,989 27,020 953,383 1,143,749 1,176,358 0.85 29.25 4.15 93,800 – $6,753,929 – – $7,977,738 4.06 5.15 4.56 4.28 4.76 5.08 5.82 7.23 4.69 5.05 1.10 6.26 5.87 5.25 2.79 4.60 2.21 2.81 2.77 4.27 – – 4.63 $ – 59,612 128,600 151,677 174,192 227,898 195,186 115,491 672,217 1,724,873 1,986 4,977 73,973 80,936 142,301 101,380 696,174 26,347 823,901 $ 255,352 296,000 285,060 207,500 177,300 209,202 242,990 341,506 153,655 2,168,565 – 204,617 370,466 575,083 – 92,457 19,630 – 112,087 – 1,087,385 – – $2,772,011 – – $3,943,120 P.20 _ 2 0 0 6 a n n u a l r e p o r t newcastle Our debt obligations existing at December 31, 2006 (gross of $41.4 million of discounts) have contractual maturities as follows (unaudited) (in thousands): 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. 2007 2008 2009 2010 2011 Thereafter Total $2,126,761 – 213,172 – 364,794 4,841,367 $7,546,094 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 col- lateral is not available to other creditors of ours. 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 December 31, 2006. Two classes of separately issued 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. Two classes of CBO bonds, with an aggregate $50.0 million of face amount, were upgraded to a rating of A+ by Fitch in 2006. 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 inter- est 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 manufac- tured housing loan portfolio which provided for an initial In March 2006, a consolidated subsidiary of ours acquired a port - folio 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 securi- tization: (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 agree- ment, 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 com- mon 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 newcastle 2 0 0 6 a n n u a l r e p o r t _ P.21 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. We will not incur any unused fees. We simultaneously terminated our prior credit facil- ity 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. The lender received an upfront structuring fee equal to 0.5% on the ini- tial financing amount and is entitled to expense reimbursement of up to 0.125% on the initial financing amount. In November 2006, we closed our ninth CBO financing to term finance a $950 million portfolio of real estate securities and loans. Approximately 69%, or $560.5 million, of the debt issued, all of which is investment grade, is rated AAA. In December 2006, we closed a $2 billion asset backed commercial paper (ABCP) facility through our wholly owned subsidiary, Windsor Funding Trust. This facility provides us with the ability to finance our agency residential mortgage backed securities (RMBS) and AAA-rated MBS by issuing secured liquidity notes that are rated A-1+, P-1 and F-1+, by Standard & Poor’s, Moody’s and Fitch respectively, and have maturities of up to 250 days. The facility also permits the issuance of subordinated notes rated at least BBB/Baa by Standard & Poor’s, Moody’s or Fitch. As of December 31, 2006, Windsor Funding Trust had approximately $1.1 billion of secured liquidity notes and $8.3 million of subordinated notes issued and outstanding. The weighted average maturities of the secured liquidity notes and the subordinated notes were 0.12 years and 5 years, respectively. We own all of the trust certifi- cates of the Windsor Funding Trust. Windsor Funding Trust used the proceeds of the issuance to enter into a repurchase agree- ment with us to purchase interests in our agency RMBS. The repurchase agreement represents Windsor Funding Trust’s only asset. The interest rate on the repurchase agreement is effectively the weighted average interest rate on the secured liquidity notes and subordinated notes. Under the provisions of FIN 46R, we determined that the noteholders were the primary beneficiaries of the Windsor Funding Trust. As a result, we did not consolidate the Windsor Funding Trust and have reflected our obligation pur- suant to the asset backed commercial paper facility under the caption Repurchase Agreements subject to ABCP Facility. In January 2007, we entered into an $700 million non-recourse 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%. other We have entered into total rate of return swaps with major investment banks 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 there- fore 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 December 31, 2006 we held an aggregate of $299.7 million notional amount of total rate of return swaps on 8 reference assets on which we had deposited $46.8 million of margin. These total rate of return swaps had an aggregate fair value of approxi- mately $1.3 million, a weighted average receive interest rate of LIBOR + 2.59%, a weighted average pay interest rate of LIBOR + 0.63%, and a weighted average swap maturity of 1.5 years. P.22 _ 2 0 0 6 a n n u a l r e p o r t newcastle stockholders’ equity Common Stock The following table presents information on shares of our com- mon stock issued since our formation. range of issue options shares prices per proceeds granted to (millions) manager issued share(1) net year Formation 2002 2003 16,488,517 7,000,000 7,886,316 2004 8,484,648 4,053,928 2005 2006 1,800,408 December31, 2006 45,713,817 2,420,000 January 2007 N/A $13.00 $20.35– $22.85 $26.30– $31.40 $29.60 $29.42 N/A $ 80.0 $163.4 N/A 700,000 788,227 $224.3 837,500 $108.2 $ 51.2 330,000 170,000 $31.30 $ 75.0 242,000 (1) Excludes prices of shares issued pursuant to the exercise of options and of shares issued to our independent directors. Through December 31, 2006, our manager had assigned, for no value, options to purchase approximately 0.9 million shares of our common stock to certain of our manager’s employees, of which approximately 0.3 million had been exercised. In addition, our man- ager had exercised 0.7 million of its options. As of December 31, 2006, our outstanding options had a weighted average strike price of $25.89 and were summarized as follows: Held by our manager Issued to our manager and subsequently assigned to certain of our manager’s employees Held by directors and former directors Total 1,278,014 591,793 14,000 1,883,807 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 mil- lion 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 liquida- tion 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. If the Series C Preferred ceases to be listed on the NYSE or the AMEX, or quoted on the NASDAQ, and we are not subject to the reporting requirements of the Exchange Act, we have the option to redeem the Series C Preferred at their face amount and, during such time any shares of Series C Preferred are outstanding, the dividend will increase to 9.05% per annum. Other Comprehensive Income During the year ended December 31, 2006, our accumulated other comprehensive income changed due to the following factors (in thousands): Accumulated other comprehensive income, December 31, 2005 Net unrealized gain on securities Reclassification of net realized (gain) on securities into earnings Foreign currency translation Net unrealized gain on derivatives designated as cash flow hedges Reclassification of net realized (gain) on derivatives designated as cash flow hedges into earnings Accumulated other comprehensive income, December 31, 2006 $45,564 26,242 (282) (26) 7,773 (3,287) $75,984 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 year, the combination of tight- newcastle 2 0 0 6 a n n u a l r e p o r t _ P.23 ening credit spreads and increasing interest rates has resulted in a net increase in unrealized gains on our real estate securities and derivatives. We believe that our ongoing investment activities bene- fit in general from an environment of widening credit spreads and increasing interest rates. While such an environment would likely result in a decrease in the fair value of our existing securities port - folio 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 March 31, 2004 June 30, 2004 September 30, 2004 December 31, 2004 March 31, 2005 June 30, 2005 September 30, 2005 December 31, 2005 March 31, 2006 June 30, 2006 September 30, 2006 December 31, 2006 cash flow paid April 2004 July 2004 October 2004 January 2005 April 2005 July 2005 October 2005 January 2006 April 2006 July 2006 October 2006 January 2007 amount per share $0.600 $0.600 $0.600 $0.625 $0.625 $0.625 $0.625 $0.625 $0.625 $0.650 $0.650 $0.690 Net cash flow provided by operating activities decreased from $98.8 million for the year ended December 31, 2005 to $16.3 million for the year ended December 31, 2006. It increased from $90.4 mil- lion for the year ended December 31, 2004 to $98.8 million for the year ended December 31, 2005. These changes primarily resulted from the acquisition and settlement of our investments as described above. Investing activities used ($1,963.1 million), ($1,334.7 million) and ($1,332.2 million) during the years ended December 31, 2006, 2005 and 2004, respectively. Investing activities consisted primarily of the investments made in real estate securities and loans, net of proceeds from the sale or settlement of investments. Financing activities provided $1,930.8 million, $1,219.3 million and $1,219.3 million during the years ended December 31, 2006, 2005 and 2004, 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 pay- ment 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 in our consoli- dated financial statements included in “Financial Statements and Supplementary Data” 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 secu- rities, 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 maturi- ties 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) when appropri- ate, 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. P.24 _ 2 0 0 6 a n n u a l r e p o r t newcastle 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 mate- rial 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 abil- ity 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 per- formance 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 and loan 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 inter- est 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 secu- rities were to decrease (or “tighten”), the value of our real estate securities portfolio would tend to increase. Our floating rate secu- rities 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 the amount of unrealized gains or losses on available- for-sale securities, and therefore on 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 abil- ity 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 repre- sents 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 opera- tions to a change in spreads. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.25 loans Similar to our real estate securities portfolio, we are subject to credit and spread risk with respect to our real estate related com- mercial mortgage and residential mortgage loan portfolios. However, unlike our real estate securities portfolio, our loans gen- erally 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 these 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 statistics 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 affected similarly by changes in U.S. Treasury spreads. If the value of our loans subject to repurchase agreements or commercial paper were to decline, it could affect our ability to refinance such loans upon the maturity of the related repurchase agreements or commercial paper. Any credit or spread losses incurred with respect to our loan port- folios 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 pay- ment not being received on a loan, changes in the value of our loan portfolio will not directly affect our recurring earnings or our ability to pay dividends. december 31, 2006 december 31, 2005 Real Estate Securities and Related Loans Agency RMBS Total Real Estate Securities and Related Loans Residential Mortgage Loans Other Subprime Loans Subject to Future Repurchase Investment in Joint Venture ICH Loans Total Portfolio face amount $6,196,179 1,177,779 7,373,958 % total face amount % total 71.7% 13.6% 85.3% $4,802,172 697,530 5,499,702 812,561 9.4% 610,970 299,176 38,469 123,390 $8,647,554 3.5% 0.4% 1.4% 100.0% – 38,164 165,514 $6,314,350 76.1% 11.0% 87.1% 9.7% 0.0% 0.6% 2.6% 100.0% The table excludes operating real estate of $33.8 million at December 31, 2006 and $20.2 million at December 31, 2005. P.26 _ 2 0 0 6 a n n u a l r e p o r t newcastle asset quality and diversification at december 31, 2006 margin • Total real estate securities and related loans of $7.4 billion face amount, representing 85.3% of the total portfolio. Asset Quality • • • • $6.0 billion or 81.5% of this portfolio is rated by third parties, or had an implied AAA rating, with a weighted average rating of BBB+. $1.4 billion or 18.5% of this portfolio is not rated by third par- ties but had a weighted average loan to value ratio of 68.6%. 63% of this portfolio has an investment grade rating (BBB- or higher). The weighted average credit spread (i.e., the yield premium on our investments over the comparable U.S. Treasury or LIBOR) for the core real estate securities and related loans of $6.2 billion (excluding agency RMBS) was 2.56%. Diversity • Our real estate securities and loans are diversified by asset • type, industry, location and issuer. This portfolio had 635 investments. The largest investment was $179.5 million and the average investment size was $11.6 million. • Our real estate securities are supported by pools of underly- ing loans. For instance, our CMBS investments had over 21,000 underlying loans. • Residential mortgage loans of $0.8 billion face amount, repre- senting 9.4% of the total portfolio. Asset Quality • These residential loans are to high quality borrowers with an average Fair Isaac Corp. credit score (“FICO”) of 697. • Approximately $142.3 million face amount were held in secu- ritized form, of which 95.7% was rated investment grade. Diversity • Our residential and manufactured housing loans were well diversified with 491 and 18,343 loans, respectively. Certain of our investments are financed through repurchase agreements or total rate of return swaps which are subject to mar- gin 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 result- ing 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 December 31, 2006, we had one material off-balance sheet arrangement. • In April 2006, we securitized our portfolio of subprime mort- gage 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 invest- ments, see “Liquidity and Capital Resources.” • We have made investments in four unconsolidated sub- sidiaries. See Note 3 to our consolidated financial statements in “Financial Statements and Supplementary Data.” 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. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.27 contractual obligations As of December 31, 2006, we had the following material contractual obligations (payments in thousands): contract terms CBO bonds payable Other bonds payable Notes payable Described under “Quantitative and Qualitative Disclosures About Market Risk” Described under “Quantitative and Qualitative Disclosures About Market Risk” Described under “Quantitative and Qualitative Disclosures About Market Risk” Repurchase agreements Described under “Quantitative and Qualitative Disclosures About Market Risk” Repurchase agreements subject to ABCP facility We entered into a repurchase agreement with our wholly owned subsidiary Windsor Funding Trust as described under “Liquidity and Capital Resources” Credit facility Described under “Quantitative and Qualitative Disclosures About Market Risk” Junior subordinated notes payable Described under “Quantitative and Qualitative Disclosures About Market Risk” Interest rate swaps, treated as hedges Described under “Quantitative and Qualitative Disclosures About Market Risk” Non-hedge derivative obligations Described under “Quantitative and Qualitative Disclosures About Market Risk” CBO wrap agreement CBO backstop agreements CBO remarketing agreements Subprime loan securitization Loan servicing agreements Trustee agreements Management agreement Two classes of our 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, pursuant to a financial guaranty insurance policy (“wrap”). We pay annual fees of 0.12% of the outstanding face amount of the bonds under this agreement. In connection with the remarketing procedures described above, backstop agreements have been created whereby a third party financial institution is required to purchase the $718.0 million face amount of bonds at the end of any remarketing period if such bonds could not be resold in the market by the remarketing agent. We pay annual fees between 0.15% and 0.20% of the outstanding face amount of such bonds under these agreements. In connection with the remarketing procedures described above, the remarketing agent is paid an annual fee of 0.05% of the outstanding face amount of the bonds under the remarketing agreements. We entered into the securitization of our subprime mortgage loan portfolio as described under “Liquidity and Capital Resources.” We are a party to servicing agreements with respect to our residential mortgage loans, including manufactured housing loans and subprime mortgage loans, and our ICH loans. We pay annual fees generally equal to 0.38% of the outstanding face amount of the residential mortgage loans, 1.00% and 0.625% of the outstanding face amount of the two portfolios of manufactured housing loans, respec- tively, and approximately 0.11% of the outstanding face amount of the ICH loans under these agreements. Our subprime loans are held off balance sheet. We have entered into trustee agreements in connection with our securitized investments, primarily our CBOs. We pay annual fees of between 0.015% and 0.020% of the outstanding face amount of the CBO bonds under these agreements. Our manager is paid an annual management fee of 1.5% of our gross equity, as defined, an expense reimbursement, and incentive compensation equal to 25% of our FFO above a certain threshold. For more information on this agreement, as well as historical amounts earned, see Note 10 to our audited consolidated financial statements under “Financial Statements and Supplementary Data.” P.28 _ 2 0 0 6 a n n u a l r e p o r t newcastle contract CBO bonds payable Other bonds payable Notes payable Repurchase agreements Repurchase agreements subject to ABCP facility Financing of subprime mortgage loans subject to future repurchase Credit facility Junior subordinated notes payable Interest rate swaps, treated as hedges Non-hedge derivative obligations CBO wrap agreement CBO backstop agreements CBO remarketing agreements Subprime loan securitization Loan servicing agreements Trustee agreements Management agreement Total actual payments 2006(1) $ 233,913 335,625 141,584 2,872,327 181,605 – 501,202 4,444 3,197 34 481 1,292 364 1,462,427 4,755 826 21,581 $5,765,657 fixed and determinable payments due by period(2) 2010–2011 thereafter 2008–2009 2007 total $ – – 128,866 760,346 1,143,749 – 93,800 – (3) (3) (3) (3) (3) (3) (3) (3) $ – 213,172 – – – $ – 364,794 – – – $4,340,166 101,925 – – – $4,340,166 679,891 128,866 760,346 1,143,749 – – – (3) (3) (3) (3) (3) (3) (3) (3) – – – (3) (3) (3) (3) (3) (3) (3) (3) 299,176 – 100,100 (3) 299,176 93,800 100,100 (3) (3) (3) (3) (3) (3) (3) (3) (3) (3) (3) (3) (3) (3) (3) (3) $2,126,761 (3) $213,172 (3) $364,794 (3) $4,841,367 (3) $7,546,094 (1) Includes all payments made under the respective agreements. The management agreement payments shown include $14.0 million of management fees and expense reim- bursements and $7.6 million of incentive compensation. (2)Represents debt principal due based on contractual maturities. (3)These contracts do not have fixed and determinable payments. inflation We believe that our risk of increases in 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. funds from operations We believe Funds from Operations (FFO) is one appropriate meas- ure 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. Further more, FFO is used to compute our incentive compensation to our manager. FFO, for our purposes, represents net income available for common stockholders (computed in accordance with GAAP), excluding extraordinary items, plus depreciation of our operating real estate, and after adjustments for unconsoli- dated 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 sub- sidiaries, 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 per- formance or as an alternative to cash flow as a measure of liquidity and is not necessarily indicative of cash available to fund cash needs. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.29 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 year ended december 31, 2004 2005 2006 Income available for common stockholders Operating real estate depreciation Accumulated depreciation on operating real estate sold Funds from operations (FFO) $118,609 812 – $119,421 $110,271 702 (6,942) $104,031 $92,321 2,199 (8,319) $86,201 Funds from operations was derived from our segments as follows (unaudited) (in thousands): average invested common equity for the ffo for the year ended year ended december 31, december 31, december 31, book equity 2006,(1) 2005,(2) 2006 return on invested common equity(3) for the year ended december 31, 2004 2005 2006 Real estate securities and real estate related loans Residential mortgage loans Operating real estate Unallocated(1) Total(2) Preferred stock Accumulated depreciation Accumulated other comprehensive income Net book equity $ 998,473 125,647 49,085 (345,521) 827,684 102,500 (4,188) 75,984 $1,001,980 $ 903,165 109,966 46,331 (260,045) $ 799,417 $146,048 21,596 3,831 (52,054) $119,421 16.2% 19.6% 8.3% N/A 14.9% 17.9% 9.1% 3.5% N/A 13.4% 20.5% 16.7% 9.2% N/A 14.5% (1) Unallocated FFO represents ($11.7 million) of interest expense, ($9.3 million) of preferred dividends and ($31.1 million) of corporate general and administrative expense, manage- ment fees and incentive compensation. (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. P.30 _ 2 0 0 6 a n n u a l r e p o r t newcastle related party transactions In November 2003, we and a private investment fund managed by an affiliate of our manager co-invested and each indirectly own an approximately 38% interest in a limited liability company that acquired a pool of franchise loans from a third party financial institution. Our investment in this entity, reflected as an invest- ment in an unconsolidated subsidiary on our consolidated balance sheet, was approximately $10.2 million at December 31, 2006. The remaining approximately 24% interest in the limited lia- bility company is owned by the above referenced third party financial institution. As of December 31, 2006, we owned an aggregate of approximately $108.0 million of securities of Global Signal Trust II and III, special purpose vehicles established by Global Signal Inc., which were pur- chased in private placements from underwriters in January 2004, April 2005 and February 2006. Our CEO and chairman of our board of directors was 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 January 2007, Global Signal was acquired by Crown Castle International Corp. Newcastle’s affiliate no longer had significant influence over Global Signal subsequent to the acquisition. In March 2004, we and a private investment fund managed by an affiliate of our manager co-invested and each indirectly own an approximately 49% interest in two limited liability companies that have acquired, in a sale-leaseback transaction, a portfolio of con- venience and retail gas stores from a public company. The properties are subject to a number of master leases, the initial term of which in each case is a minimum of 15 years. This investment was financed with nonrecourse debt at the limited liability company level and our investment in this entity, reflected as an investment in an unconsolidated subsidiary on our consolidated balance sheet, was approximately $12.5 million at December 31, 2006. In March 2005, the property management agreement related to these properties was transferred to an affiliate of our manager from a third party ser- vicer; our allocable portion of the related fees, approximately $20,000 per year for three years, was not changed. 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 serv- iced. 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. The outstanding unpaid principal balance of this portfolio was approximately $245.7 mil- lion at December 31, 2006. 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 mort- gage lender (“Subprime Servicer”) to service this portfolio. In July 2006, private equity funds managed by an affiliate of our man- ager 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 portfo- lio. The outstanding unpaid principal balance of this portfolio was approximately $1.2 billion at December 31, 2006. In August 2006, we acquired a portfolio of manufactured housing loans. The loans are being serviced by a portfolio company of a pri- vate 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 thresh- olds. The outstanding unpaid principal balance of this portfolio was approximately $398.3 million at December 31, 2006. In September 2006, we were co-lenders with two private invest- ment funds managed by an affiliate of our manager in a new real estate related loan. 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 hold- ers 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 newcastle 2 0 0 6 a n n u a l r e p o r t _ P.31 loan to third parties. In October 2006, we and the private invest- ment funds sold, on a pro-rata basis, a $125.0 million senior participation interest in the loan to an unaffiliated third party, resulting in us owning a 20% interest in the junior participation interest in the loan. Our investment in this loan was approxi- mately $26.1 million at December 31, 2006. As of December 31, 2006, we held total investments of $192.2 mil- lion face amount of real estate securities and real estate related loans issued by affiliates of our manager and earned approxi- mately $18.5 million, $13.7 million and $13.1 million of interest on investments issued by affiliates for the years ended December 31, 2006, 2005 and 2004, respectively. In each instance described above, affiliates of our manager have an investment in the applicable affiliated fund and receive from the fund, in addition to management fees, incentive com- pensation if the fund’s aggregate investment returns exceed certain thresholds. 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 opera- tions, there can be no assurance that our profitability will not be adversely affected during any period as a result of changing inter- est 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 December 31, 2006, a 100 basis point increase in short-term interest rates would increase our earnings by approximately $0.2 million per annum. 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 inter - national economic and political considerations and other factors beyond our control. All of our market risk sensitive assets, liabili- ties 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 the “Application of Critical Accounting Policies” section of “Manage - ment’s Discussion and Analysis of Financial Condition and Results of Operations.” interest rate exposure Our primary interest rate exposures relate to our real estate secu- rities, loans, floating rate debt obligations, interest rate swaps, and interest rate caps. Changes in the general level of interest A period of rising interest rates 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, caus- ing a decrease in return on equity during a period of rising interest rates. When interest rates stabilize, we expect these investments would 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 P.32 _ 2 0 0 6 a n n u a l r e p o r t newcastle result of book value changes. Accordingly, unless there is a mate- rial 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 December 31, 2006, a 100 basis point change in short term interest rates would impact our net book value by approximately $65.7 million. Our general financing strategy focuses on the use of match funded structures. This means that, when appropriate, 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 lia- bilities 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 liabili- ties 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 upfront 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 annual- ized basis will equal the contractual notional face amount multiplied by the difference between the actual reference rate and the contracted strike rate. 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 quali- fied 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 pur- poses 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 unantici- pated 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 pro- tect 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 a higher (or “wider”) spread over the benchmark rate (usually the applicable U.S. Treasury security yield) to value such securities. Under such newcastle 2 0 0 6 a n n u a l r e p o r t _ P.33 margin Certain of our investments are financed through repurchase agreements or total rate of return swaps which are subject to mar- gin 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 result- ing 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. fair value Fair values for a majority of our investments are readily obtain- able 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 valua- tion 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 val- ues, and that the fair values reflected below are indicative of the interest rate and credit spread environments as of December 31, 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 securi- ties, loans and derivative instruments 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. conditions, the value of our real estate securities portfolio would tend to decline. Conversely, if the spread used to value such secu- rities were to decrease (or “tighten”), the value of our real estate securities portfolio would tend to increase. Our floating rate secu- rities 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 securi- ties, or indirectly through their impact on our ability to borrow and access capital. Furthermore, shifts in the U.S. Treasury yield curve, which repre- sents 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 opera- tions 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 these 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 affected similarly by changes in U.S. Treasury spreads. If the value of our loans subject to repurchase agreements or commercial paper were to decline, it could affect our ability to refinance such loans upon the maturity of the related repurchase agreements or commercial paper. 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 December 31, 2006, a 25 basis point movement in credit spreads would impact our net book value by approximately $62.5 million, but would not directly affect our earnings or cash flow. P.34 _ 2 0 0 6 a n n u a l r e p o r t newcastle Interest Rate and Credit Spread Risk We held the following interest rate and credit spread risk sensitive instruments at December 31, 2006 (in thousands): carrying value december 31, december 31, 2006 fair value december 31, principal balance or notional amount 2006 2005 weighted average yield/ funding maturity date cost 2006 2005 Assets: Real estate securities, available for sale(1) Real estate related loans(2) Residential mortgage loans(3) Subprime mortgage loans subject to future repurchase(4) Interest rate caps, treated as hedges(5) Total rate of return swaps(6) Liabilities: CBO bonds payable(7) Other bonds payable(8) Notes payable(9) Repurchase agreements(10) Repurchase agreements subject to ABCP facility(10) Financing of subprime mortgage loans subject to future repurchase(4) Credit facility(11) Junior subordinated notes payable(12) Interest rate swaps, treated as hedges(13) Non-hedge derivatives(14) $5,581,228 1,568,916 809,097 $4,554,519 615,551 600,682 $5,604,249 1,573,570 812,561 288,202 1,262 1,288 4,313,824 675,844 128,866 760,346 1,143,749 288,202 93,800 100,100 (42,887) 360 – 2,145 3,096 3,530,384 353,330 260,441 1,048,203 299,176 334,971 299,654 4,340,166 679,891 128,866 760,346 – 1,143,749 – 20,000 – (41,170) 90 299,176 93,800 100,100 3,943,120 (14) 6.60% 8.48% 8.03% (4) N/A N/A 5.73% 6.63% 5.68% 5.92% 4.97% (4) 7.08% 7.72% N/A N/A (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (10) (4) (11) (12) (13) (14) $5,581,228 1,571,412 829,980 $4,554,519 615,865 609,486 288,202 1,262 1,288 4,369,540 676,512 128,866 760,346 – 2,145 3,096 3,594,638 356,294 260,441 1,048,203 1,143,749 – 288,202 93,800 101,629 (42,887) 360 – 20,000 – (41,170) 90 (1) These securities contain various terms, including fixed and floating rates, self-amortizing and interest only. Their weighted average maturity is 5.02 years. The fair value of these securities is estimated by obtaining third party broker quotations, if available and practicable, and counterparty quotations. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.35 (2)Represents the following loans: loan type B-Notes Mezzanine Loans Bank Loans Whole Loans ICH Loans current face amount $ 248,240 906,907 233,793 61,240 123,390 $1,573,570 carrying value $ 246,798 904,686 233,895 61,703 121,834 $1,568,916 weighted average yield weighted average maturity (years) 7.98% 8.61% 7.75% 12.63% 7.77% 8.48% 2.71 2.67 3.92 1.81 1.10 2.71 floating rate loans as a % of carrying value 73.0% 97.5% 100.0% 100.0% 1.6% 86.7% fair value $ 248,662 904,996 234,680 61,240 121,834 $1,571,412 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 and two portfolios of substantially fixed rate manufactured hous- ing loans. The $168.6 million portfolio of residential mortgage loans has a weighted average maturity of 2.79 years. The $643.9 million portfolios of manufactured housing loans have a weighted average maturity of 6.02 years. These loans were valued by reference to current market interest rates and credit spreads. (4)These two 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 $255,352 18,000 8,619 53,000 $334,971 Current January 2010 December 2010 May 2011 March 2009 October 2015 June 2015 September 2015 1-Month LIBOR 3-Month LIBOR 3-Month LIBOR 1-Month LIBOR 6.50% 8.00% 7.00% 7.50% $ 31 154 371 706 $1,262 The fair value of these agreements is estimated by obtaining counterparty quotations. (6)Represents total 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 discus- sion 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 5.83 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 1.04 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 2.48 years. 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 0.74 years and is subject to adjustment monthly based on the agreed upon 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 compa- rable 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 0.08 years. (11) This facility, which has a weighted average maturity of 0.85 years, bears a floating rate of interest. This facility was valued at par because management believes it could currently enter into a similar arrangement under similar terms. P.36 _ 2 0 0 6 a n n u a l r e p o r t newcastle (12)These notes have a weighted average maturity of 29.25 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. (13)Represents current swap agreements as follows: year of maturity Agreements which receive 1-Month LIBOR: 2009 2010 2011 2012 2015 2016 Agreements which receive 3-Month LIBOR: 2011 2013 2014 2016 weighted average maturity aggregate notional amount weighted average fixed pay rate aggregate fair value May 2009 Jun 2010 Jun 2011 Jan 2012 Jul 2015 Apr 2016 Apr 2011 Mar 2013 Jun 2014 Apr 2016 $ 331,620* 402,533 591,800 127,001 776,996 728,738 337,000 276,060 357,852 13,520 $3,943,120 3.27% 4.37% 5.24% 4.92% 4.92% 5.18% 5.81% 3.87% 4.21% 5.57% $ (9,517) (6,211) 2,688 (546) (7,465) 2,776 7,785 (15,183) (17,603) 389 $(42,887) * $255,352 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 $59.6 million of gross interest rate swap assets and $16.7 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 mil- lion 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. consolidated balance sheets (dollars in thousands, except share data) december 31, Assets Real estate securities, available for sale – Note 4 Real estate related loans, net – Note 5 Residential mortgage loans, net – Note 5 Subprime mortgage loans subject to future repurchase – Note 5 Investments in unconsolidated subsidiaries – Note 3 Operating real estate, net – Note 6 Cash and cash equivalents Restricted cash Derivative assets – Note 7 Receivables and other assets Liabilities and Stockholders’ Equity Liabilities CBO bonds payable – Note 8 Other bonds payable – Note 8 Notes payable – Note 8 Repurchase agreements – Note 8 Repurchase agreements subject to ABCP facility – Note 8 Financing of subprime mortgage loans subject to future repurchase – Notes 5 and 8 Credit facility – Note 8 Junior subordinated notes payable (security for trust preferred) – Note 8 Derivative liabilities – Note 7 Dividends payable Due to affiliates – Note 10 Accrued expenses and other liabilities Commitments and contingencies – Notes 9, 10 and 11 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 Common stock, $0.01 par value, 500,000,000 shares authorized, 45,713,817 and 43,913,409 shares issued and outstanding at December 31, 2006 and 2005, respectively Additional paid-in capital Dividends in excess of earnings – Note 2 Accumulated other comprehensive income – Note 2 See notes to consolidated financial statements. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.37 2006 2005 $5,581,228 1,568,916 809,097 288,202 22,868 29,626 5,371 184,169 62,884 52,031 $8,604,392 $4,313,824 675,844 128,866 760,346 1,143,749 288,202 93,800 100,100 17,715 33,095 13,465 33,406 7,602,412 $4,554,519 615,551 600,682 – 29,953 16,673 21,275 268,910 63,834 38,302 $6,209,699 $3,530,384 353,330 260,441 1,048,203 – 20,000 – 18,392 29,052 8,783 23,111 5,291,696 102,500 102,500 457 833,887 (10,848) 75,984 1,001,980 $8,604,392 439 782,735 (13,235) 45,564 918,003 $6,209,699 P.38 _ 2 0 0 6 a n n u a l r e p o r t newcastle consolidated statements of income (dollars in thousands, except share data) year ended december 31, Revenues Interest income Rental and escalation income Gain on sale of investments, net Other income, net Expenses Interest expense Property operating expense Loan and security servicing expense Provision for credit losses Provision for losses, loans held for sale – Note 5 General and administrative expense Management fee to affiliate – Note 10 Incentive compensation to affiliate – Note 10 Depreciation and amortization Income before equity in earnings of unconsolidated subsidiaries Equity in earnings of unconsolidated subsidiaries – Note 3 Income taxes on related taxable subsidiaries – Note 12 Income from continuing operations Income from discontinued operations – Note 6 Net Income Preferred dividends Income Available For Common Stockholders Net Income Per Share of Common Stock Basic Diluted Income from continuing operations per share of common stock, after preferred dividends Basic Diluted Income from discontinued operations per share of common stock Basic Diluted Weighted Average Number of Shares of Common Stock Outstanding Basic Diluted Dividends Declared Per Share of Common Stock See notes to consolidated financial statements. 2006 2005 2004 $530,006 4,861 12,340 5,402 552,609 374,269 3,805 6,944 9,438 4,127 4,946 14,018 12,245 1,085 430,877 121,732 5,968 – 127,700 223 127,923 (9,314) $118,609 $ 2.68 $ 2.67 $ 2.67 $ 2.67 $ 0.01 $ 0.00 $348,516 6,647 20,305 2,745 378,213 226,446 2,363 5,993 8,421 – 4,159 13,325 7,627 641 268,975 109,238 5,930 (321) 114,847 2,108 116,955 (6,684) $110,271 $ 2.53 $ 2.51 $ 2.48 $ 2.46 $ 0.05 $ 0.05 $225,761 4,744 18,314 850 249,669 136,398 2,575 3,057 – – 4,597 10,620 7,959 451 165,657 84,012 12,465 (2,508) 93,969 4,446 98,415 (6,094) $ 92,321 $ 2.50 $ 2.46 $ 2.38 $ 2.34 $ 0.12 $ 0.12 44,268,575 44,417,113 $ 2.615 43,671,517 43,985,642 $ 2.500 36,943,752 37,557,790 $ 2.425 consolidated statements of stockholders’ equity (for the years ended December 31, 2006, 2005 and 2004) (dollars in thousands) newcastle 2 0 0 6 a n n u a l r e p o r t _ P.39 Stockholders- equity – December 31, 2006 4,100,000 $102,500 45,713,817 $457 $833,887 $ (10,848) Stockholders’ equity – December 31, 2005 Dividends declared Issuance of common stock Issuance of common stock to directors Exercise of common stock options Comprehensive income: Net income Net unrealized (loss) on securities Reclassification of net realized (gain) on securities into earnings Foreign currency translation Net unrealized gain on derivatives designated as cash flow hedges Reclassification of net realized (gain) on derivatives designated as cash flow hedges into earnings Total comprehensive income Stockholders’ equity – December 31, 2004 Dividends declared Issuance of common stock Issuance of common stock to directors Exercise of common stock options Issuance of preferred stock Comprehensive income: Net income Net unrealized (loss) on securities Reclassification of net realized (gain) on securities into earnings Foreign currency translation Reclassification of net realized foreign currency translation into earnings Net unrealized gain on derivatives designated as cash flow hedges Reclassification of net realized loss on derivatives designated as cash flow hedges into earnings Total comprehensive income preferred stock shares amount common stock shares amount addi- dividends in excess tional paid in of capital earnings total accum. other stock- comp. holders’ equity income 4,100,000 $102,500 – – – – – – – – 43,913,409 – 1,700,000 2,408 98,000 $439 – 17 – 1 $ 782,735 – 49,376 60 1,716 $ (13,235) (125,536) – – – $ 45,564 $ 918,003 (125,536) 49,393 60 1,717 – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – 2,500,000 $ 62,500 – – – – – – – – 40,000 1,600,000 39,859,481 – 3,300,000 2,008 751,920 – $399 – 33 – 7 – $676,015 – 96,449 67 11,687 (1,483) $ (13,969) (116,221)– – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – 127,923 – – 26,242 127,923 26,242 – – – – – – – – – (282) (26) (282) (26) 7,773 7,773 (3,287) (3,287) 158,343 $ 75,984 $1,001,980 $ 71,770 $ 796,715 (116,221) 96,482 67 11,694 38,517 – – – – – (16,015) (1,089) (16,015) (1,089) (626) (626) 56,426 56,426 2,175 2,175 90,749 $ 45,564 $ 918,003 116,955 – – (67,077) 116,955 (67,077) Stockholders’ equity – December 31, 2005 4,100,000 $102,500 43,913,409 $439 $ 782,735 $ (13,235) (continued) P.40 _ 2 0 0 6 a n n u a l r e p o r t newcastle consolidated statements of stockholders’ equity (continued) (for the years ended December 31, 2006, 2005 and 2004) (dollars in thousands) preferred stock shares amount common stock shares amount addi- dividends in excess tional paid in of capital earnings total accum. other. stock- comp. holders’ equity income 2,500,000 $62,500 – – – – – – – – 31,374,833 – 8,375,000 2,148 107,500 $314 – 84 – 1 $451,806 – 222,721 60 1,428 $(14,670) (97,714) – – – $ 39,413 – – – – $539,363 (97,714) 222,805 60 1,429 – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – 98,415 – – 34,088 98,415 34,088 – – – – – (14,574) 1,984 (14,574) 1,984 (1,478) (1,478) 11,973 11,973 364 364 130,772 $796,715 2,500,000 $62,500 39,859,481 $399 $676,015 $(13,969) $ 71,770 Stockholders’ equity – December 31, 2003 Dividends declared Issuance of common stock Issuance of common stock to directors Exercise of common stock options Comprehensive income: Net income Net unrealized gain on securities Reclassification of net realized (gain) on securities into earnings Foreign currency translation Reclassification of net realized foreign currency translation into earnings Net unrealized gain on derivatives designated as cash flow hedges Reclassification of net unrealized loss on derivatives designated as cash flow hedges into earnings Total comprehensive income Stockholders’ equity – December 31, 2004 See notes to consolidated financial statements. consolidated statements of cash flows (dollars in thousands) year ended december 31, Cash Flows From Operating Activities newcastle 2 0 0 6 a n n u a l r e p o r t _ P.41 2006 2005 2004 Net income Adjustments to reconcile net income to net cash provided by operating activities $ 127,923 $ 116,955 $ 98,415 (inclusive of amounts related to discontinued operations): Depreciation and amortization Accretion of discount and other amortization Equity in earnings of unconsolidated subsidiaries Distributions of earnings from unconsolidated subsidiaries Deferred rent Gain on sale of investments Unrealized gain on non-hedge derivatives and hedge ineffectiveness Provision for credit losses Provision for losses, loans held for sale Purchase of loans held for sale – Note 5 Sale of loans held for sale – Note 5 Non-cash directors’ compensation Change in Restricted cash Receivables and other assets Due to affiliates Accrued expenses and other liabilities Net cash provided by operating activities: Cash Flows From Investing Activities Purchase of real estate securities Proceeds from sale of real estate securities Deposit on real estate securities (treated as a derivative) Purchase of and advances on loans Proceeds from settlement of loans Repayments of loan and security principal Margin received on derivative instruments Return of margin on derivative instruments Margin deposits on total rate of return swaps (treated as derivative instruments) Return of margin deposits on total rate of return swaps (treated as derivative instruments) Proceeds from termination of derivative instruments Proceeds from sale of derivative instruments into Securitization Trust – Note 5 Payments on settlement of derivative instruments Purchase and improvement of operating real estate Proceeds from sale of operating real estate Contributions to unconsolidated subsidiaries Distributions of capital from unconsolidated subsidiaries Payment of deferred transaction costs Net cash used in investing activities (continued) 1,085 (15,365) (5,968) 5,968 (1,274) (13,359) (4,284) 9,438 4,127 (1,511,086) 1,411,530 60 1,400 (8,985) 4,682 10,430 16,322 (1,295,067) 318,007 – (1,643,062) 24,750 579,166 50,701 (50,799) (55,922) 81,619 16,426 5,623 – (1,585) – (125) 7,210 – (1,963,058) 818 (2,645) (5,930) 5,930 (2,539) (20,811) (2,839) 8,421 – – – 67 (7,980) 218 (180) 9,278 98,763 (1,463,581) 60,254 (57,149) (584,270) 1,901 698,002 – – (53,518) – 1,338 – (1,112) (182) 52,333 – 11,277 (39) (1,334,746) 2,253 1,898 (12,465) 12,465 (1,380) (22,029) (3,332) – – – – 60 (8,137) (5,431) 6,518 21,520 90,355 (1,426,762) 193,246 (80,311) (631,728) 124,440 428,091 – – – – – – – (141) 71,871 (26,789) 16,199 (280) (1,332,164) P.42 _ 2 0 0 6 a n n u a l r e p o r t newcastle consolidated statements of cash flows (continued) (dollars in thousands) year ended december 31, Cash Flows From Financing Activities Issuance of CBO bonds payable Repayments of CBO bonds payable Issuance of other bonds payable Repayments of other bonds payable Borrowings under notes payable Repayments of notes payable Borrowings under repurchase agreements Repayments of repurchase agreements Issuance of repurchase agreement subject to ABCP facility Draws under credit facility Repayments of credit facility Issuance of junior subordinated notes payable Issuance of common stock Costs related to issuance of common stock Exercise of common stock options Issuance of preferred stock Costs related to issuance of preferred stock Dividends paid Payment of deferred financing costs Net cash provided by financing activities Net Increase (Decrease) in Cash and Cash Equivalents Cash and Cash Equivalents, Beginning of Period Cash and Cash Equivalents, End of Period Supplemental Disclosure of Cash Flow Information Cash paid during the period for interest expense Cash paid during the period for income taxes Supplemental Schedule of Non–cash Investing and Financing Activities Common stock dividends declared but not paid Preferred stock dividends declared but not paid Deposits used in acquisition of real estate securities (treated as derivatives) Foreclosure of loans Acquisition and financing of loans subject to future repurchase Retained bonds and equity in securitization See notes to consolidated financial statements. 2006 2005 2004 $ 807,464 (18,889) 631,988 (305,428) – (131,575) 3,953,324 (4,241,181) 1,143,749 570,400 (496,600) 100,100 50,014 (581) 1,717 – – (121,493) (12,177) 1,930,832 (15,904) 21,275 $ 5,371 $ 880,570 (10,241) 246,547 (114,780) – (391,559) 815,840 (258,257) – 62,000 (42,000) – 97,680 (1,198) 11,694 40,000 (1,483) (113,097) (2,369) 1,219,347 (16,636) 37,911 $ 21,275 $ 859,719 (604) – (41,759) 614,106 (119,407) 654,254 (879,417) – – – – 222,805 – 1,429 – – (88,489) (3,320) 1,219,317 (22,492) 60,403 $ 37,911 $ 335,545 $ 244 $ 213,070 $ 448 $ 135,172 $ 2,639 $ 31,543 $ 1,552 $ – $ 14,780 $ 286,315 $ 96,058 $ 27,446 $ 1,606 $ 82,334 $ – $ – $ – $ 24,912 $ 1,016 $ 75,824 $ – $ – $ – notes to consolidated financial statements December 31, 2006, 2005 and 2004 (dollars in tables in thousands, except per share data) 1. organization Newcastle Investment Corp. (and its subsidiaries, “Newcastle”) is a Maryland corporation that was formed in 2002. Newcastle con- ducts its business through three primary segments: (i) real estate securities and real estate related loans, (ii) residential mortgage loans, and (iii) operating real estate. The following table presents information on shares of Newcastle’s common stock issued subsequent to its formation: shares issued range of issue prices(1) net proceeds (millions) newcastle 2 0 0 6 a n n u a l r e p o r t _ P.43 fee and incentive compensation, both as defined in the Management Agreement. For a further discussion of the Management Agreement, see Note 10. Approximately 2.9 million shares of Newcastle’s common stock were held by the Manager, through its affiliates, and principals of Fortress at December 31, 2006. In addition, the Manager, through its affiliates, held options to purchase approximately 1.3 million shares of Newcastle’s common stock at December 31, 2006. 2. summary of significant accounting policies general year Formation 2002 2003 2004 2005 2006 December 31, 2006 January 2007 16,488,517 7,000,000 7,886,316 8,484,648 4,053,928 1,800,408 45,713,817 2,420,000 N/A $ 13.00 $20.35– $ 22.85 $26.30– $ 31.40 $ 29.60 $ 29.42 N/A $ 80.0 $163.4 $224.3 $108.2 $ 51.2 $ 31.30 $ 75.0 Basis of Accounting – The accompanying consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The consolidated finan- cial statements include the accounts of Newcastle and its consolidated subsidiaries. All significant intercompany trans - actions and balances have been eliminated. Newcastle consolidates those entities in which it has an investment of 50% or more and has control over significant operating, financial and investing decisions of the entity. (1) Excludes prices of shares issued pursuant to the exercise of options and of shares issued to Newcastle’s independent directors. Newcastle is organized and conducts its operations to qualify as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). As such, Newcastle will gen- erally not be subject to U.S. federal corporate income tax on that portion of its net income that is distributed to stockholders if it dis- tributes 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 FIG LLC (the “Manager”), an affiliate of Fortress Investment Group LLC, 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 direc- tors. For its services, the Manager receives an annual management In December 2003, Financial Accounting Standards Board Interpre - tation (“FIN”) No. 46R “Consolidation of Variable Interest Entities” was issued as a modification of FIN 46. FIN 46R, which became effective in the first quarter of 2004, 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 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. The application of FIN 46R did not result in a change in our accounting for any entities. Our CBO subsidiaries are considered VIEs of which we are the primary beneficiary. P.44 _ 2 0 0 6 a n n u a l r e p o r t newcastle For entities over which Newcastle exercises significant influence, but which do not meet the requirements for consolidation, Newcastle uses the equity method of accounting whereby it records its share of the underlying income of such entities. Newcastle owns an equity method investment in two limited lia- bility companies (Note 3) which are investment companies and therefore maintain their financial records on a fair value basis. Newcastle has retained such accounting relative to its invest- ments in such companies pursuant to the Emerging Issues Task Force (“EITF”) Issue No. 85-12 “Retention of Specialized Accounting for Investments in Consolidation.” In addition, Newcastle owns equity method investments in two entities which issued trust pre- ferred securities and asset backed commercial paper (Note 8). Risks and Uncertainties – In the normal course of business, Newcastle encounters primarily two significant types of eco- nomic risk: credit and market. Credit risk is the risk of default on Newcastle’s securities, loans, derivatives, and leases that results from a borrower’s, derivative counterparty’s or lessee’s inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of investments in securities, loans and derivatives or in real estate due to changes in interest rates, spreads or other market factors, including the value of the collateral underlying loans and securities and the valuation of real estate held by Newcastle. Management believes that the car- rying values of its investments are reasonable taking into consideration these risks along with estimated collateral values, payment histories, and other borrower information. Additionally, Newcastle is subject to significant tax risks. If Newcastle were to fail to qualify as a REIT in any taxable year, Newcastle would be subject to U.S. federal corporate income tax (including any applicable alternative minimum tax), which could be material. In addition, if Newcastle’s predecessor, Newcastle Investment Holdings Corp. (“Holdings”), failed to qualify as a REIT and Newcastle is treated as a successor to Holdings, this could cause Newcastle to likewise fail to qualify as a REIT. Unless enti- tled to relief under certain statutory provisions, Newcastle would also be disqualified from treatment as a REIT for the four taxable years following the year during which qualification is lost. Use of Estimates – The preparation of financial statements in con- formity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabil- ities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could dif- fer from those estimates. Comprehensive Income – Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances, excluding those resulting from investments by and distributions to owners. For Newcastle’s purposes, comprehensive income represents net income, as presented in the statements of income, adjusted for unrealized gains or losses on securities available for sale and derivatives designated as cash flow hedges and net foreign cur- rency translation adjustments. The following table summarizes our accumulated other comprehensive income: december 31, Net unrealized gains on securities Net unrealized gains on derivatives designated as cash flow hedges Net foreign currency translation adjustments Accumulated other comprehensive income 2006 2005 $42,742 $16,782 31,224 2,018 $75,984 26,738 2,044 $45,564 revenue recognition Real Estate Securities and Loans Receivable – Newcastle invests in securities, including commercial mortgage backed securities, sen- ior unsecured debt issued by property REITS, real estate related asset backed securities and agency residential mortgage backed securities. Newcastle also invests in loans, including real estate related loans, commercial mortgage loans, residential mort- gage loans, manufactured housing loans and subprime mortgage loans. Newcastle determines at acquisition whether loans will be aggregated into pools based on common risk characteristics (credit quality, loan type, and date of origination or acquisition); loans aggregated into pools are accounted for as if each pool were a single loan. Loans receivable are presented in the consolidated balance sheet net of any unamortized discount (or gross of any unamortized premium) and an allowance for loan losses. Discounts or premiums are accreted into interest income on an effective yield or “interest” method, based upon a comparison of actual and expected cash flows, through the expected maturity date of the security or loan. Depending on the nature of the investment, changes to expected cash flows may result in a newcastle 2 0 0 6 a n n u a l r e p o r t _ P.45 prospective change to yield or a retrospective change which would include a catch up adjustment. For loans acquired at a dis- count for credit quality, the difference between contractual cash flows and expected cash flows at acquisition is not accreted (nonaccretable difference). Income is not accrued on non- performing securities or loans; cash received on such securities or loans is treated as income to the extent of interest previously accrued. Interest income with respect to non-discounted securi- ties or loans is recognized on an accrual basis. Deferred fees and costs, if any, are recognized as interest income over the terms of the securities or loans using the interest method. Upon settle- ment of securities and loans, the excess (or deficiency) of net proceeds over the net carrying value of such security or loan is recognized as a gain (or loss) in the period of settlement. Interest income includes prepayment penalties received of $5.9 million, $3.2 million and $0.6 million in 2006, 2005 and 2004, respectively. Impairment of Securities and Loans – Newcastle continually eval- uates securities and loans for impairment. This evaluation includes the following, as applicable: (i) review of the credit of the issuer or the borrower, (ii) review of the credit rating of the secu- rity, (iii) review of the key terms of the security or loan, (iv) review of the performance of the loan or underlying loans, including debt service coverage and loan to value ratios, (v) analysis of the value of the collateral for the loan or underlying loans, (vi) analysis of the effect of local, industry and broader economic factors, and (vii) analysis of trends in defaults and loss severities for similar loans. Securities and loans are considered to be impaired, for financial reporting purposes, when it is probable that Newcastle will be unable to collect all principal or interest when due according to the contractual terms of the original agreements, or, for securities or loans purchased at a discount for credit quality or that repre- sent beneficial interests in securitizations, when Newcastle determines that it is probable that it will be unable to collect as anticipated. For loans purchased at a discount for credit quality, if Newcastle determines that it is probable that it will collect more than previously anticipated, the yield accrued on such loan or security is adjusted upward, on a prospective basis. Upon determi- nation of impairment, Newcastle establishes specific valuation allowances for loans or records a direct write-down for securities, through provisions for losses, based on the estimated fair value of the underlying collateral using a discounted cash flow analysis or based on observable market value. Newcastle also establishes allowances for estimated unidentified incurred losses on pools of loans. The allowance for each security or loan is maintained at a level believed adequate by management to absorb probable losses, based on periodic reviews of actual and expected losses. It is Newcastle’s policy to establish an allowance for uncollectible interest on performing securities or loans that are past due more than 90 days or sooner when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. Upon such a determination, those loans are deemed to be non-performing. Actual losses may differ from Newcastle’s estimate. expense recognition Interest Expense – Newcastle finances its investments using both fixed and floating rate debt, including securitizations, loans, repurchase agreements, and other financing vehicles. Certain of this debt has been issued at discounts. Discounts are accreted into interest expense on the interest method through the expected maturity date of the financing. Deferred Costs and Interest Rate Cap Premiums – Deferred costs consist primarily of costs incurred in obtaining financing which are amortized into interest expense over the term of such financing using the interest method. Interest rate cap premiums, which are included in Derivative Assets, are amortized as described below. Derivatives and Hedging Activities – All derivatives are recognized as either assets or liabilities on the balance sheet and measured at fair value. Fair value adjustments affect either stockholders’ equity or net income depending on whether the derivative instru- ment qualifies as a hedge for accounting purposes and, if so, the nature of the hedging activity. For those derivative instru- ments that are designated and qualify as hedging instruments, Newcastle designates the hedging instrument, based upon the exposure being hedged, as either a cash flow hedge, a fair value hedge or a hedge of a net investment in a foreign operation. Derivative transactions are entered into by Newcastle solely for risk management purposes, except for real estate securities port- folio deposits as described in Note 4 and the total rate of return swaps described in Note 5. Such total rate of return swaps are essentially financings of certain reference assets which are treated as derivatives for accounting purposes. The decision of whether or not a given transaction/position (or portion thereof) is hedged is made on a case-by-case basis, based on the risks involved and other factors as determined by senior management, P.46 _ 2 0 0 6 a n n u a l r e p o r t newcastle including restrictions imposed by the Code among others. In determining whether to hedge a risk, Newcastle may consider whether other assets, liabilities, firm commitments and antici- pated transactions already offset or reduce the risk. All transactions undertaken as hedges are entered into with a view towards minimizing the potential for economic losses that could be incurred by Newcastle. Generally, all derivatives entered into are intended to qualify as hedges under GAAP, unless specifically stated otherwise. To this end, terms of hedges are matched closely to the terms of hedged items. Description of the risks being hedged 1) Interest rate risk, existing debt obligations – Newcastle gener- ally hedges the risk of interest rate fluctuations with respect to its borrowings, regardless of the form of such borrowings, which require payments based on a variable interest rate index. Newcastle generally intends to hedge only the risk related to changes in the benchmark interest rate (LIBOR or a Treasury rate). In order to reduce such risks, Newcastle may enter into swap agreements whereby Newcastle would receive floating rate payments in exchange for fixed rate payments, effectively converting the borrowing to fixed rate. Newcastle may also enter into cap agreements whereby, in exchange for a pre- mium, Newcastle would be reimbursed for interest paid in excess of a certain cap rate. 2) Interest rate risk, anticipated transactions – Newcastle may hedge the aggregate risk of interest rate fluctuations with respect to anticipated transactions, primarily anticipated bor- rowings. The primary risk involved in an anticipated borrowing is that interest rates may increase between the date the trans- action becomes probable and the date of consummation. Newcastle generally intends to hedge only the risk related to changes in the benchmark interest rate (LIBOR or a Treasury rate). This is generally accomplished through the use of interest rate swaps. 3) Interest rate risk, fair value of investments – Newcastle occa- sionally hedges the fair value of investments acquired outside of its warehouse agreements (Note 4) prior to such investments being included in a CBO financing (Note 8). The primary risk involved is the risk that the fair value of such an investment will change between the acquisition date and the date the terms of the related financing are “locked in.” Newcastle generally intends to hedge only the risk related to changes in the bench- mark interest rate (LIBOR or a Treasury rate). This is generally accomplished through the use of interest rate swaps. Cash flow hedges To qualify for cash flow hedge accounting, interest rate swaps and caps must meet certain criteria, including (1) the items to be hedged expose Newcastle to interest rate risk, (2) the interest rate swaps or caps are highly effective in reducing Newcastle’s expo- sure to interest rate risk, and (3) with respect to an anticipated transaction, such transaction is probable. Correlation and effec- tiveness are periodically assessed based upon a comparison of the relative changes in the fair values or cash flows of the interest rate swaps and caps and the items being hedged. For derivative instruments that are designated and qualify as a cash flow hedge (i.e., hedging the exposure to variability in expected future cash flows that is attributable to a particular risk), the effective portion of the gain or loss, and net payments received or made, on the derivative instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of future cash flows of the hedged item, if any, is rec- ognized in current earnings during the period of change. The premiums paid for interest rate caps, treated as cash flow hedges, are amortized into interest expense based on the estimated value of such cap for each period covered by such cap. With respect to interest rate swaps which have been designated as hedges of anticipated financings, periodic net payments are recognized currently as adjustments to interest expense; any gain or loss from fluctuations in the fair value of the interest rate swaps is recorded as a deferred hedge gain or loss in accumulated other comprehensive income and treated as a component of the anticipated transaction. In the event the anticipated refinancing failed to occur as expected, the deferred hedge credit or charge would be recognized immediately in income. Newcastle’s hedges of such refinancing were terminated upon the consummation of such financing. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.47 Newcastle has dedesignated certain of its hedge derivatives, and in some cases redesignated all or a portion thereof as hedges. As a result of these dedesignations, in the cases where the originally hedged items were still owned by Newcastle, the unrealized gain or loss was recorded in OCI as a deferred hedge gain or loss and is being amortized over the life of the hedged item. Fair Value Hedges Any unrealized gains or losses, as well as net payments received or made, on these derivative instruments are recorded currently in income, as are any unrealized gains or losses on the associated hedged items related to changes in interest rates. Non-Hedge Derivatives With respect to interest rate swaps and caps that have not been designated as hedges, any net payments under, or fluctuations in the fair value of, such swaps and caps has been recognized cur- rently in Other Income. Classification Newcastle’s derivatives are recorded on its balance sheet as fol- lows (excluding the real estate securities portfolio deposit, which is reported separately): december 31, 2006 2005 Derivative Assets Interest rate caps(A) Interest rate swaps(A) Total rate of return swaps Non-hedge derivatives(B) Derivative Liabilities Interest rate swaps(A) Interest (receivable) payable Non-hedge derivatives(B) (A)Treated as hedges (B)Interest rate swaps and caps $ 1,262 59,551 1,288 783 $62,884 $16,664 (92) 1,143 $17,715 $ 2,145 56,829 3,096 1,764 $63,834 $15,659 1,059 1,674 $18,392 The following table summarizes financial information related to derivatives (excluding the real estate securities portfolio deposit and total rate of return swaps, which are reported separately) : december 31, Cash flow hedges Notional amount Interest rate cap agreements Interest rate swap agreements Deferred hedge gain (loss) related to anticipated financings, net of amortization Deferred hedge gain (loss) related to dedesignation, net of amortization Expected reclassification of deferred hedges from AOCI into earnings over the next 12 months Fair value hedges Notional amount Deferred hedge gain (loss) related to 2006 2005 $ 334,971 3,937,544 $ 342,351 2,941,625 (1,585) (3,536) (2,554) (202) (1,251) (1,002) 5,575 2,127 lease payments, net of amortization – (129) Non-hedge Derivatives Notional amount of interest rate cap and swap agreements 147,500 166,700 year ended december 31, 2006 2005 2004 Cash flow hedges Gain (loss) on the ineffective portion Gain (loss) immediately recognized at dedesignation Fair value hedges Gain (loss) on the effective portion(A) Gain (loss) on the ineffective portion Non-hedge derivatives gain (loss) $ 49 $164 $(100) 5,133 342 (333) (22) 7 – 6,178 976 – (1) – – (A)Offset by the unrealized gain (loss) on the associated hedged items which is recog- nized in earnings. P.48 _ 2 0 0 6 a n n u a l r e p o r t newcastle Newcastle’s derivative financial instruments contain credit risk to the extent that its bank counterparties may be unable to meet the terms of the agreements. Newcastle minimizes such risk by limiting its counterparties to highly rated major financial institutions with good credit ratings. In addition, the potential risk of loss with any one party resulting from this type of credit risk is monitored. Management does not expect any material losses as a result of default by other parties. Newcastle does not require collateral; however, Newcastle does call margin from its counterparties when applicable. Management Fees and Incentive Compensation to Affiliate – These represent amounts due to the Manager pursuant to the Management Agreement. For further information on the Management Agree - ment, see Note 10. balance sheet measurement Investment in Real Estate Securities – Newcastle has classified its investments in securities as available for sale. Securities available for sale are carried at market value with the net unrealized gains or losses reported as a separate component of accumulated other comprehensive income. At disposition, the net realized gain or loss is determined on the basis of the cost of the specific invest- ments and is included in earnings. Unrealized losses on securities are charged to earnings if they reflect a decline in value that is other than temporary. A decline in value is considered other than temporary if either (a) it is deemed probable that Newcastle will be unable to collect all amounts anticipated to be collected at acquisition, or (b) Newcastle does not have the ability and intent to hold such investment until a forecasted market price recovery. Investment in Loans – Loans receivable are presented net of any unamortized discount (or gross of any unamortized premium), including any fees received, and an allowance for loan losses. All of Newcastle’s loans receivable are classified as held for investment. Investment in Operating Real Estate – Operating real estate is recorded at cost less accumulated depreciation. Depreciation is computed on a straight-line basis. Buildings are depreciated over 40 years. Major improvements are capitalized and depreciated over their estimated useful lives. Fees and costs incurred in the successful negotiation of leases are deferred and amortized on a straight-line basis over the terms of the respective leases. Expenditures for repairs and maintenance are expensed as incurred. Newcastle reviews its real estate assets for impairment annually or whenever events or changes in circumstances indi- cate that the carrying value of an asset may not be recoverable. Long-lived assets to be disposed of by sale, which meet certain cri- teria, are reclassified to Real Estate Held for Sale and measured at the lower of their carrying amount or fair value less costs of sale. The results of operations for such an asset, assuming such asset qualifies as a “component of an entity” as defined, are retro - actively reclassified to Income (Loss) from Discontinued Operations for all periods presented. Foreign Currency Investments – Assets and liabilities relating to foreign investments are translated using exchange rates as of the end of each reporting period. The results of Newcastle’s foreign operations are translated at the weighted average exchange rate for each reporting period. Translation adjustments are included as a component of accumulated other comprehensive income until realized. Cash and Cash Equivalents and Restricted Cash – Newcastle con- siders all highly liquid short-term investments with maturities of 90 days or less when purchased to be cash equivalents. Substantially all amounts on deposit with major financial institu- tions exceed insured limits. Restricted cash consisted of: december 31, 2006 2005 Held in CBO structures pending reinvestment (Note 8) Total rate of return swap margin accounts Bond sinking funds Trustee accounts Reserve accounts Derivative margin accounts Restricted property operating accounts $123,886 46,760 101 10,031 1,539 1,794 58 $184,169 $173,438 72,427 9,532 9,047 2,558 1,908 – $268,910 Stock Options – Newcastle accounts for stock options granted in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation” as revised in December 2004 and amended by EITF Issue No. 96-18 “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Loans or Services.” The fair value of the options issued as compensation to the Manager for its successful efforts in raising capital for Newcastle in 2006, 2005 and 2004 was recorded as an increase in stockholders’ equity with an offsetting reduction of cap- ital proceeds received. Options granted to Newcastle’s directors were accounted for using the fair value method. Preferred Stock – In March 2003, Newcastle issued 2.5 million shares ($62.5 million face amount) of its 9.75% Series B Cumulative Redeemable Preferred Stock (the “Series B Preferred”) for net pro- ceeds of approximately $60.1 million. In October 2005, Newcastle issued 1.6 million shares ($40.0 million face amount) of its 8.05% Series C Cumulative Redeemable Preferred Stock (the “Series C Preferred”) for net proceeds of approximately $38.5 million. The Series B Preferred and Series C Preferred are non-voting, have a $25 per share liquidation preference, no maturity date and no mandatory redemption. Newcastle has the option to redeem the Series B Preferred beginning in March 2008 and the Series C Preferred beginning in October 2010 at their face amount. If the Series C Preferred ceases to be listed on the NYSE or the AMEX, or quoted on the NASDAQ, and Newcastle is not subject to the report- ing requirements of the Exchange Act, Newcastle has the option to redeem the Series C Preferred at their face amount and, during such time any shares of Series C Preferred are outstanding, the dividend will increase to 9.05% per annum. In connection with the issuance of the Series B Preferred Stock and Series C Preferred Stock, Newcastle incurred approximately $2.4 million and $1.5 million of costs, respectively, which were net- ted against the proceeds of such offerings. If either series of preferred stock were redeemed, the related costs would be recorded as an adjustment to income available for common stock- holders at that time. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.49 Accretion of Discount and Other Amortization – As reflected on the Consolidated Statements of Cash Flow, this item is comprised of the following: 2006 2005 2004 Accretion of net discount on securities and loans $(27,657) $(13,432) $(4,282) Amortization of net discount on debt obligations Amortization of deferred financing costs and interest rate cap premiums Amortization of net deferred hedge gains and losses – debt Amortization of deferred hedge loss – leases 7,328 4,574 4,132 4,434 4,417 3,979 401 1,587 (2,118) 129 $(15,365) 209 $ (2,645) 187 $ 1,898 Securitization of Subprime Mortgage Loans – Newcastle’s accounting policy for its securitization of subprime mortgage loans is disclosed in Note 5. Accounting Treatment for Certain Investments Financed with Repurchase Agreements – Newcastle owned $305.7 million of assets purchased from particular counterparties which are financed via $243.7 million of repurchase agreements with the same counterparties at December 31, 2006. Currently, Newcastle records such assets and the related financings as gross on its bal- ance sheet, and the corresponding interest income and interest expense as gross on its 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”). However, in a transaction where assets are acquired from and financed under a repurchase agreement with the same counter- party, 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 Newcastle, based on their “con- tinuing involvement” with such investments. The result is that Newcastle may be precluded from presenting the assets gross on its balance sheet as it currently does, and may instead be required to treat its net investment in such assets as a derivative. P.50 _ 2 0 0 6 a n n u a l r e p o r t newcastle If it is determined that these transactions should be treated as investments in derivatives, the interest rate swaps entered into by Newcastle to hedge its 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 trans - actions are reported in Newcastle’s financial statements. Newcastle’s cash flows, its liquidity and its ability to pay a divi- dend would be unchanged, and Newcastle does not believe its taxable income would be affected. Newcastle’s 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. Management understands that this issue has been submitted to accounting standard setters for resolution. If Newcastle were to change its current accounting treatment for these transactions, its total assets and total liabilities would each be reduced by $244.3 million and $287.9 million at December 31, 2006 and 2005, respectively. Recent Accounting Pronouncements – In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, as interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 requires companies to recognize the tax benefits of uncertain tax positions only where the position is “more likely than not” to be sustained assuming examination by tax authorities. The tax benefit recognized is the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. FIN 48 is effective for fis- cal years beginning after December 15, 2006. The adoption of FIN 48 is not expected to have a material impact on Newcastle’s financial condition or results of operations. In February 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 155, “Accounting for Certain Hybrid Financial Instruments”, which amends SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”. SFAS 155 provides, among other things, that (i) for embedded derivatives which would otherwise be required to be bifurcated from their host contracts and accounted for at fair value in accordance with SFAS 133 an entity may make an irrevocable election, on an instrument-by-instrument basis, to measure the hybrid financial instrument at fair value in its entirety, with changes in fair value recognized in earnings and (ii) concentrations of credit risk in the form of subordination are not considered embedded derivatives. SFAS 155 is effective for all financial instruments acquired, issued or subject to remeasure- ment after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Upon adoption, differences between the total carrying amount of the individual components of an existing bifurcated hybrid financial instrument and the fair value of the combined hybrid financial instrument should be recognized as a cumulative effect adjustment to beginning retained earnings. Prior periods are not restated. The adoption of SFAS 155 is not expected to have a material impact on Newcastle’s financial con- dition or results of operations. In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment”, which requires all equity-based payments to employ- ees and non-employees to be recognized using a fair value based method. However, SFAS 123(R) does not change the meas- urement method for equity-based payments to non-employees which were already measured at fair value. On January 1, 2006, Newcastle adopted SFAS No. 123(R) using the modified prospec- tive method and therefore prior period amounts will not be restated. The adoption of SFAS 123(R) did not have a material impact on Newcastle’s financial condition or results of operations. In September 2006, the FASB cleared Statement of Position No. 71, “Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies” (“SOP 71”) for issuance. SOP 71 addresses whether the accounting principles of the Audit and Accounting Guide for Investment Companies may be applied to an entity by clarifying the definition of an investment company and whether those accounting princi- ples may be retained by a parent company in consolidation or by an investor in the application of the equity method of accounting. SOP 71 applies to the later of the (i) reporting periods beginning on or after December 15, 2007 or (ii) the first permitted early adoption date of the FASB’s proposed fair value option statement. Newcastle is currently evaluating the potential impact on adop- tion of SOP 71. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.51 In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. SFAS 157 defines fair value, establishes a frame- work for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 applies to reporting periods begin- ning after November 15, 2007. The adoption of SFAS 157 is not expected to have a material impact on Newcastle’s financial con- dition or results of operations. In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 per- mits entities to choose to measure many financial instruments, and certain other items, at fair value. SFAS 159 applies to reporting periods beginning after November 15, 2007. Newcastle is currently evaluating the potential impact on adoption of SFAS 159. 3. information regarding business segments and unconsolidated subsidiaries Newcastle conducts its business through three primary segments: real estate securities and real estate related loans, residential mort- gage loans and operating real estate. Details of Newcastle’s investments in such segments can be found in Notes 4, 5 and 6. 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. The unallocated portion consists primarily of interest on short-term investments, general and administrative expenses, interest expense on the credit facility and junior subordinated notes payable and management fees and incentive compensation pursuant to the Management Agreement. Summary financial data on Newcastle’s segments is given below, together with a reconciliation to the same data for Newcastle as a whole: December 31, 2006 and the Year then Ended Gross revenues Operating expenses Operating income (loss) Interest expense Depreciation and amortization Equity in earnings of unconsolidated subsidiaries(A) Income (loss) from continuing operations Income (loss) from discontinued operations Net income (loss) Preferred dividends Income (loss) available for common stockholders Revenue derived from non-U.S. sources: Canada Total assets Long-lived assets outside the U.S.: Canada (A)Net of income taxes on related taxable subsidiaries. real estate securities and residential mortgage real estate related loans operating loans real estate unallocated $ 441,965 (2,961) 439,004 (296,368) – 3,412 146,048 – 146,048 – $ 146,048 $ 105,621 (17,844) 87,777 (66,181) – – 21,596 – 21,596 – $ 21,596 $ – $7,366,684 $ – $1,179,547 $ 5,117 (4,059) 1,058 – (812) 2,550 2,796 223 3,019 – $ 3,019 $ 3,671 $48,518 total $ 552,609 (55,523) 497,086 (374,269) (1,085) 5,968 127,700 223 127,923 (9,314) $ 118,609 $ (94) (30,659) (30,753) (11,720) (273) 6 (42,740) – (42,740) (9,314) $(52,054) $ – $ 9,643 $ 3,671 $8,604,392 $ – $ – $16,553 $ – $ 16,553 P.52 _ 2 0 0 6 a n n u a l r e p o r t newcastle December 31, 2005 and the Year then Ended Gross revenues Operating expenses Operating income (loss) Interest expense Depreciation and amortization Equity in earnings of unconsolidated subsidiaries(A) Income (loss) from continuing operations Income (loss) from discontinued operations Net income (loss) Preferred dividends Income (loss) available for common stockholders Revenue derived from non-U.S. sources: Canada Total assets Long-lived assets outside the U.S.: Canada (A)Net of income taxes on related taxable subsidiaries. December 31, 2004 and the Year then Ended Gross revenues Operating expenses Operating income (loss) Interest expense Depreciation and amortization Equity in earnings of unconsolidated subsidiaries(A) Income (loss) from continuing operations Income (loss) from discontinued operations Net income (loss) Preferred dividends Income (loss) available for common stockholders Revenue derived from non-U.S. sources: Canada Belgium Total assets Long-lived assets outside the U.S.: Canada Belgium (A)Net of income taxes on related taxable subsidiaries. real estate securities and residential mortgage real estate related loans operating loans real estate unallocated $ 321,889 (4,163) 317,726 (196,026) – 3,328 125,028 – 125,028 – $ 125,028 $ – $5,544,818 $ 48,844 (10,384) 38,460 (29,754) – – 8,706 – 8,706 – $ 8,706 $ – $606,320 $ 6,772 (2,456) 4,316 (251) (528) 2,281 5,818 2,108 7,926 – $ 7,926 $ 708 (24,885) (24,177) (415) (113) – (24,705) – (24,705) (6,684) $(31,389) total $ 378,213 (41,888) 336,325 (226,446) (641) 5,609 114,847 2,108 116,955 (6,684) $ 110,271 $12,157 $36,306 $ – $ 22,255 $ 12,157 $6,209,699 $ – $ – $16,673 $ – $ 16,673 real estate securities and residential mortgage real estate related loans operating loans real estate unallocated $ 225,236 (828) 224,408 (124,930) – 3,767 103,245 – 103,245 – $ 103,245 $ – $ – $4,136,203 $ – $ – $ 19,135 (2,319) 16,816 (10,863) – – 5,953 – 5,953 – $ 5,953 $ – $ – $658,643 $ – $ – $ 4,745 (2,678) 2,067 (605) (445) 6,190 7,207 4,446 11,653 – $ 11,653 $ 13,203 $ 10,602 $108,322 $ 57,193 $ 12,376 total $ 249,669 (28,808) 220,861 (136,398) (451) 9,957 93,969 4,446 98,415 (6,094) $92,321 $ 13,203 $ 10,602 $4,932,720 $ 553 (22,983) (22,430) – (6) – (22,436) – (22,436) (6,094) $(28,530) $ – $ – $ 29,552 $ – $ – $ 57,193 $ 12,376 newcastle 2 0 0 6 a n n u a l r e p o r t _ P.53 unconsolidated subsidiaries Newcastle has four unconsolidated subsidiaries which it accounts for under the equity method. The following table summarizes the activity for significant subsidiaries affecting the equity held by Newcastle in unconsolidated subsidiairies: operating real estate loan real estate Balance at December 31, 2004 Contributions to unconsolidated subsidiaries Distributions from unconsolidated subsidiaries Equity in earnings of unconsolidated subsidiaries Balance at December 31, 2005 Contributions to unconsolidated subsidiaries Distributions from unconsolidated subsidiaries Equity in earnings of unconsolidated subsidiaries Balance at December 31, 2006 $17,778 – (8,229) 2,602 $12,151 – (2,173) 2,550 $12,528 Summarized financial information related to Newcastle’s unconsolidated subsidiaries was as follows: operating real estate(A) (C) december 31, 2005 2004 2006 Assets Liabilities Minority interest Equity Equity held by Newcastle $ 78,381 (52,856) (470) $ 25,055 $ 12,528 $ 77,758 (53,000) (455) $ 24,303 $ 12,151 $ 89,222 (53,000) (666) $ 35,556 $ 17,778 real estate loan(B) december 31, 2005 $35,806 – (202) $35,604 $17,802 2006 $20,615 – (116) $20,499 $10,249 $23,452 – (8,978) 3,328 $17,802 – (11,041) 3,488 $10,249 2004 $47,170 – (266) $46,904 $23,452 Revenues Expenses Minority interest Net income Newcastle’s equity in net income 2006 2005 2004 2006 2005 2004 $ 8,626 (3,430) (96) $ 5,100 $ 2,550 $ 10,196 (4,896) (97) $ 5,203 $ 2,602 $25,011 (7,159) (328) $17,524 $ 8,698 $ 7,048 (32) (40) $ 6,976 $ 3,488 $ 6,738 (42) (39) $ 6,657 $ 3,328 $ 7,852 (111) (44) $ 7,697 $ 3,767 The unconsolidated subsidiaries’ summary financial information above is presented on a fair value basis, consistent with their internal basis of accounting. (A)Included in the operating real estate segment. (B)Included in the real estate securities and real estate related loans segment. (C)With respect to the operating real estate subsidiary, no income was recorded from the company holding assets available for sale in 2006 and $0.8 million and $7.2 million was derived from holding assets available for sale in 2005 and 2004, respectively. The remaining of Newcastle’s equity in net income was derived from the company holding assets for investment in 2006, 2005 and 2004, respectively. As of December 31, 2006 and 2005, all of the equity held by Newcastle related to the company holding assets for investment. This subsidiary is more fully described below. P.54 _ 2 0 0 6 a n n u a l r e p o r t newcastle operating real estate subsidiary In March 2004 Newcastle purchased a 49% interest in a portfolio of convenience and retail gas stores located throughout the south- eastern and southwestern regions of the U.S. The properties are subject to a sale-leaseback arrangement under long term triple net leases with a 15-year minimum term. Circle K Stores Inc. (“Tenant”), an indirect wholly owned subsidiary of Alimentation Couche-Tard Inc. (“ACT”), is the counterparty under the leases. ACT guarantees the obligations of Tenant under the leases. Newcastle structured this transaction through a joint venture in two limited liability companies with a private investment fund managed by an affiliate of its manager, pursuant to which such affiliate co- invested on equal terms. One company held assets available for sale, the last of which was sold in September 2005, and one holds assets for investment. In October 2004, the investment’s initial financing was refinanced with a nonrecourse term loan ($52.9 mil- lion outstanding at December 31, 2006), which bears interest at a fixed rate of 6.04%. The required payments under the loan con- sist of interest only during the first two years, followed by a 25-year amortization schedule with a balloon payment due in October 2014. Newcastle has no additional capital commitment to the limited liability companies. real estate loan subsidiary In November 2003, Newcastle and a private investment fund man- aged by an affiliate of the Manager co-invested and each indirectly own an approximately 38% interest in DBNC Peach Manager LLC, a limited liability company that has acquired a pool of franchise loans collateralized by fee and leasehold interests and other assets from a third party financial institution. The remaining approximately 24% interest in the limited liability company is owned by the above-referenced third party financial institution. Newcastle has no additional capital commitment to the limited liability company. Each of these limited liability companies is an investment com- pany and therefore maintains its financial records on a fair value basis. Newcastle has retained such accounting relative to its investment in such limited liability companies, which are accounted for under the equity method at fair value. trust preferred subsidiary As of December 31, 2006, Newcastle’s investment in the Trust Preferred Subsidiary was $0.1 million. For Information regarding the trust preferred subsidiary, which is a financing subsidiary with no material net income or cash flow, see Note 8. abcp subsidiary As of December 31, 2006, Newcastle had a deminimus investment in this subsidiary. For information regarding the ABCP Subsidiary, which is a financing subsidiary with no material net income or net cash flow, see Note 8. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.55 4. real estate securities The following is a summary of Newcastle’s real estate securities at December 31, 2006 and 2005, all of which are classified as available for sale and are therefore marked to market through other comprehensive income. december 31, 2006 asset type CMBS – Conduit CMBS – Large Loan CMBS – CDO CMBS– B-Note Unsecured REIT Debt ABS – Manufactured Housing ABS – Home Equity ABS – Franchise Agency RMBS Subtotal/Average(A) Residual interest(B) Total/Average gross unrealized weighted average current amortized cost basis face amount $1,469,298 714,617 23,500 282,677 1,004,540 80,839 729,292 76,777 1,177,779 5,559,319 44,930 $5,604,249 $1,421,069 712,655 20,820 270,257 1,017,280 76,347 713,135 76,264 1,182,946 5,490,773 44,930 $5,535,703 gains losses $41,465 6,991 1,265 6,141 18,923 1,744 4,677 1,713 2,144 85,063 – $85,063 $ (9,745) (421) (127) (208) (11,163) (391) (7,481) (1,270) (8,732) (39,538) – $(39,538) number s&p of equiva- lent secu- carrying value rities rating coupon yield maturity (years) $1,452,789 719,225 21,958 276,190 1,025,040 77,700 710,331 76,707 1,176,358 5,536,298 44,930 $5,581,228 202 53 2 41 101 9 124 22 35 589 1 590 BBB– BBB– BB BB BBB– BBB– BBB+ BBB– AAA– BBB+ NR BBB+ 5.84% 6.51% 6.85% 7.02% 9.47% 12.03% 6.85% 7.51% 6.36% 6.06% 6.68% 7.79% 7.15% 7.89% 7.28% 8.21% 5.22% 5.19% 6.20% 6.50% 0.00% 18.77% 6.15% 6.60% 6.93 2.62 7.68 6.02 6.17 6.54 2.70 4.80 4.27 5.04 2.52 5.02 (A)The total current face amount of fixed rate securities was $4.4 billion, and of floating rate securities was $1.2 billion. (B)Represents the equity from the Securitization Trust as described in Note 5. This security has been treated as part of the residential mortgage loan segment – see Note 3. 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 years ended December 31, 2006, 2005, or 2004. 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 December 31, 2006. Newcastle has performed credit analyses (described in Note 2) in relation to P.56 _ 2 0 0 6 a n n u a l r e p o r t newcastle 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 current amortized cost basis face amount gains losses number s&p of equiva- lent secu- carrying value rities rating coupon yield maturity (years) Securities in an Unrealized Loss Position Less Than Twelve Months $ 700,782 $ 683,237 Twelve or More Months Total december 31, 2005 1,600,903 $2,301,685 1,622,047 $2,305,284 $ – – $ – $ (8,731) $ 674,506 84 (30,807) $(39,538) 1,591,240 $2,265,746 185 269 A– A– A– 6.55% 7.28% 5.56% 5.29% 5.86% 5.88% 4.11 5.46 5.05 gross unrealized weighted average asset type CMBS – Conduit CMBS – Large Loan CMBS – B-Note Unsecured REIT Debt ABS – Manufactured Housing ABS – Home Equity ABS – Franchise Agency RMBS Total/Average(A) current amortized cost basis face amount $1,455,345 578,331 180,201 916,262 178,915 525,004 70,837 697,530 $4,602,425 $1,397,868 575,444 176,228 931,777 162,410 523,363 69,732 700,912 $4,537,734 gains losses $26,367 9,096 4,732 20,804 2,422 3,429 1,113 145 $68,108 $(26,906) (377) (329) (9,835) (1,766) (2,315) (1,223) (8,572) $(51,323) number s&p of equiva- lent secu- carrying value rities rating coupon yield maturity (years) $1,397,329 584,163 180,631 942,746 163,066 524,477 69,622 692,485 $4,554,519 197 61 32 99 10 89 18 19 525 BBB– BBB– BBB– BBB– A– B– BBB+ AAA– BBB+ 5.84% 6.61% 6.64% 6.75% 6.62% 6.95% 6.34% 5.96% 7.12% 8.65% 6.03% 6.10% 6.66% 8.12% 4.76% 4.67% 5.99% 6.25% 7.87 2.10 5.97 6.95 6.64 3.16 5.14 4.90 5.81 (A)The total current face amount of fixed rate securities was $3.6 billion, and of floating rate securities was $1.0 billion. As of December 31, 2006, 2005 and 2004, Newcastle has no loss allowance recorded on its real estate securities. During 2006 and 2005, Newcastle recorded gross realized gains of approximately $9.2 million and $24.0 million, respectively, and gross realized losses of approximately $2.1 million and $3.4 mil- lion, respectively, related to the sale of real estate securities. The securities are encumbered by the CBO bonds payable (Note 8) at December 31, 2006. As of December 31, 2006 and 2005, Newcastle had $123.9 million and $173.4 million of restricted cash, respectively, held in CBO financing structures pending its investment in real estate securi- ties and loans. Newcastle may enter into short term warehouse agreements pur- suant to which it makes deposits with major investment banks for the right to purchase commercial mortgage backed securities, unsecured REIT debt, real estate related loans and real estate newcastle 2 0 0 6 a n n u a l r e p o r t _ P.57 related asset backed securities prior to their being financed with CBOs. This type of warehouse agreement is treated as a non-hedge derivative for accounting purposes and is therefore marked to market through current income. The cost to Newcastle if the related CBO is not consummated is limited, except where the non- consummation results from Newcastle’s gross negligence, willful misconduct or breach of contract, to payment of the Net Loss, if any, as defined, up to the related deposit, less any Excess Carry Amount, as defined, earned on such deposit. No income was recorded in 2006 and the income recorded on these agreements was approximately $2.4 million and $3.1 million in 2005 and 2004, respectively. 5. 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. The loans contain vari- ous terms, including fixed and floating rates, self-amortizing and interest only. They are generally subject to prepayment. december 31, december 31, 2006 loan type B-Notes Mezzanine Loans(A) Bank Loans Whole Loans ICH Loans(B) Total Real Estate Related Loans Residential Loans Manufactured Housing Loans Total Residential Mortgage Loans Subprime Mortgage loans subject 2006 2005 current face amount 2006 2005 carrying value(D) loan count weighted delin- weighted quent average average maturity carrying yield (years)(E) amount(F) $ 248,240 906,907 233,793 61,240 123,390 $1,573,570 $ 168,649 $ 72,173 $ 246,798 904,686 302,740 233,895 56,274 61,703 23,082 121,834 165,514 $619,783 $1,568,916 $326,100 $ 172,839 $ 72,520 302,816 56,563 22,364 161,288 $615,551 $333,226 9 22 6 3 70 110 491 643,912 $ 812,561 284,870 636,258 $610,970 $ 809,097 267,456 $600,682 18,343 18,834 7.98% 8.61% 7.75% 12.63% 7.77% 8.48% 6.42% 8.48% 8.03% 2.71 2.67 3.92 1.81 1.10 2.71 2.79 6.02 5.35 $ – – – – 3,530 $ 3,530 $ 4,742 8,199 $12,941 to Future Repurchase(C) $ 299,176 $ 288,202 (A)One of these loans has an $8.9 million contractual exit fee which Newcastle will begin to accrue when management believes it is probable that such exit fee will be received. These loans are comprised as follows: $ 100,000 70,000 87,500 108,690 87,664 453,053 $ 906,907 $100,000 $ 100,023 70,000 – 87,500 – 108,518 – 87,689 – 450,956 202,740 $302,740 $ 904,686 $100,052 – – – – 202,764 $302,816 1 1 1 1 1 17 22 8.58% 8.35% 9.59% 8.30% 7.07% 8.84% 8.61% 1.79 1.28 3.36 1.80 9.53 1.83 2.67 $ – – – – – – $ – (B)In 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 ICH, 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 below. (D)The aggregate United States federal income tax basis for such assets at December 31, 2006 was approximately equal to their book basis. (E) The weighted average maturity 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. (F) This face amount of loans is 60 or more days delinquent. P.58 _ 2 0 0 6 a n n u a l r e p o r t newcastle The following is a reconciliation of loss allowance: real estate residential related mortgage loans loans Balance at December 31, 2004 Provision for credit losses Realized losses Balance at December 31, 2005 Provision for credit losses Realized losses Balance at December 31, 2006 $(2,473) (2,852) 1,099 $(4,226) (1,154) 3,230 $(2,150) $ – (5,568) 2,361 $(3,207) (8,284) 4,235 $(7,256) Newcastle has entered into total rate of return swaps with major investment banks 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. Under the agreements, Newcastle is required to post an initial margin deposit to an inter- est 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 December 31, 2006, Newcastle held an aggregate of $299.7 million notional amount of total rate of return swaps on 8 reference assets on which it had deposited $46.8 million of mar- gin. These total rate of return swaps had an aggregate fair value of approximately $1.3 million, a weighted average receive interest rate of LIBOR + 2.59%, a weighted average pay interest rate of LIBOR + 0.63%, and a weighted average swap maturity of 1.5 years. The average carrying amount of Newcastle’s real estate related loans was approximately $995.8 million, $594.1 million and $486.2 million during 2006, 2005 and 2004, respectively, on which Newcastle earned approximately $67.3 million, $54.7 million and $36.7 million of gross revenues, respectively. The average carrying amount of Newcastle’s residential mort- gage loans was approximately $783.2 million, $764.2 million and $637.4 million during 2006, 2005 and 2004, respectively, on which Newcastle earned approximately $105.6 million, $48.8 million and $19.1 million of gross revenues, respectively. The loans are encumbered by various debt obligations as described in Note 8. Real estate owned (“REO”) as a result of foreclosure on loans is included in Receivables and Other Assets, and is recorded at the lower of cost or fair value. No material REO was owned as of December 31, 2006 or 2005. 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 Nationstar Mortgage, LLC (formerly known as Centex Home Equity Company, LLC) for a servicing fee equal to 0.50% per annum on the unpaid principal bal- ance 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 approxi- mately $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 inter- est 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. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.59 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 December 31, 2006: Total securitized loans (unpaid principal balance) Loans subject to future repurchase (carrying value) Retained interests (fair value) Weighted average life (years) of residual interest Expected credit losses Effect on fair value of retained interests of 10% adverse change Effect on fair value of retained interests of 20% adverse change Weighted average constant prepayment rate Effect on fair value of retained interests of 10% adverse change Effect on fair value of retained interests of 20% adverse change Discount rate Effect on fair value of retained interests of 10% adverse change Effect on fair value of retained interests of 20% adverse change $1,192,763 $ 288,202 $ 79,105 2.52 5.1% $ (3,160) $ (5,460) 31.0% $ (3,806) $ (6,435) 18.8% $ (2,175) $ (4,272) The sensitivity analysis is hypothetical and should be used with caution. In particular, the results are calculated by stressing a par- ticular 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 sensitiv- ities. 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. 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 consoli- dated 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 invest- ment 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 securi- tization. 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. 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 Expected credit losses Weighted average constant prepayment rate Discount rate 3.1% 5.3% 28.0% 18.8% P.60 _ 2 0 0 6 a n n u a l r e p o r t newcastle The following table summarizes principal amounts outstanding and delinquencies of the securitized loans as of December 31, 2006 and net credit losses for the period then ended: Loan unpaid principal balance (UPB) Delinquencies of 60 or more days (UPB) Net credit losses $1,192,763 $ 52,281 $ 57 Newcastle received net proceeds of $1.41 billion from the securiti- zation transaction completed in April 2006 and net cash inflows of $27.4 million from the retained interests subsequent to the securiti- zation in 2006. The weighted average yield of the retained bonds was 11.04% and the weighted average funding cost of the related repurchase agreement was 5.80% as of December 31, 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%. 6. operating real estate The following is a reconciliation of operating real estate assets and accumulated depreciation: operating real estate gross Balance at December 31, 2004 $ 65,691 – Improvements (422) Foreign currency translation Depreciation – Transferred to Real Estate Held for Sale (45,060) Balance at December 31, 2005 $ 20,209 12,486 Foreclosed loans 1,301 Improvements (32) Foreign currency translation (150) Fully depreciated assets Depreciation – Balance at December 31, 2006 $ 33,814 accumu- lated depre- ciation $(8,498) – (28) (704) 5,694 $(3,536) – – 7 150 (809) $(4,188) net $ 57,193 – (450) (704) (39,366) $ 16,673 12,486 1,301 (25) – (809) $ 29,626 real estate held for sale Balance at December 31, 2004 Improvements Foreign currency translation Sold Transferred from Operating Real Estate Balance at December 31, 2005 and 2006 net $ 12,376 182 (1,620) (50,304) 39,366 $ – During the periods presented, Newcastle’s operating real estate was comprised of Canadian properties, Belgian properties, fore- closed domestic properties and an investment in an unconsolidated subsidiary which owns domestic properties. The following is a schedule of the future minimum rental pay- ments to be received under non-cancelable operating leases: 2007 2008 2009 2010 2011 $ 3,084 2,300 2,116 1,954 1,751 $11,205 In June 2004, Newcastle consummated the sale of five properties in Belgian. These properties had been classified as held for sale since December 2003. Newcastle recognized a $1.5 million loss on this sale in December 2003. In addition, Newcastle recognized a $1.1 mil- lion loss in 2004, primarily related to the prepayment of the debt on such properties. In December 2004, Newcastle sold two properties in the Belgian portfolio at a gain of approximately $5.3 million, net of $2.6 million of prepayment penalties on the related debt. In March 2005, Newcastle closed on the sale of a property in the Canadian portfolio and recorded a gain of approximately $0.4 mil- lion, net of $0.9 million of prepayment penalties on the related debt. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.61 In June 2005, Newcastle closed on the sale of a property in the Canadian portfolio and recorded a gain (net of Canadian taxes) of approximately $0.9 million, net of $2.1 million of prepayment penalties on the related debt. In June 2005, Newcastle closed on the sale of the last property in the Belgian portfolio and recorded a loss of approximately $0.7 million. Pursuant to SFAS No. 144, Newcastle has retroactively recorded the operations, including the gain or loss, of all sold or “held for sale” properties in Income from Discontinued Operations for all periods presented. The following table summarizes the financial information for the discontinued operations: year ended december 31, 2006 2005 2004 Interest and other income Net gain on sale Gross revenues Interest expense Other expenses Net income $ 18 419 437 – 214 $223 $4,744 780 5,524 804 2,612 $2,108 $15,301 3,778 19,079 5,885 8,748 $ 4,446 No income tax related to discontinued operations was recorded for the years ended December 31, 2006, 2005 or 2004. The following table sets forth certain information regarding the operating real estate portfolio. type of property Canada Portfolio Office Building Ohio Portfolio Office Building Office Building Office Building Retail Office Building Office Building portfolio Canada Portfolio Ohio Portfolio location net rentable sq. ft.(A) acqui- sition date year built/ renovated(A) London, ON 312,874 Oct 98 Beavercreek, OH Beavercreek, OH Beavercreek, OH Dayton, OH Vandalia, OH Dayton, OH 54,927 29,916 45,299 33,485 46,614 42,286 Mar 06 Mar 06 Mar 06 Mar 06 Mar 06 Mar 06 1982 1986 1986 1986 1989 1987 1985 costs capitalized subsequent to acqui- sition(B) initial cost(B) gross carrying amount accumu- lated depre- ciation net carrying value(C) occupancy(A) december 31, 2006 $19,758 12,486 $688 882 $20,446 13,368 $(3,893) (295) $16,553 13,073 60.6% 59.1% No encumbrances were recorded as of December 31, 2006. (A)Unaudited. (B)For the Canada portfolio, adjusted for changes in foreign currency exchange rates, which aggregated $0.0 million of gain and $0.7 million of gain between land, building and improvements in 2006 and 2005, respectively and net of fully depreciated assets of $0.2 million. (C)The aggregate United States federal income tax basis for such assets at December 31, 2006 was equal to its net carrying value. P.62 _ 2 0 0 6 a n n u a l r e p o r t newcastle 7. fair value of financial instruments Fair values for a majority of Newcastle’s investments are readily obtainable through broker quotations. For certain of Newcastle’s finan- cial 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 tech- niques, 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. It should be noted 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 December 31, 2006 and do not take into consider- ation the effects of subsequent interest rate or credit spread fluctuations. The carrying values and estimated fair values of Newcastle’s financial instruments at December 31, 2006 and 2005 were as follows: Assets: Real estate securities, available for sale Real estate related loans Residential mortgage loans Subprime mortgage loans subject to future repurchase Interest rate caps, treated as hedges(A) Total return swaps(A) Liabilities: CBO bonds payable Other bonds payable Notes payable Repurchase agreements Repurchase agreements subject to ABCP Financing of subprime mortgage loans subject to future repurchase Credit facility Junior subordinated notes payable Interest rate swaps, treated as hedges(B) Non-hedge derivative obligations(C) carrying value december 31, 2006 2005 principal balance or notional amount december 31, 2006 $5,581,228 1,568,916 809,097 288,202 1,262 1,288 4,313,824 675,844 128,866 760,346 1,143,749 288,202 93,800 100,100 (42,887) 360 $4,554,519 615,551 600,682 – 2,145 3,096 3,530,384 353,330 260,441 1,048,203 – – 20,000 – (41,170) 90 $5,604,249 1,573,570 812,561 299,176 334,971 299,654 4,340,166 679,891 128,866 760,346 1,143,749 299,176 93,800 100,100 3,943,120 See below estimated fair value december 31, 2006 2005 $5,581,228 1,571,412 829,980 288,202 1,262 1,288 4,369,540 676,512 128,866 760,346 1,143,749 288,202 93,800 101,629 (42,887) 360 $4,554,519 615,865 609,486 – 2,145 3,096 3,594,638 356,294 260,441 1,048,203 – – 20,000 – (41,170) 90 (A)Included in Derivative Assets. The longest cap maturity is October 2015. The longest total rate of return swap maturity is December 2008. (B)Included in Derivative Assets or Liabilities, as applicable. A positive number represents a liability. The longest swap maturity is June 2016. (C)Included in Derivative Assets or Liabilities, as applicable. A positive number represents a liability. The longest maturity is July 2038. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.63 The methodologies used and key assumptions made to estimate fair value are as follows: Real Estate Securities, Available for Sale – The fair value of these securities is estimated by obtaining third party broker quotations, if available and practicable, and counterparty quotations. Real Estate Related Loans – The ICH loans were valued by dis- counting 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 counter- party quotations. Residential Mortgage Loans – This aggregate portfolio of residen- tial loans consists of a portfolio of floating rate residential mortgage loans as well as two portfolios of substantially fixed rate manufactured housing loans. These loans were valued by ref- erence to current market interest rates and credit spreads. Subprime Mortgage Loans Subject to Future Repurchase and related Financing – These two items, related to the securitization of subprime mortgage loans, are equal and offsetting. They are further described in Note 5. Interest Rate Cap and Swap Agreements, Total Rate of Return Swaps and Non-Hedge Derivative Obligations – The fair value of these agreements is estimated by obtaining counterparty quotations. The total rate of return swaps are more fully described in Note 5. CBO Bonds Payable – These bonds were valued by discounting expected future cash flows by a rate calculated based on current market conditions for comparable financial instruments, includ- ing market interest rates and credit spreads. Other Bonds Payable – The ICH bonds were valued by discounting expected future cash flows by a rate calculated based on current market conditions for comparable financial instruments, includ- ing market interest rates and credit spreads. The manufactured housing loan bonds were valued by reference to current market interest rates and credit spreads. Notes Payable – The residential mortgage loan financing was val- ued by reference to current market interest rates and credit spreads. Repurchase Agreements – These agreements bear floating rates of interest, which reset monthly or quarterly to a market credit spread, and Newcastle believes 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. Credit facility – This facility was valued at par because manage- ment believes it could currently enter into a similar arrangement under similar terms. Junior Subordinated Notes Payable – These notes were values by discounting expected future cash flows by a rate calculated based on current market conditions for comparable financial instru- ments, including market interest rates and credit spreads. The credit spread used was obtained from a broker quotation. P.64 _ 2 0 0 6 a n n u a l r e p o r t newcastle 8. debt obligations The following table presents certain information regarding Newcastle’s debt obligations and related hedges: month issued Jul 1999 Apr 2002 Mar 2003 Sep 2003 Mar 2004 Sep 2004 Apr 2005 Dec 2005 Nov 2006 (3) Jan 2006 Aug 2006 current face amount december 31, 2006 2005 carrying value december 31, 2006 2005 $ 398,366 444,000 472,000 460,000 414,000 454,500 447,000 442,800 807,500 4,340,166 101,925 213,172 364,794 679,891 $ 426,653 444,000 472,000 460,000 414,000 454,500 447,000 442,800 – 3,560,953 141,311 212,019 – 353,330 $ 395,646 441,660 468,944 456,250 411,014 451,137 442,870 438,894 807,409 4,313,824 101,925 211,738 362,181 675,844 $ 423,191 441,054 468,413 455,657 410,511 450,639 442,379 438,540 – 3,530,384 141,311 212,019 – 353,330 unhedged weighted average funding cost 6.94%(2) 6.42%(2) 6.23%(2) 6.08%(2) 5.93%(2) 5.91%(2) 5.81%(2) 5.85%(2) 5.98%(2) 6.78%(2) LIBOR + 1.25% LIBOR + 1.25% Nov 2004 128,866 260,441 128,866 260,441 LIBOR + 0.16% Rolling Rolling Rolling 181,059 553,944 25,343 760,346 149,546 185,278 41,853 376,677 181,059 553,944 25,343 760,346 149,546 185,278 41,853 376,677 LIBOR + 0.41% LIBOR + 0.69% LIBOR + 0.43% Dec 2006 1,143,749 671,526 1,143,749 671,526 5.41% May 2006 Mar 2006 93,800 100,100 7,246,918 20,000 – 5,242,927 93,800 100,100 7,216,529 20,000 – 5,212,358 LIBOR + 1.75% 7.80%(6) debt obligation/collateral CBO Bonds Payable Real estate securities Real estate securities and loans Real estate securities and loans Real estate securities and loans Real estate securities and loans Real estate securities and loans Real estate securities and loans Real estate securities Real estate securities and loans Other Bonds Payable ICH loans(3) Manufactured housing loans Manufactured housing loans Notes Payable Residential mortgage loans(4) Repurchase Agreements(4)(8) Real estate securities Real estate related loans Residential mortgage loans Repurchase agreements subject to ABCP facility(7) Agency RMBS Credit facility(5) Junior subordinated notes payable Subtotal debt obligations Financing on subprime mortgage loans subject to future repurchase(3) Apr 2006 Total debt obligations 299,176 $7,546,094 – $5,242,927 288,202 $7,504,731 – $5,212,358 (1) Including the effect of applicable hedges. (2)Weighted average, including floating and fixed rate classes. (3)See Note 5. (4)Subject to potential mandatory prepayments based on collateral value. (5) A maximum of $200 million can be drawn. (6)LIBOR + 2.25% after April 2016. (7) ABCP means asset backed commercial paper. See below. (8)The counterparties on our repurchase agreements include: Bear Stearns Mortgage Capital Corporation ($270.6 million), Credit Suisse ($216.2 million), Deutsche Bank AG ($181.7 million) and other ($91.8 million). Certain of the debt obligations included above are obligations of consolidated subsidiaries of Newcastle which own the related collateral. In some cases, including the CBO and Other Bonds Payable, such collateral is not available to other creditors of Newcastle. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.65 final stated maturity weighted average funding cost(1) weighted average maturity (years) face amount of floating rate debt december 31, 2006 collateral carrying value collateral weighted average maturity (years) face amount of floating rate collateral aggregate notional amount of current hedges Jul 2038 Apr 2037 Mar 2038 Sep 2038 Mar 2039 Sep 2039 Apr 2040 Dec 2050 Nov 2052 Aug 2030 Jan 2009 Aug 2011 Nov 2007 Jan 2007 Jan 2007 Mar 2007 Jan 2007 Nov 2007 Apr 2036 5.50% 6.78% 5.35% 5.88% 5.38% 5.49% 5.53% 5.57% 5.92% 5.73% 6.78% 6.14% 6.87% 6.63% 5.68% 5.62% 6.02% 5.79% 5.92% 4.97% 7.08% 7.72% 5.76% 1.99 3.45 5.30 5.85 5.61 6.19 7.16 8.48 7.06 5.83 1.04 1.46 3.07 2.26 0.74 0.08 0.08 0.23 0.08 $ 303,366 372,000 427,800 442,500 382,750 442,500 439,600 436,800 799,900 4,047,216 1,986 213,172 364,794 579,952 $ 544,469 498,754 515,335 505,450 446,749 499,389 491,398 512,249 930,293 4,944,086 121,834 237,133 399,125 758,092 128,866 145,819 181,059 553,944 25,343 760,346 207,374 718,989 27,020 953,383 0.08 1,143,749 1,176,358 0.85 29.25 4.15 93,800 – $6,753,929 – – $7,977,738 4.06 5.15 4.56 4.28 4.76 5.08 5.82 7.23 4.69 5.05 1.10 6.26 5.87 5.23 2.79 4.60 2.21 2.81 2.77 4.27 – – 4.63 $ – 59,612 128,600 151,677 174,192 227,898 195,186 115,491 672,217 1,724,873 1,986 4,977 73,973 80,936 142,301 101,380 696,174 26,347 823,901 $ 255,352 296,000 285,060 207,500 177,300 209,202 242,990 341,506 153,655 2,168,565 – 204,617 370,466 575,083 – 92,457 19,630 – 112,087 – 1,087,385 – – $2,772,011 – – $3,943,120 P.66 _ 2 0 0 6 a n n u a l r e p o r t newcastle CBO Bonds Payable Repurchase Agreements Subject to ABCP Facility In connection with the sale of two classes of CBO bonds in our first CBO, Newcastle entered into two interest rate swaps and three inter- est rate cap agreements that do not qualify for hedge accounting. Two classes of separately issued 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. Junior Subordinated Notes Payable In March 2006, Newcastle completed the placement of $100 mil- lion 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 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 pre- ferred 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 cap- tion 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 (Note 3). In December 2006, Newcastle closed a $2 billion asset backed com- mercial paper (ABCP) facility through its wholly owned subsidiary, Windsor Funding Trust. This facility provides Newcastle with the ability to finance its agency residential mortgage backed securi- ties (RMBS) and AAA-rated MBS by issuing secured liquidity notes that are rated A-1+, P-1 and F-1+, by Standard & Poor’s, Moody’s and Fitch respectively, and have maturities of up to 250 days. The facility also permits the issuance of subordinated notes rated at least BBB/ Baa by Standard & Poor’s, Moody’s or Fitch. As of December 31, 2006, Windsor Trust Funding had approximately $1.1 billion of secured liquidity notes and $8.3 million of subordinated notes issued and outstanding. The weighted average maturities of the secured liquidity notes and the subordinated notes were 0.12 years and 5 years, respectively. Newcastle owns all of the trust certificates of the Windsor Funding Trust. Windsor Funding Trust used the proceeds of the issuance to enter into a repurchase agreement with Newcastle to purchase interests in Newcastle’s agency RMBS. The repurchase agreements represent Windsor Funding Trust’s only asset. The interest rate on the repurchase agreement is effectively the weighted average interest rate on the secured liquidity notes and subordinated notes. Under the provi- sions of FIN 46R, Newcastle determined that the noteholders were the primary beneficiaries of the Windsor Funding Trust. As a result, Newcastle did not consolidate the Windsor Funding Trust and has reflected its obligation pursuant to the asset backed com- mercial paper facility under the caption Repurchase Agreements subject to ABCP Facility. Maturity Table Newcastle’s debt obligations (gross of $41.4 million of discounts at December 31, 2006) have contractual maturities as follows: Credit Facility In May 2006, Newcastle entered into a new 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 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. 2007 2008 2009 2010 2011 Thereafter $2,126,761 – 213,172 – 364,794 4,841,367 $7,546,094 newcastle 2 0 0 6 a n n u a l r e p o r t _ P.67 9. stock option plan and earnings per share Newcastle is required to present both basic and diluted earnings per share (“EPS”). Basic EPS is calculated by dividing net income avail- able 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 com- mon stock outstanding plus the additional dilutive effect of common stock equivalents during each period. Newcastle’s common stock equivalents are its stock options. During 2006, 2005 and 2004, based on the treasury stock method, Newcastle had 148,538, 314,125 and 614,038 dilutive common stock equivalents, respectively, resulting from its outstanding options. Net income available for common stockholders is equal to net income less preferred dividends. In June 2002, Newcastle (with the approval of the board of direc- tors) adopted a nonqualified stock option and incentive award plan (the “Newcastle Option Plan’’) for officers, directors, consult- ants and advisors, including the Manager and its employees. The maximum available for issuance is equal to 10% of the number of outstanding equity interests of Newcastle, subject to a maximum of 10,000,000 shares in the aggregate over the term of the plan. Upon joining the board, the non-employee directors have been, in accordance with the Newcastle Option Plan, automatically granted options to acquire an aggregate of 18,000 shares of common stock. The fair value of such options was not material at the date of grant. Through December 31, 2006, for the purpose of compensating the Manager for its successful efforts in raising capital for Newcastle, the Manager has been granted options representing the right to acquire 2,825,727 shares of common stock, with strike prices subject to adjustment as necessary to preserve the value of such options in connection with the occurrence of certain events (including capital dividends and capital distributions made by Newcastle). The Manager options represented an amount equal to 10% of the shares of common stock of Newcastle sold in its public offerings and the value of such options was recorded as an increase in stockholders’ equity with an offsetting reduction of capital proceeds received. The options granted to the Manager, which may be assigned by the Manager to its employees, were fully vested on the date of grant and one thirtieth of the options become exercisable on the first day of each of the following thirty calendar months, or earlier upon the occurrence of certain events, such as a change in control of Newcastle or the termination of the Management Agreement. The options expire ten years from the date of issuance. The following table summarizes our outstanding options at December 31, 2006. Note that the last sales price on the New York Stock Exchange for our common stock in the year ended December 31, 2006 was $31.32. recipient Directors Manager(B) Manager(B) Manager(B) Manager(B) Manager(B) Manager(B) Manager(B) Manager(B) Exercised(B) Exercised(B) Outstanding date of grant/ exercise number of options weighted average exercise price fair value at grant date (millions) Various October 2002 July 2003 December 2003 January 2004 May 2004 November 2004 January 2005 November 2006 Prior to 2006 2006 18,000 700,000 460,000 328,227 330,000 345,000 162,500 330,000 170,000 (861,920) (98,000) 1,883,807 Not Material $0.4(A) $0.8(A) $0.4(A) $0.6(A) $0.5(A) $0.5(A) $1.1(A) $0.5(A) $17.38 $13.00 $20.35 $22.85 $26.30 $25.75 $31.40 $29.60 $29.42 $15.27 $18.06 $25.89 (A)The fair value of the options was estimated using a binomial option pricing model. Since the Newcastle Option Plan has characteristics significantly different from those of traded options, and since the assumptions used in such model, particularly the volatility assumption, are subject to significant judgment and variability, the actual value of the options could vary materially from management’s estimate. P.68 _ 2 0 0 6 a n n u a l r e p o r t newcastle The assumptions used in such model were as follows: date of grant volatility dividend yield expected life (years) risk-free rate October 2002 July 2003 December 2003 January 2004 May 2004 November 2004 January 2005 November 2006 15% 15% 15% 15% 15% 18% 21% 21% 13.85% 9.83% 8.75% 7.60% 9.32% 7.64% 8.45% 8.84% 10 10 10 10 10 10 10 5 4.05% 3.63% 4.23% 4.23% 4.77% 4.21% 4.27% 4.69% The volatility assumption for options issued in 2005 and 2006 was estimated based primarily on the historical volatility of Newcastle’s common stock and manage- ment’s expectations regarding future volatility. The expected life assumption for options issued subsequent to January 2005 was estimated based on the simplified term method. (B)The Manager assigned certain of its options to its employees as follows: strike price $13.00 $20.35 $22.85 $26.30 $31.40 $29.42 Total total inception to date 269,500 193,200 139,355 127,050 62,563 85,425 877,093 670,620 of the total options exercised were by the Manager. 285,300 of the total options exercised were by employees of the Manager subsequent to their assign- ment. 4,000 of the total options exercised were by directors. 10. management agreement and related party transactions manager Newcastle entered into the Management Agreement with the Manager in June 2002, as amended, which provided for an initial term of one year with automatic one-year extensions, subject to certain termination rights. After the initial one-year term, the Manager’s performance is reviewed annually and the Management Agreement may be terminated by Newcastle by payment of a termination fee, as defined in the Management Agreement, equal to the amount of management fees earned by the Manager during the twelve consecutive calendar months immediately preceding the termination, upon the affirmative vote of at least two-thirds of the independent directors, or by a majority vote of the holders of common stock. Pursuant to the Management Agreement, the Manager, under the supervision of Newcastle’s board of directors, formulates investment strategies, arranges for the acquisition of assets, arranges for financing, monitors the performance of Newcastle’s assets and provides certain advisory, administrative and managerial services in connection with the operations of Newcastle. For performing these services, Newcastle pays the Manager an annual management fee equal to 1.5% of the gross equity of Newcastle, as defined. The Management Agreement provides that Newcastle will reim- burse the Manager for various expenses incurred by the Manager or its officers, employees and agents on Newcastle’s behalf, including costs of legal, accounting, tax, auditing, administrative and other similar services rendered for Newcastle by providers retained by the Manager or, if provided by the Manager’s employ- ees, in amounts which are no greater than those which would be payable to outside professionals or consultants engaged to per- form such services pursuant to agreements negotiated on an arm’s-length basis. To provide an incentive for the Manager to enhance the value of the common stock, the Manager is entitled to receive an incentive return (the “Incentive Compensation’’) on a cumulative, but not compounding, basis in an amount equal to the product of (A) 25% of the dollar amount by which (1) (a) the Funds from Operations, as defined (before the Incentive Compensation) of Newcastle per share of common stock (based on the weighted average number of shares of common stock outstanding) plus (b) gains (or losses) from debt restructuring and from sales of property and other assets per share of common stock (based on the weighted average number of shares of common stock outstanding), exceed (2) an amount equal to (a) the weighted average of the price per share of common stock in the IPO and the value attributed to the net assets transferred to us by our predecessor, and in any subse- quent offerings by Newcastle (adjusted for prior capital dividends or capital distributions) multiplied by (b) a simple interest rate of 10% per annum (divided by four to adjust for quarterly calculations) newcastle 2 0 0 6 a n n u a l r e p o r t _ P.69 multiplied by (B) the weighted average number of shares of com- mon stock outstanding. no longer had significant influence over Global Signal subsequent to the acquisition. amounts incurred (in millions) 2005 2004 $12.8 0.5 7.6 $10.1 0.5 8.0 2006 $13.5 0.5 12.2 Management Fee Expense Reimbursement Incentive Compensation At December 31, 2006, the Manager, through its affiliates, and princi- pals of Fortress, owned 2.9 million shares of Newcastle’s common stock and the Manager, through its affiliates, had options to pur- chase an additional 1.3 million shares of Newcastle’s common stock (Note 9). At December 31, 2006, Due To Affiliates is comprised of $12.2 million of incentive compensation payable and $1.3 million of manage- ment fees and expense reimbursements payable to the Manager. Other Affiliates In November 2003, Newcastle and a private investment fund man- aged by an affiliate of our manager co-invested and each indirectly own an approximately 38% interest in a limited liability company (Note 3) that has acquired a pool of franchise loans from a third party financial institution. Newcastle’s investment in this entity, reflected as an investment in an unconsolidated subsidiary on Newcastle’s consolidated balance sheet, was approximately $10.2 million at December 31, 2006. The remaining approximately 24% interest in the limited liability company is owned by the above-referenced third party financial institution. As of December 31, 2006, Newcastle owned an aggregate of approximately $108.0 million of securities of Global Trust II and III, special purpose vehicles established by Global Signal Inc., which were purchased in private placements from underwriters in January 2004, April 2005 and February 2006. Newcastle’s CEO and chairman of its board of directors was the chairman of the board of Global Signal, Inc. and private equity funds managed by an affil- iate of Newcastle’s manager own a significant portion of Global Signal Inc.’s common stock. In January 2007, Global Signal was acquired by Crown Castle International Corp. Newcastle’s affiliate In March 2004, Newcastle and a private investment fund managed by an affiliate of Newcastle’s manager co-invested and each indi- rectly own an approximately 49% interest in two limited liability companies (Note 3) that have acquired, in a sale-leaseback trans- action, a portfolio of convenience and retail gas stores from a public company. The properties are subject to a number of master leases, the initial term of which in each case is a minimum of 15 years. This investment was financed with nonrecourse debt at the limited liability company level and Newcastle’s investment in this entity, reflected as an investment in an unconsolidated sub- sidiary on Newcastle’s consolidated balance sheet, was approximately $12.5 million at December 31, 2006. In March 2005, the property management agreement related to these properties was transferred to an affiliate of Newcastle’s manager from a third party servicer; Newcastle’s allocable portion of the related fees, approximately $20,000 per year for three years, was not changed. In January 2005, Newcastle entered into a servicing agreement with a portfolio company of a private equity fund advised by an affiliate of Newcastle’s manager for them to service a portfolio of manufactured housing loans (Note 5), 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, Newcastle closed on a new term financing of this portfolio. In connection with this term financing, Newcastle renewed its servicing agreement at the same terms. The outstanding unpaid principal balance of this portfolio was approximately $245.7 million at December 31, 2006. In April 2006, Newcastle securitized its portfolio of subprime resi- dential 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 Newcastle’s 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 $1.2 billion at December 31, 2006. P.70 _ 2 0 0 6 a n n u a l r e p o r t newcastle In August 2006, Newcastle acquired a portfolio of manufactured housing loans. The loans are being serviced by a portfolio company of a private equity fund advised by an affiliate of Newcastle’s man- ager. 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 thresh- olds. The outstanding unpaid principal balance of this portfolio was approximately $398.3 million at December 31, 2006. In September 2006, Newcastle was a co-lender with two private investment funds managed by an affiliate of Newcastle’s manager in a new real estate related loan. The loan is secured by a first mort- gage interest on a parcel of land in Arizona. Newcastle owns 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 deci- sions 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, Newcastle and the pri- vate 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 Newcastle owning a 20% interest in the junior participation interest in the loan. Newcastle’s investment in this loan was approximately $26.1 million at December 31, 2006. As of December 31, 2006, Newcastle held total investments of $192.2 million face amount of real estate securities and real estate related loans issued by affiliates of its manager and earned approximately $18.5 million, $13.7 million and $13.1 million of interest on investments issued by affiliates for the years ended December 31, 2006, 2005 and 2004, respectively. In each instance described above, affiliates of Newcastle’s man- ager have an investment in the applicable affiliated fund and receive from the fund, in addition to management fees, incentive compensation if the fund’s aggregate investment returns exceed certain thresholds. 11. commitments and contingencies were issued subject to remarketing procedures and related agree- ments 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, pursuant to a financial guaranty insurance policy (“wrap”). Newcastle pays annual fees of 0.12% of the outstanding face amount of such bonds under this agreement. In connection with the remarketing procedures described above, backstop agreements have been created whereby a third party financial institution is required to purchase the $718.0 million face amount of bonds at the end of any remarketing period if such bonds could not be resold in the market by the remarketing agent. Newcastle pays an annual fee of between 0.15% and 0.20% of the outstanding face amount of such bonds under these agreements. In addition, the remarketing agent is paid an annual fee of 0.05% of the outstanding face amount of such bonds under the remar- keting agreements. Loan Commitment – With respect to one of its real estate related loans, Newcastle was committed to fund up to an additional $6.6 mil- lion at December 31, 2006, subject to certain conditions to be met by the borrower. Stockholder Rights Agreement – Newcastle has adopted a stock- holder rights agreement (the “Rights Agreement”). Pursuant to the terms of the Rights Agreement, Newcastle will attach to each share of common stock one preferred stock purchase right (a “Right’’). Each Right entitles the registered holder to purchase from Newcastle a unit consisting of one one-hundredth of a share of Series A Junior Participation Preferred Stock, par value $0.01 per share, at a purchase price of $70 per unit. Initially, the Rights are not exercisable and are attached to and transfer and trade with the outstanding shares of common stock. The Rights will separate from the common stock and will become exercisable upon the acquisition or tender offer to acquire a 15% beneficial ownership interest by an acquiring person, as defined. The effect of the Rights Agreement will be to dilute the acquiring party’s beneficial interest. Until a Right is exercised, the holder thereof, as such, will have no rights as a stockholder of Newcastle. Remarketing Agreements – Two classes of separately issued CBO bonds (Note 8), with an aggregate $718.0 million face amount, Litigation – Newcastle is, from time to time, a defendant in legal actions from transactions conducted in the ordinary course of newcastle 2 0 0 6 a n n u a l r e p o r t _ P.71 business. Management, after consultation with legal counsel, believes the ultimate liability arising from such actions which existed at December 31, 2006, if any, will not materially affect Newcastle’s consolidated results of operations or financial position. Environmental Costs – As a commercial real estate owner, Newcastle is subject to potential environmental costs. At December 31, 2006, management of Newcastle is not aware of any environmental con- cerns that would have a material adverse effect on Newcastle’s consolidated financial position or results of operations. 12. income taxes and dividends Debt Covenants – Newcastle’s debt obligations contain various customary loan covenants. Such covenants do not, in management’s opinion, materially restrict Newcastle’s investment strategy or ability to raise capital at this time. Newcastle is in compliance with all of its loan covenants at December 31, 2006. Exit Fee – One of Newcastle’s loan investments provides for an $8.9 million contractual exit fee which Newcastle will begin to accrue for if and when management believes it is probable that such exit fee will be received. Newcastle Investment Corp. is organized and conducts its operations to qualify as a REIT under the Code. A REIT will generally not be sub- ject 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. Since Newcastle distributed 100% of its 2006, 2005 and 2004 REIT taxable income, no provision has been made for U.S. federal corporate income taxes in the accompanying consolidated financial statements, except in connection with Newcastle’s taxable REIT subsidiary (“TRS”). Distributions relating to 2006, 2005, and 2004 were taxable as follows: 2006 2005 2004 dividends per share(A) tax basis book basis ordinary/ qualified income capital gains return of capital $2.615 $2.500 $2.425 $2.948 $2.540 $2.432 100.00% 86.41% 76.60% – 13.59% 23.40% None None None (A)Any excess of book basis dividends over tax basis dividends would generally be carried forward to the next year for tax purposes. Dividends in Excess of Earnings includes ($14.5 million) related to the operations of our predecessor. statement carrying amounts of existing assets and liabilities and their respective tax bases. No such material differences have been recognized through December 31, 2006. Newcastle has elected to treat NC Circle Holdings II LLC as a tax- able REIT subsidiary (“TRS”), effective February 27, 2004. NC Circle Holdings II LLC owned a portion of Newcastle’s investment in a portfolio of convenience and retail gas stores as described in Note 3. For taxable income generated by NC Circle Holdings II LLC, Newcastle has provided for relevant income taxes based on a blended statutory rate of 40%. Newcastle accounts for income taxes using the asset and liability method under which deferred tax assets and liabilities are recognized for the future tax con - sequences attributable to differences between the financial 13. subsequent events In January 2007, Newcastle issued 2.42 million shares of its common stock in a public offering at a price to the public of $31.30 per share for net proceeds of approximately $75.0 million. For the purpose of compensating the Manager for its successful efforts in raising capi- tal for Newcastle, in connection with this offering, Newcastle granted options to the Manager to purchase 242,000 shares of Newcastle’s common stock at the public offering price, which were valued at approximately $0.8 million. P.72 _ 2 0 0 6 a n n u a l r e p o r t newcastle In January 2007, certain of the Manager’s employees exercised options to acquire 3,282 shares of Newcastle’s common stock for net proceeds of $0.1 million. In January 2007, Newcastle entered into an $700 million non-recourse 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%. 14. summary quarterly consolidated financial information (unaudited) The following is unaudited summary information on Newcastle’s quarterly operations. 2006 march 31(A) june 30(A) september 30(A) december 31 quarter ended year ended december 31 Gross Revenues Operating expenses Operating income Interest expense Depreciation and amortization Equity in earnings of unconsolidated subsidiaries(B) Income from continuing operations Income (loss) from discontinued operations Preferred dividends Income available for common stockholders Net Income per share of common stock Basic Diluted Income from continuing operations per share of common stock, after preferred dividends and related accretion Basic Diluted Income (loss) from discontinued operations per share of common stock Basic Diluted Weighted average number of shares of common stock outstanding Basic Diluted $123,548 (16,911) 106,637 (76,965) (199) 1,195 30,668 251 (2,328) $ 28,591 $ 0.65 $ 0.65 $129,027 (10,999) 118,028 (87,909) (278) 1,215 31,056 (26) (2,329) $ 28,701 $ 0.65 $ 0.65 $ 144,094 (13,032) 131,062 (100,239) (290) 1,506 32,039 (12) (2,328) $ 29,699 $ 0.68 $ 0.67 $ 155,940 (14,581) 141,359 (109,156) (318) 2,052 33,937 10 (2,329) $ 31,618 $ 0.70 $ 0.70 $ 552,609 (55,523) 497,086 (374,269) (1,085) 5,968 127,700 223 (9,314) $ 118,609 $ 2.68 $ 2.67 $ 0.64 $ 0.64 $ 0.65 $ 0.65 $ 0.68 $ 0.67 $ 0.70 $ 0.70 $ 2.67 $ 2.67 $ 0.01 $ 0.01 $ 0.00 $ 0.00 $ 0.00 $ 0.00 $ 0.00 $ 0.00 $ 0.01 $ 0.00 43,945 44,064 43,991 44,071 44,000 44,137 45,129 45,385 44,269 44,417 (A)The Income Available for Common Stockholders shown agrees with Newcastle’s quarterly report(s) on Form 10-Q as filed with the Securities and Exchange Commission. However, individual line items may vary from such report(s) due to the operations of properties sold, or classified as held for sale, during subsequent periods being retroactively reclassified to Income for Discontinued Operations for all periods presented (Note 5). (B)Net of income taxes on related taxable subsidiaries. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.73 2005 march 31(A) june 30(A) september 30(A) december 31 quarter ended year ended december 31 Gross Revenues Operating expenses Operating income Interest expense Depreciation and amortization Equity in earnings of unconsolidated subsidiaries(B) Income from continuing operations Income (loss) from discontinued operations Preferred dividends Income available for common stockholders Net Income per share of common stock Basic Diluted Income from continuing operations per share of common stock, after preferred dividends and related accretion Basic Diluted Income (loss) from discontinued operations per share of common stock Basic Diluted Weighted average number of shares of common stock outstanding Basic Diluted $ 83,663 (9,114) 74,549 (48,766) (136) 1,853 27,500 1,184 (1,523) $ 27,161 $ 0.63 $ 0.62 $ 0.60 $ 0.59 $ 0.03 $ 0.03 43,222 43,629 $ 92,065 (8,832) 83,233 (55,791) (135) 1,393 28,700 781 (1,524) $ 27,957 $ 0.64 $ 0.63 $ 0.62 $ 0.61 $ 0.02 $ 0.02 43,768 44,127 $ 99,850 (12,934) 86,916 (58,681) (182) 1,061 29,114 86 (1,523) $ 27,677 $ 0.63 $ 0.63 $102,635 (11,008) 91,627 (63,208) (188) 1,302 29,533 57 (2,114) $ 27,476 $ 0.63 $ 0.63 $378,213 (41,888) 336,325 (226,446) (641) 5,609 114,847 2,108 (6,684) $110,271 $ 2.53 $ 2.51 $ 0.63 $ 0.63 $ 0.63 $ 0.63 $ 2.48 $ 2.46 $ 0.00 $ 0.00 $ 0.00 $ 0.00 $ 0.05 $ 0.05 43,790 44,121 43,897 44,059 43,672 43,986 (A)The Income Available for Common Stockholders shown agrees with Newcastle’s quarterly report(s) on Form 10-Q as filed with the Securities and Exchange Commission. However, individual line items may vary from such report(s) due to the operations of properties sold, or classified as held for sale, during subsequent periods being retroactively reclassified to Income for Discontinued Operations for all periods presented (Note 5). (B)Net of income taxes on related taxable subsidiaries. P.74 _ 2 0 0 6 a n n u a l r e p o r t newcastle 2004 march 31(A) june 30(A) september 30(A) december 31 quarter ended year ended december 31 Gross Revenues Operating expenses Operating income Interest expense Depreciation and amortization Equity in earnings of unconsolidated subsidiaries(B) Income from continuing operations Income (loss) from discontinued operations Preferred dividends Income available for common stockholders Net Income per share of common stock Basic Diluted Income from continuing operations per share of common stock, after preferred dividends and related accretion Basic Diluted Income (loss) from discontinued operations per share of common stock Basic Diluted Weighted average number of shares of common stock outstanding Basic Diluted $ 55,309 (7,333) 47,976 (28,091) (113) 1,223 20,995 856 (1,523) $ 20,328 $ 0.59 $ 0.58 $ 0.57 $ 0.56 $ 0.02 $ 0.02 34,402 34,976 $ 61,612 (6,354) 55,258 (32,615) (95) 2,218 24,766 (1,591) (1,524) $ 21,651 $ 0.60 $ 0.59 $ 0.64 $ 0.63 $ (0.04) $ (0.04) 36,161 36,671 $ 63,146 (7,822) 55,324 (33,612) (108) 3,179 24,783 185 (1,523) $ 23,445 $ 0.61 $ 0.60 $ 0.61 $ 0.60 $ 0.00 $ 0.00 38,234 38,883 $ 69,602 (7,299) 62,303 (42,080) (135) 3,337 23,425 4,996 (1,524) $ 26,897 $ 0.70 $ 0.69 $ 249,669 (28,808) 220,861 (136,398) (451) 9,957 93,969 4,446 (6,094) $ 92,321 $ 2.50 $ 2.46 $ 0.56 $ 0.55 $ 2.38 $ 2.34 $ 0.14 $ 0.14 $ 0.12 $ 0.12 38,941 39,663 36,944 37,558 (A)The Income Available for Common Stockholders shown agrees with Newcastle’s quarterly report(s) on Form 10-Q as filed with the Securities and Exchange Commission. However, individual line items may vary from such report(s) due to the operations of properties sold, or classified as held for sale, during subsequent periods being retroactively reclassified to Income for Discontinued Operations for all periods presented (Note 5). (B)Net of income taxes on related taxable subsidiaries. report of independent registered public accounting firm The Board of Directors and Stockholders of Newcastle Investment Corp. We have audited the accompanying consolidated balance sheets of Newcastle Investment Corp. and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity, and cash flow for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial state- ments are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant esti- mates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits pro- vide a reasonable basis for our opinion. newcastle 2 0 0 6 a n n u a l r e p o r t _ P.75 In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 2006 and 2005, and the consoli- dated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in con- formity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness the Company’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 22, 2007 expressed an unqualified opin- ion thereon. New York, NY February 22, 2007 P.76 _ 2 0 0 6 a n n u a l r e p o r t newcastle report on internal control over financial reporting of independent registered public accounting firm The Board of Directors and Stockholders of Newcastle Investment Corp. We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Newcastle Investment Corp. and sub- sidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over finan- cial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over finan- cial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of inter- nal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other pro- cedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial state- ments in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of manage- ment and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unautho- rized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projec- tions of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that the Company main- tained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity, and cash flow for each of the three years in the period ended December 31, 2006 of the Company and our report dated February 22, 2007 expressed an unqualified opinion thereon. New York, NY February 22, 2007 newcastle 2 0 0 6 a n n u a l r e p o r t _ P.77 management’s report on internal control over financial reporting Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a–15(f) and 15d–15(f) under the Securities Exchange Act of 1934, as amended, as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States and includes those policies and procedures that: Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management assessed the effectiveness of the Company’s inter- nal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework. • pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; Based on our assessment, management concluded that, as of December 31, 2006, the Company’s internal control over financial reporting is designed and operating effectively. • provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States, and that receipts and expenditures of the Company are being made only in accordance with authoriza- tions of management and directors of the Company; and • provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. The Company’s independent registered public accounting firm has issued an audit report on our assessment of the Company’s internal control over financial reporting. P.78 _ 2 0 0 6 a n n u a l r e p o r t newcastle common stock prices Our common stock has been listed and is traded on the New York Stock Exchange (NYSE) under the symbol “NCT” since our initial public offering in October 2002. The following table sets forth, for the periods indicated, the high, low and last sale prices in dollars on the NYSE for our common stock and the distributions we declared with respect to the periods indicated. 2006 high low last distributions declared sale First Quarter Second Quarter Third Quarter Fourth Quarter $27.50 $26.30 $28.58 $32.59 $23.34 $22.16 $24.60 $26.78 $23.92 $25.32 $27.41 $31.32 $0.625 $0.650 $0.650 $0.690 2005 high low last distributions declared sale First Quarter Second Quarter Third Quarter Fourth Quarter $31.95 $32.31 $31.25 $27.96 $29.27 $28.25 $27.00 $24.74 $29.60 $30.15 $27.90 $24.85 $0.625 $0.625 $0.625 $0.625 We intend to continue to declare quarterly distributions on our common stock. No assurance, however, can be given as to the amounts or timing of future distributions as such distributions are subject to our earnings, financial condition, capital requirements and such other factors as our board of directors deems relevant. On February 16, 2007, the closing sale price for our common stock, as reported on the NYSE, was $31.50. As of February 16, 2007, there were approximately 113 record holders of our common stock. This figure does not reflect the beneficial ownership of shares held in nominee name. CORPORATE INFORMATION BOARD OF DIRECTORS CORPORATE OFFICERS CORPORATE HEADQUARTERS wesley r. edens Chairman of the Board Chairman and Chief Executive Officer Fortress Investment Group LLC kevin j. finnerty(1) Founder and Managing Partner F.I.Capital Management stuart a. mcfarland(1) Chairman Federal City Bancorp, Inc. david k. mckown(1) Senior Advisor Eaton Vance Management peter m. miller(1) Managing Director Dresdner Kleinwort Wasserstein Securities LLC kenneth m. riis Managing Director FIG LLC kenneth m. riis Chief Executive Officer and President jonathan ashley Chief Operating Officer debra a. hess Chief Financial Officer phillip j. evanski Chief Investment Officer erik p. nygaard Chief Information Officer randal a. nardone Secretary lilly h. donohue Assistant Secretary (1) Member of Audit Committee, Nominating and Corporate Governance Committee and Compensation Committee Newcastle Investment Corp. submitted a timely CEO certification to the New York Stock Exchange (NYSE) in 2006 pursuant to NYSE Listed Company Manual Section 303A.12(a) stating that its CEO was not aware of any violations of the NYSE corporate governance listing standards. Newcastle Investment Corp. filed timely CEO and CFO certifications with the Securities and Exchange Commission pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 regarding Newcastle’s annual report on Form 10-K for the year ended December 31, 2006. These certifications were filed as exhibits 31.1 and 31.2 to such Form 10-K. forward-looking statements 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 and financing needs. Forward-looking statements are generally identifiable by use of forward-looking ter- minology 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 reason- able 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, changes in economic conditions generally and the real estate and bond markets specifically, changes in the financing markets we access that affect our ability to finance our real estate securities portfolios in general or particular real estate related assets, changes in interest rates and/or credit spreads and the success of our hedging strategy in relation to such changes, the availability and cost of capital for future investments, the rate at which we can invest our cash in suitable investments and legislative/regulatory changes (including in respect of rules applicable to REITs) as well as other risks detailed from time to time in our SEC reports. You should not place undue reliance on forward-looking statements contained in this report. Such forward- looking statements speak only as of the date of this report. We expressly disclaim any obligation to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or change in events, conditions or circumstances on which any statement is based. m o c . n o s i d d a w w w . n o s i d d A y b n g i s e D newcastle investment corp. c/o Fortress Investment Group LLC 1345 Avenue of the Americas, 46th Floor New York, NY 10105 (212) 798-6100 legal counsel Skadden, Arps, Slate, Meagher & Flom LLP Four Times Square New York, NY 10036-6522 independent auditors Ernst & Young LLP Five Times Square New York, NY 10036-6530 stock transfer agent and registrar American Stock Transfer & Trust Company 59 Maiden Lane Plaza Level New York, NY 10038 (800) 937-5449 stock exchange listing Newcastle Investment Corp.’s common stock is listed on the New York Stock Exchange (symbol: NCT) annual meeting of stockholders May 17, 2007, 9:00 a.m. PDT Sheraton Suites San Diego at Symphony Hall 701 A Street San Diego, CA 92101 investor information services Lilly H. Donohue Director, Investor Relations Newcastle Investment Corp. c/o Fortress Investment Group LLC 1345 Avenue of the Americas, 46th Floor New York, NY 10105 Tel: (212) 798-6118 Fax: (212) 798-6060 email: ldonohue@fortressinv.com newcastle investment corp. web site http://www.newcastleinv.com April 2007 printed on recycled paper Newcastle Investment Corp. is a real estate investment and finance company. The Company invests in a diversified portfolio of real estate debt and other real estate related assets with a disciplined approach to financing and managing its assets. The Company, which is taxed as a real estate investment trust, seeks to deliver strong dividends and superior risk-adjusted returns in varying interest rate and credit cycles. Newcastle is listed on the New York Stock Exchange under the symbol NCT. n e w c a s t l e i n v e s t m e n t c o r p . 2 0 0 6 a n n u a l r e p o r t newcastle investment corp. www.newcastleinv.com Newcastle Investment Corp. 2 0 0 6 a n n u a l r e p o r t