Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

 

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

For the fiscal year ended December 31, 2009

OR

 

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

For the transition period from              to             

Commission file number 001-33211

 

 

NewStar Financial, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   54-2157878

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

500 Boylston Street, Suite 1250, Boston, MA   02116
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (617) 848-2500

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

Common Stock, par value $0.01 per share   The NASDAQ Global Market

Securities registered pursuant to Section 12(g) of the Act:

None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large Accelerated Filer  ¨   Accelerated Filer  x   Non-Accelerated Filer  ¨   Smaller reporting company¨

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

As of June 30, 2009 the last business day of our most recently completed second fiscal quarter, the aggregate market value of the voting stock held by non-affiliates was $52,717,463, based on the number of shares held by non-affiliates of the registrant as of June 30, 2009, and based on the reported last sale price of common stock on June 30, 2009. This calculation does not reflect a determination that persons are affiliates for any other purposes.

As of March 3, 2010, 49,869,512 shares of common stock, par value of $0.01 per share, were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Definitive Proxy Statement to be filed with the Securities and Exchange Commission (“SEC”) pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), relating to the Registrant’s Annual Meeting of Stockholders scheduled to be held May 12, 2010 are incorporated by reference into Part III of this Form 10-K. With the exception of the portions of the Proxy Statement specifically incorporated herein by reference, the Proxy Statement is not deemed to be filed as part of this Form 10-K.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page
PART I
Item 1.    Business    2
Item 1A.    Risk Factors    12
Item 1B.    Unresolved Staff Comments    24
Item 2.    Properties    24
Item 3.    Legal Proceedings    24
Item 4.    Reserved    24
PART II
Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    25
Item 6.    Selected Financial Data    26
Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    29
Item 7A.    Quantitative and Qualitative Disclosures About Market Risk    55
Item 8.    Financial Statements and Supplementary Data    56
Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    102
Item 9A.    Controls and Procedures    102
Item 9B.    Other Information    102
PART III
Item 10.    Directors, Executive Officers and Corporate Governance    103
Item 11.    Executive Compensation    104
Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    104
Item 13.    Certain Relationships and Related Transactions, and Director Independence    104
Item 14.    Principal Accounting Fees and Services    104
PART IV
Item 15.    Exhibits, Financial Statement Schedules    105
Signatures    106

 

1


Table of Contents

Forward-Looking Statements

Statements in this Annual Report about our anticipated financial condition, results of operations, and growth, as well as about the future development of our products and markets and the future performance of the financial markets in general, are forward-looking statements. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. They may include words such as “anticipate,” “estimate,” “expect,” “project,” “plan,” “intend,” “believe,” “may,” “should,” “can have,” “likely” and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events and circumstances. These forward-looking statements are based on assumptions that we have made in light of our industry experience and on our perceptions of historical trends, current conditions, expected future developments and other factors. As you read this Annual Report, you should understand that these statements are not guarantees of performance or results. They involve risks and uncertainties that are beyond our control. Important information about the bases for our assumptions and factors that may cause our actual results and other circumstances to differ materially from those described in the forward-looking statements are discussed in Item 1A. “Risk Factors” and generally throughout this Annual Report.

 

Item 1. Business

Corporate History and Information

NewStar Financial, Inc. (which is referred to throughout this Annual Report as “NewStar”, “the Company”, “we” and “us”) was founded in June 2004 by a team of experienced bankers and capital markets executives. On December 14, 2006, our common stock began trading on the NASDAQ Global Market and on December 19, 2006 we completed the initial public offering of our common stock.

We are a Delaware corporation. Our principal executive office is located at 500 Boylston Street, Suite 1250, Boston, Massachusetts 02116, and our telephone number is (617) 848-2500. We maintain a website at www.newstarfin.com.

Overview

We are a commercial finance company that provides customized debt financing solutions to middle-market businesses and commercial real estate borrowers and manages investment funds for large institutional investors. We principally focus on the direct origination of loans that meet our risk and return parameters. Our direct origination efforts target mid-sized companies, private equity sponsors, corporate executives, regional banks, and a variety of other financial intermediaries to source transaction opportunities. Direct origination provides direct access to our customers’ management, enhances our due diligence, and allows significant input into our customers’ capital structure and direct negotiation of transaction pricing and terms. We employ highly experienced origination, credit and finance professionals to identify and structure our transactions. We believe that the quality of our professionals, their ability to develop creative solutions and our efficient, comprehensive credit approval process position us to be a preferred lender for mid-sized borrowers.

We specialize in providing senior debt products to mid-sized borrowers. Our loans and other debt products typically range in size from $5 million to $20 million. We also selectively arrange larger transactions, which we may hold on our balance sheet or syndicate to the NewStar Credit Opportunities Fund, Ltd. (the “NCOF”), a private debt fund, and other third-parties, thereby allowing us to provide more debt capital to our customers and generate fee income while limiting our exposure. As such, from time to time our balance sheet exposure to certain loans and other debt products may exceed $20 million.

We operate as a single segment, and we derive revenues from two specialized lending groups:

 

   

Middle Market Corporate, which originates, structures and underwrites senior debt and, to a lesser extent, second lien, mezzanine and subordinated debt, and equity and other equity-linked products for companies with annual EBITDA typically between $5 million and $50 million; and

 

2


Table of Contents
   

Commercial Real Estate, which originates, structures and underwrites first mortgage debt and, to a lesser extent, subordinated debt, primarily to finance acquisitions of real estate properties typically valued between $10 million and $50 million.

Subsequent to December 31, 2007, we discontinued the origination of structured products. We manage the remaining structured products portfolio within our Middle Market Corporate lending group. As of December 31, 2009, this portfolio had an outstanding balance of $40.7 million.

We did not originate any new commercial real estate loans during the year ended December 31, 2009.

As of December 31, 2009, our portfolio of loans and other debt products, which we refer to as our loan portfolio, totaled approximately $2.3 billion of funding commitments, representing $2.0 billion of balances outstanding and $0.3 billion of funds committed but undrawn. We finance our loan portfolio through a combination of debt and equity.

As of December 31, 2009, senior debt constituted 95.9% of our portfolio. We classify our portfolio as 84.3% Middle Market Corporate and 15.7% Commercial Real Estate.

We manage the NCOF, which has the opportunity to invest in loans and other debt products originated or acquired by us. The NCOF raised $150.0 million of equity from third-party institutional investors and had a $400.0 million committed credit facility. As of December 31, 2009, the NCOF’s and NCOF CLO II’s (defined below) loan portfolio had total funding commitments and balances outstanding of approximately $566.9 million and $542.5 million, respectively. Our managed loan portfolio, which includes our loan portfolio and the loan portfolio of the NCOF, totaled approximately $2.9 billion of commitments and $2.6 billion of balances outstanding as of December 31, 2009.

On December 17, 2007, the NewStar Credit Opportunities Funding II (the “NCOF CLO II”) securitization closed. This securitization is a $560.0 million cash flow collateralized loan obligation managed by us. The NCOF CLO II is comprised of $450.0 million AAA/Aaa—rated floating rate notes, of which $161.0 million benefit from a financial guaranty. The NCOF CLO II assets include a diversified portfolio of primarily senior secured corporate loans. Concurrent with the closing of NCOF CLO II, NCOF reduced its committed credit facility from $400.0 million to $150.0 million. On October 31, 2008, the credit facility expired and was not renewed.

Recent Developments

On November 3, 2009, we amended our credit facility with Citicorp North America, Inc. (“Citicorp”), which reduced the commitment amount under the facility to $150 million from $300 million and extended the facility’s liquidity line until November 2010, completing the annual renewal. The amendment was effective as of November 17, 2009. The credit facility is scheduled to mature on November 7, 2011.

On January 5, 2010, we entered into a note agreement with Fortress Credit Corp., an affiliate of Fortress Investment Group (“Fortress”). Under the terms of the note agreement, Fortress agreed to provide a $75 million revolving credit facility. The credit facility is scheduled to mature on July 5, 2013.

On January 7, 2010, we completed a $275.0 million term debt securitization, net of a $3.4 million discount. As part of the securitization, investors purchased approximately $190.5 million of floating-rate asset-backed notes. We retained the remaining $87.9 million of notes. The notes are expected to mature on July 30, 2018. Proceeds from this term debt securitization were used to repay all outstanding borrowings under our term debt facility with Deutsche Bank AG, New York Branch and certain advances under our credit facility with Citicorp North America, Inc.

On January 25, 2010, we announced that our Board of Directors had authorized the repurchase of up to $10 million of the Company’s common stock from time to time on the open market or in privately negotiated

 

3


Table of Contents

transactions. The timing and amount of any shares purchased will be determined by our management based on its evaluation of market condition and other factors. The repurchase program, which will expire on January 22, 2011 unless extended by the Board of Directors, may be suspended or discontinued at any time without notice.

Lending Groups

Our lending activities are organized into two specialized lending groups: Middle Market Corporate and Commercial Real Estate.

Middle Market Corporate

Our Middle Market Corporate group provides senior secured, senior subordinated, and to a lesser extent, second lien, mezzanine and subordinated debt, and equity and other equity-linked products to companies with annual EBITDA typically between $5 million and $50 million, the proceeds of which are primarily used for acquisition financing, growth and working capital, recapitalization and other purposes. Our Middle Market Corporate group also originates, structures and underwrites senior and subordinated debt for mid-sized specialty finance companies with assets generally between $25 million and $250 million, primarily to fund asset growth.

We source our loans primarily through direct origination efforts by our bankers. Our bankers establish and maintain relationships with mid-sized companies, private equity firms, corporate executives, regional banks, other non-bank “club” lenders, mid-sized consumer and commercial finance companies, and investment and commercial banks. To a lesser extent, we also source debt products by participating with other lenders in syndicated transactions.

We target selected industries where we have significant lending and underwriting experience, including:

 

   

healthcare;

 

   

manufacturing and industrial;

 

   

financial services;

 

   

energy/chemical services;

 

   

printing/publishing;

 

   

consumer, retail and restaurants; and

 

   

business services.

We currently provide senior and subordinated debt products, including revolving warehouse facilities, amortizing loans, term loans and debt securities secured by a variety of financial assets. We also continue to manage the assets remaining in our Structured Products loan portfolio as part of our Middle Market Corporate group.

Our loans and other debt products, which may be part of larger credit facilities, typically range in size from $5 million to $20 million. We also have the ability to arrange significantly larger transactions which we syndicate to others. As a result of that syndication activity our balance sheet exposure to certain loans and other debt products may exceed $20 million from time to time as reflected in “Loans held-for-sale” which are amounts in excess of our target position. Our loans and other debt products typically mature in two to six years and require monthly or quarterly interest payments at variable rates based on a spread to LIBOR or the prime rate; however, some of our loans are fixed rate.

In determining our corporate borrowers’ ability to repay the loan, we consider several factors, including the borrowers’:

 

   

equity sponsorship and capital structure;

 

   

management strength and experience;

 

4


Table of Contents
   

market position;

 

   

historical and projected profitability;

 

   

balance sheet strength and liquidity;

 

   

ability to withstand competitive challenges; and

 

   

relationships with customers and suppliers.

Borrowers are typically subject to a number of financial covenants during the term of the loan. These covenants generally may include one or more of the following:

 

   

maximum ratio of senior debt and total debt to EBITDA;

 

   

minimum level of EBITDA;

 

   

minimum fixed charge coverage;

 

   

minimum interest coverage; and

 

   

limits on capital expenditures and distributions.

As of December 31, 2009, our Middle Market Corporate loan portfolio totaled $1.9 billion in funding commitments and $1.7 billion in balances outstanding, representing 84.3% of our loan portfolio. This represented 185 transactions with an average balance outstanding of approximately $9.3 million. During 2009, we originated $43.3 million of Middle Market Corporate Loans. Additionally, we originated $77.0 million for the NCOF during 2009.

Commercial Real Estate

Prior to 2009, our Commercial Real Estate group originated, structured and underwrote first mortgage and senior subordinated asset-based debt primarily to finance the acquisition of real estate properties typically valued between $10 million and $50 million.

We sourced our commercial real estate loans and other debt products primarily through property investors, specialized commercial real estate brokers, regional banks and other financial intermediaries.

Our commercial real estate loans typically provide capital for the following purposes:

 

   

acquisition;

 

   

lease-up;

 

   

repositioning and build-out; and

 

   

refinancing and recapitalization.

We have a selective regional focus on property types where we have significant lending and underwriting experience, including:

 

   

office;

 

   

multi-family;

 

   

retail; and

 

   

industrial.

 

5


Table of Contents

Our loans and other debt products typically range in size from $5 million to $20 million. Although we generally limit loan sizes to $17.5 million, our exposure to certain loans and other debt products may exceed $20 million from time to time. Our loans and other debt products typically mature in two to five years and require monthly or quarterly interest payments at variable rates based on a spread to LIBOR or the prime rate; however, some of our loans are fixed rate.

For our commercial real estate loans, we perform due diligence that includes reviewing:

 

   

sponsor’s history, capital and liquidity, and portfolio of other properties;

 

   

the property’s historical and projected cash flow;

 

   

tenant creditworthiness;

 

   

the borrower’s plan for the subject property;

 

   

the property’s condition;

 

   

local real estate market conditions;

 

   

loan-to-value based on independent third-party appraisals;

 

   

borrower’s demonstrated operating capability and creditworthiness;

 

   

licensing and environmental issues related to the property and the borrower; and

 

   

borrower’s management.

As of December 31, 2009 our commercial real estate loan portfolio totaled $348.2 million in funding commitments and $320.7 million in balances outstanding, representing 15.7% of our loan portfolio. This represented 32 transactions with an average balance outstanding of approximately $10.0 million. During 2009, we did not originate any new commercial real estate loans. Funding new commercial real estate loans through the capital markets remained difficult in 2009, but we expect to originate new commercial real estate loans if market conditions improve.

Loan and Other Debt Products

First mortgage

Our first mortgage loans are provided by our Commercial Real Estate group and are secured by a mortgage bearing a first lien on the real property serving as collateral. Our first mortgage loans require borrowers to demonstrate satisfactory collateral value at closing through a third party property appraisal and typically contain provisions governing the use of property operating cash flow and disbursement of loan proceeds during the term of the loan.

As of December 31, 2009, first mortgage loans totaled $334.6 million in funding commitments and $306.1 million in balances outstanding, representing 15.0% of our loan portfolio.

Senior secured asset-based

Our senior secured asset-based loans were formerly provided by our Structured Products group, and to a lesser degree by our Middle Market Corporate group, and are secured by a first-priority lien on tangible assets and have a first-priority in right of payment.

As of December 31, 2009, senior secured asset-based loans totaled $35.0 million in funding commitments and $26.5 million in balances outstanding, representing 1.3% of our loan portfolio.

Senior secured cash flow

Our senior secured cash flow loans are provided by our Middle Market Corporate group. We underwrite these loans based on the cash flow, profitability and enterprise value of the borrower, with the value of any

 

6


Table of Contents

tangible assets as secondary protection. These loans are generally secured by a first-priority security interest in all or substantially all of the borrowers’ assets and, in certain transactions, the pledge of their common stock.

As of December 31, 2009, senior secured cash flow loans totaled $1.8 billion in funding commitments and $1.6 billion balances outstanding, representing 79.6% of our loan portfolio.

Senior subordinated asset-based

Senior subordinated asset-based loans and other debt products are provided by our Commercial Real Estate group and were formerly provided by our Structured Products group. They are equal as to collateral and subordinate as to right of payment to other senior lenders.

Investments in asset-backed securitizations that we classify as senior subordinated represent non-investment grade and investment grade tranches of small to mid-sized securitizations. These debt products typically occupy the mid-tier tranche of the capital structure and are supported by junior capital and credit enhancements, such as further subordinated debt tranches, the borrower’s equity, excess spread and interest reserve or collections accounts.

As of December 31, 2009, our senior subordinated asset-based loans and other debt products totaled $40.8 million in funding commitments and balances outstanding, representing 2.0% of our loan portfolio.

Senior subordinated cash flow

Our senior subordinated cash flow loans are provided by our Middle Market Corporate group. We underwrite these loans based on the cash flow, profitability and enterprise value of the borrower, with the value of any tangible assets, if any, as secondary protection. Senior subordinated cash flow loans are equal as to collateral and subordinate in right of payment of principal and interest to other senior lenders.

As of December 31, 2009, we did not have any senior subordinated cash flow loans.

Second lien

Our second lien loans are provided by our Middle Market Corporate group. Our second lien loans have second liens on all or substantially all of our borrowers’ assets, and in some cases, are junior in right of payment to those of senior lenders. Our second lien loans generally possess higher yields and greater risk of loss than our senior secured cash flow loans. The financial covenants of second lien loans are generally less restrictive than those of senior secured loans and permit borrowers to maintain higher levels of leverage. We pursue second lien loans selectively. Our intercreditor agreements for these loans are highly negotiated.

As of December 31, 2009, our second lien loans totaled $33.7 million in funding commitments and balances outstanding, representing 1.7% of our loan portfolio.

Subordinated and mezzanine

Subordinated debt products and mezzanine loans are provided by our Middle Market group. Subordinated debt products generally refer to debt products that are subordinated as to rights to collateral and right of payment to those of senior lenders. Mezzanine loans are cash flow based loans that do not have security interests in our borrowers’ assets and are junior in right of payment to senior secured loans.

As of December 31, 2009, subordinated debt products and mezzanine loans totaled $7.4 million in funding commitments and balances outstanding, representing 0.4% of our loan portfolio.

 

7


Table of Contents

Loan Portfolio Overview

The following tables present information regarding the outstanding balances of our loans and other debt products:

 

     December 31,  
     2009     2008     2007  
     ($ in thousands)  

Composition Type

            

First mortgage

   $ 306,075   15.0   $ 370,810   15.4   $ 353,755   14.7

Senior secured asset-based

     26,463   1.3        40,969   1.7        56,988   2.4   

Senior secured cash flow

     1,621,816   79.6        1,884,862   78.2        1,829,734   76.2   

Senior subordinated asset-based

     40,810   2.0        64,156   2.7        110,719   4.6   

Senior subordinated cash flow

     —     —          8,182   0.3        14,352   0.6   

Second lien

     33,680   1.7        33,086   1.4        32,295   1.3   

Mezzanine / subordinated

     7,369   0.4        7,083   0.3        4,479   0.2   
                                    

Total

   $ 2,036,213   100.0   $ 2,409,148   100.0   $ 2,402,322   100.0
                                    

 

     December 31,
     2009    2008    2007
     ($ in thousands)

Composition by Lending Group

        

Middle Market Corporate

   $ 1,715,554    $ 2,016,447    $ 2,021,559

Commercial Real Estate

     320,659      392,701      380,763
                    

Total

   $ 2,036,213    $ 2,409,148    $ 2,402,322
                    

 

     December 31, 2009  
     Percentage of
Middle Market
Corporate
    Percentage of
Loan Portfolio
 

Middle Market Corporate by Industry

    

Healthcare

   12.2   10.2

Manufacturing—consumer non-durable

   8.8      7.4   

Printing/Publishing

   8.4      7.1   

Industrial/Other

   8.3      7.0   

Energy/Chemical services

   8.1      6.8   

Financial services

   7.1      6.0   

Other business services

   7.0      5.9   

Tech services

   6.4      5.4   

Marketing services

   5.9      5.0   

Restaurants

   4.9      4.2   

Building materials

   3.6      3.0   

Cable/Telecom

   3.4      2.8   

Environmental services

   2.9      2.5   

Retail

   2.8      2.4   

Broadcasting

   2.6      2.2   

Auto/Transportation

   2.2      1.8   

Entertainment/Leisure

   2.1      1.8   

Manufacturing—consumer durable

   2.0      1.7   

Consumer services

   1.3      1.1   
            

Total

   100.0   84.3
            

 

8


Table of Contents
     December 31, 2009  
   Percentage of
Commercial
Real

Estate
    Percentage of
Loan Portfolio
 

Commercial Real Estate by Property Type

    

Office

   54.3   8.6

Multi-family

   20.3      3.2   

Industrial

   13.0      2.0   

Retail

   7.8      1.2   

Other

   4.6      0.7   
            

Total

   100.0   15.7
            

The table below shows the final maturities of our loan portfolio as of December 31, 2009:

 

     Due in One
Year or Less
   Due in One to
Five Years
   Due After
Five Years
   Total
     ($ in thousands)

First mortgage

   $ 230,402    $ 71,963    $ 3,710    $ 306,075

Senior secured asset-based

     5,000      21,463      —        26,463

Senior secured cash flow

     71,598      1,550,218      —        1,621,816

Senior subordinated asset-based

     31,512      7,000      2,298      40,810

Senior subordinated cash flow

     —        —        —        —  

Second lien

     3,139      30,541      —        33,680

Mezzanine / subordinated

     —        7,369      —        7,369
                           

Total

   $ 341,651    $ 1,688,554    $ 6,008    $ 2,036,213
                           

The table below shows the outstanding balances of fixed-rate and adjustable-rate loans and other debt products as of December 31, 2009:

 

     Fixed-
Rate (1)
   Adjustable-
Rate(2)
   Total
     ($ in thousands)

First mortgage

   $ —      $ 306,075    $ 306,075

Senior secured asset-based

     4,488      21,975      26,463

Senior secured cash flow

     31,372      1,590,444      1,621,816

Senior subordinated asset-based

     8,494      32,316      40,810

Senior subordinated cash flow

     —        —        —  

Second lien

     —        33,680      33,680

Mezzanine / subordinated

     7,369      —        7,369
                    

Total

   $ 51,723    $ 1,984,490    $ 2,036,213
                    

 

(1)

As of December 31, 2009, we had purchased interest-rate protection products in the notional amount of $12.9 million against the $51.7 million of fixed-rate loans and other debt products outstanding.

(2)

As of December 31, 2009 we had interest rate floors on $775.0 million of adjustable-rate loans outstanding.

Competition

Our markets are highly competitive and are characterized by competitive factors that vary based upon product and geographic region. We currently compete with a large number of financial services companies, including:

 

   

specialty and commercial finance companies, including business development companies and real estate investment trusts;

 

9


Table of Contents
   

private investment funds and hedge funds;

 

   

national and regional banks;

 

   

investment banks; and

 

   

insurance companies.

The markets in which we operate are highly fragmented. We compete based on the following factors, which vary by industry, asset class and property types:

 

   

the interest rates and other pricing and/or loan or other debt product terms;

 

   

the quality of our people and their relationships;

 

   

our knowledge of our customers’ industries and business needs;

 

   

the flexibility of our product offering;

 

   

the responsiveness of our process; and

 

   

our focus on customer service.

Regulation

Some aspects of our operations are subject to supervision and regulation by state and federal governmental authorities and may be subject to various laws and regulations imposing various requirements and restrictions, which, among other things:

 

   

regulate credit granting activities, including establishing licensing requirements in some jurisdictions;

 

   

establish the maximum interest rates, finance charges and other fees we may charge our customers;

 

   

govern secured transactions;

 

   

require specified information disclosures to our customers;

 

   

set collection, foreclosure, repossession and claims handling customer procedures and other trade practices;

 

   

regulate our customers’ insurance coverage;

 

   

prohibit discrimination in the extension of credit and administration of our loans; and

 

   

regulate the use and reporting of information related to a customer’s credit experience.

Many of our competitors are subject to more extensive supervision and regulation. If we were to become subject to similar supervision or regulation in the future, it could impact our ability to conduct our business.

Employees

As of December 31, 2009, we employed 61 people compared to 94 people at December 31, 2008. At December 31, 2009, our origination group had 16 employees, including 11 bankers who were either managing directors, directors or vice presidents, and 5 associates and analysts. Our credit organization had 14 employees, including 8 managing directors. Additionally, we employed 31 people who were involved in administrative roles. We believe our relations with our employees are good. We had 60 employees as of March 3, 2010.

 

10


Table of Contents

Available Information

NewStar files Annual, Quarterly and Current Reports, proxy statements and other information with the Securities and Exchange Commission (SEC). These documents are available free of charge at www.newstarfin.com shortly after such material is electronically filed with or furnished to the SEC. In addition, NewStar’s codes of business conduct and ethics as well as the various charters governing the actions of certain of NewStar’s Committees of its Board of Directors, including its Audit Committee, Risk Policy Committee, Compensation Committee and its Nominating and Corporate Governance Committee, are available at www.newstarfin.com. References to our website are not intended to incorporate information on our website into this Annual Report by reference.

We will provide to any shareholder, upon request and without charge, copies of these documents (excluding any applicable exhibits unless specifically requested). Written requests should be directed to: Investor Relations, NewStar Financial, Inc., 500 Boylston St., Suite 1250, Boston, Massachusetts 02116.

 

11


Table of Contents
Item 1A. Risk Factors

The following are important risks and uncertainties we have identified that could materially affect our future results. You should consider them carefully when evaluating forward-looking statements contained in this Annual Report and otherwise made by us or on our behalf because these contingencies could cause actual results and circumstances to differ materially from those projected in forward-looking statements. The Company’s actual future results and trends may differ materially depending on a variety of factors including, but not limited to, the risks and uncertainties discussed below. If any of those contingencies actually occurs, our business, financial condition and results of operations could be negatively impacted and the trading price of our common stock could decline.

Risks Related to Our Loan Portfolio and Lending Activities

We may not recover all amounts contractually owed to us by our borrowers resulting in charge-offs, impairments and non-accruals, which may exceed our allowance for credit losses and could negatively impact our financial results and our ability to secure additional funding.

We charged off $72.6 million during the year ended December 31, 2009, and expect to have additional credit losses in the future through the normal course of our lending operations. If we were to experience a material increase in credit losses exceeding our allowance for loan losses in the future, our assets, net income and operating results would be adversely impacted, which could also lead to challenges in securing additional financing.

As of December 31, 2009, we had delinquent loans of $123.9 million and had 40 loans with an aggregate outstanding balance of $352.4 million classified as impaired. Of these impaired loans, 19 loans with an aggregate outstanding balance of $162.7 million at December 31, 2009 were also on non-accrual status.

Like other commercial lenders, we experience delinquencies, impairments and non-accruals, which may indicate that our risk of credit loss for a particular loan has materially increased. When a loan is over 90 days past due or if management believes it is probable that we will be unable to collect principal and interest contractually owed to us, it is our policy to place the loan on non-accrual status and classify it is as impaired. In certain circumstances, a loan can be classified as impaired, but continue to be performing as a result of a troubled debt restructuring.

As of December 31, 2009, we had an allowance for credit losses of $114.5 million, including specific reserves of $75.4 million. The allowance for credit losses does not include a reserve for impairments on our debt products. Management periodically reviews the appropriateness of our allowance for credit losses. However, the limited history of our loans makes it difficult to judge the expected credit performance of our loans. Our estimates and judgments with respect to the appropriateness of our allowance for credit losses may not be accurate, and the assumptions we use to make such estimates and judgments may be inaccurate. Our allowance may not be adequate to cover credit or other losses related to our loans as a result of unanticipated adverse changes in the economy or events adversely affecting specific customers, industries or markets. If we were to experience material credit losses related to our loans, such losses could adversely impact our ability to fund future loans and our business and, to the extent losses exceed our allowance for credit losses, our results of operations and financial condition would be adversely affected.

The disruptions in the global financial markets that began in 2008 have and may continue to increase the number of charge-offs, impairments and non-accruals in our loan portfolio, which may exceed our allowance for credit losses and could negatively impact our financial results.

Our business, financial condition and results of operations may be adversely affected by the economic and business conditions in the markets in which we operate. Delinquencies, non-accruals and credit losses generally increase during economic slowdowns or recessions. Our Middle Market Corporate group primarily consists of

 

12


Table of Contents

loans to small and medium-sized businesses that may be particularly susceptible to economic slowdowns or recessions and may be unable to make scheduled payments of interest or principal on their borrowings during these periods. In our Commercial Real Estate group, the recent economic slowdown and recession has led to increases in payment defaults on the underlying commercial real estate. Therefore, to the extent that economic and business conditions remain unfavorable as they have during recent periods, our non-performing assets are likely to remain elevated and the value of our loan portfolio is likely to decrease. Adverse economic conditions also may continue to decrease the estimated value of the collateral, particularly real estate, securing some of our loans or other debt products. As a result, we may have certain commercial real estate loans that we have not classified as impaired with outstanding balances greater than the estimated value of the underlying collateral. Further or prolonged economic slowdowns or recessions could lead to financial losses in our loan portfolio and a decrease in our net interest income, net income and book value.

The economic recession that began in 2008 has led to a decline in overall credit quality across the market. We are closely monitoring the credit quality of our loans. We expect to experience elevated loan delinquencies, losses, specific reserves, non-accruals, troubled debt restructurings and charge offs due to the recent recession and as our portfolio continues to season. A prolonged economic downturn could lead to loan delinquencies, non-accruals, impairments and charge-offs in our loan portfolio exceeding our allowance for credit losses, which could negatively impact our financial results.

Unfavorable economic conditions have made it more difficult for us to maintain both our new origination volume, the credit quality of new business at levels previously attained and the amounts we are able to recover from borrowers who are unable to fulfill their repayment obligations. These events negatively impacted our results of operations during 2009 and may continue to do so in future periods.

We make loans primarily to privately-owned, small and medium-sized companies that may carry more inherent risk and present an increased potential for loss than loans to larger companies.

Our loan portfolio consists primarily of loans to small and medium-sized, privately-owned companies, many of which do not publicly report their financial condition. Compared to larger, publicly-traded firms, loans to these types of companies may carry more inherent risk. The companies that we lend to generally have more limited access to capital and higher funding costs, may be in a weaker financial position, may need more capital to expand or compete, and may be unable to obtain financing from public capital markets or from traditional sources, such as commercial banks. Accordingly, loans made to these types of customers involve higher risks than loans made to companies that have larger businesses, greater financial resources or are otherwise able to access traditional credit sources. Numerous factors may make these types of companies more vulnerable to variations in results of operations, changes impacting their industry and changes in general market conditions. Companies in this market segment also face intense competition, including from companies with greater financial, technical, managerial and marketing resources. Any of these factors could impair a customer’s cash flow or result in other adverse events, such as bankruptcy, which could limit a customer’s ability to make scheduled payments on our loans, and may lead to losses in our loan portfolio and a decrease in our net interest income, net income and book value.

Additionally, because most of our customers do not publicly report their financial condition, we are more susceptible to a customer’s fraud, which could cause us to suffer losses on our loan portfolio. The failure of a customer to accurately report its financial position, compliance with loan covenants or eligibility for additional borrowings could result in our providing loans or other debt products that do not meet our underwriting criteria, defaults in loan payments, the loss of some or all of the principal of a particular loan or loans, including, in the case of revolving loans, amounts we may not have advanced had we possessed complete and accurate information.

 

13


Table of Contents

Our concentration of loans and other debt products within a particular industry or region could impair our financial condition or results of operations if that industry or region were to experience adverse changes to economic or business conditions.

We specialize in certain broad industry segments, such as commercial real estate, healthcare and media in which our bankers have experience and strong networks of proprietary deal sources and our credit personnel have significant underwriting expertise. As a result, our portfolio currently has and may develop other concentrations of risk exposure related to those industry segments. If industry segments in which we have a concentration of investments experience adverse economic or business conditions, our delinquencies, default rate and loan charge-offs in those segments may increase, which may negatively impact our financial condition and results of operations.

Our balloon and bullet transactions may involve a greater degree of risk than other types of loans.

As of December 31, 2009, balloon and bullet transactions represented 82% of the outstanding balance of our loan portfolio, and most of our revolving loans and some of our term loans and other debt products are bullet transactions. Balloon and bullet loans involve a greater degree of risk than other types of transactions because they are structured to allow for either small (balloon) or no (bullet) principal payments over the term of the loan, requiring the borrower to make a large final payment upon the maturity of the loan. The ability of our customers to make this final payment upon the maturity of the loan typically depends upon their ability either to refinance the loan prior to maturity or to generate sufficient cash flow to repay the loan at maturity. The ability of a customer to accomplish any of these goals will be affected by many factors, including the availability of financing at acceptable rates to the customer, the financial condition of the customer, the marketability of the related collateral, the operating history of the related business, tax laws and the prevailing general economic conditions. Consequently, the customer may not have the ability to repay the loan at maturity, and we could lose all or most of the principal of our loan. Given their relative size and limited resources and access to capital, our small and mid-sized customers may have difficulty in repaying or financing their balloon and bullet loans on a timely basis or at all.

Our cash flow transactions are not fully covered by the value of tangible assets or collateral of the customer and, consequently, if any of these transactions become non-performing, we could suffer a loss of some or all of our value in the assets.

Cash flow lending involves lending money to a customer based primarily on the expected cash flow, profitability and enterprise value of a customer, with the value of any tangible assets as secondary protection. In some cases, these loans may have more leverage than traditional bank debt. As of December 31, 2009, cash flow transactions comprised $1.6 billion, or 80%, of the outstanding balance of our loan portfolio. In the case of our senior cash flow loans, we generally take a lien on substantially all of a customer’s assets, but the value of those assets is typically substantially less than the amount of money we advance to the customer under a cash flow transaction. In addition, some of our cash flow loans may be viewed as stretch loans, meaning they may be at leverage multiples that exceed accepted traditional bank lending standards for senior cash flow loans. Thus, if a cash flow transaction becomes non-performing, our primary recourse to recover some or all of the principal of our loan or other debt product would be to force the sale of all or part of the company as a going concern. The risks inherent in cash flow lending include, among other things:

 

   

reduced use of or demand for the customer’s products or services and, thus, reduced cash flow of the customer to service the loan and other debt product as well as reduced value of the customer as a going concern;

 

   

inability of the customer to manage working capital, which could result in lower cash flow;

 

   

inaccurate or fraudulent reporting of our customer’s positions or financial statements;

 

   

economic downturns, political events, regulatory changes, litigation or acts of terrorism that affect the customer’s business, financial condition and prospects; and

 

   

our customer’s poor management of their business.

 

14


Table of Contents

Additionally, many of our customers use the proceeds of our cash flow transactions to make acquisitions. Poorly executed or poorly conceived acquisitions can tax management, systems and the operations of the existing business, causing a decline in both the customer’s cash flow and the value of its business as a going concern. In addition, many acquisitions involve new management teams taking over control of a business. These new management teams may fail to execute at the same level as the former management team, which could reduce the cash flow of the customer available to service the loan or other debt product, as well as reduce the value of the customer as a going concern.

We provide second lien, subordinated / mezzanine loans, other debt products and equity-linked products that may rank junior to rights of other lenders, representing a higher risk of loss than our other loans and debt products in which we have a first priority position.

To a lesser extent, we provide second lien, subordinated / mezzanine loans, other debt products and equity-linked products, which are typically junior in right of payment to obligations to customers’ senior secured lenders and contain either junior or no collateral rights. As a result of their junior nature, we may be limited in our ability to enforce our rights to collect principal and interest on these loans and other debt products or to recover any of their outstanding balance through a foreclosure of collateral. For example, typically we are not contractually entitled to receive payments of principal on a junior loan or other debt product until the senior loan or other debt product is paid in full, and we may only receive interest payments on a second lien or subordinated / mezzanine asset if the customer is not in default under its senior secured loan. In many instances, we are also prohibited from foreclosing on collateral securing a second lien, subordinated / mezzanine loan or other debt product until the senior loan is paid in full. Moreover, any amounts that we might realize as a result of our collection efforts or in connection with a bankruptcy or insolvency proceeding involving a customer under a second lien, subordinated / mezzanine loan or other debt product must generally be turned over to the senior secured lender until the senior secured lender has realized the full value of its own claims. These restrictions may materially and adversely affect our ability to recover the principal of any non-performing senior subordinate, second lien, subordinated / mezzanine loans and other debt product. In addition, on occasion we provide senior loans or other debt products that are contractually subordinated to one or more senior secured loans for the customer. In those cases we may have a first lien security interest, but one or more creditors have payment priority over us. As of December 31, 2009, our second lien and, subordinated/mezzanine loans totaled $41.0 million.

If interest rates rise, demand for our loans or other debt products may decrease and some of our existing customers may be unable to service interest on their loans or other debt products.

Most of our loans and other debt products bear interest at floating interest rates. To the extent interest rates increase, monthly interest obligations owed by our customers to us will also increase. Demand for our loans or other debt products may decrease as interest rates rise or if interest rates are expected to rise in the future. In addition, if prevailing interest rates increase, some of our customers may not be able to make the increased interest payments or refinance their balloon and bullet transaction, resulting in payment defaults and loan impairments. Conversely if interest rates decline, our customers may refinance the loans they have with us at lower interest rates, or with others, leading to lower revenues.

Errors by, or dishonesty of, our employees in making credit decisions or in our loan and other debt product servicing activities could result in credit losses and harm our reputation.

We rely heavily on the performance and integrity of our employees in making our initial credit decisions with respect to our loans and other debt products and in servicing our loans and other debt products after they have closed. Because there is generally little or no publicly available information about our customers, we cannot independently confirm or verify the information our employees provide us for use in making our credit and funding decisions. Errors by our employees in assembling, analyzing or recording information concerning our customers could cause us to originate loans or fund subsequent advances that we would not otherwise originate or fund, which could result in loan losses. Losses could also arise if any of our employees were dishonest, particularly if they colluded with a customer to misrepresent the creditworthiness of a prospective customer or to

 

15


Table of Contents

provide inaccurate reports regarding the customer’s compliance with the covenants in its loan or other debt products agreement. If, based on an employee’s dishonesty, we made a loan or other debt product to a customer that was not creditworthy or failed to exercise our rights under a loan or other debt product agreement against a customer that was not in compliance with covenants in the agreement, we could lose some or all of the principal of the loan or other debt product. Fraud or dishonesty on the part of our employees could also damage our reputation which could harm our competitive position and adversely affect our business.

We are not the sole lender or agent for most of our loans or other debt products. Consequently, we do not have absolute control over how these loans or other debt products are administered or have control over those loans. When we are not the sole lender or agent, we may be required to seek approvals from other lenders before we take actions to enforce our rights.

A majority of our loan portfolio consists of loans and other debt products in which we are neither the sole lender, the agent for the lending group that receives payments under the loan or other debt product nor the agent that controls the underlying collateral. For these loans and other debt products, we may not have direct access to the customer and, as a result, may not receive the same financial or operational information as we receive for loans or other debt products for which we are the agent. This may make it more difficult for us to track or rate these loans or other debt products. Additionally, we may be prohibited or otherwise restricted from taking actions to enforce the loan or other debt product or to foreclose upon the collateral securing the loan or other debt product without the agreement of other lenders holding a specified minimum aggregate percentage, generally a majority or two-thirds of the outstanding principal balance. It is possible that an agent for one of these loans or other debt products may choose not to take the same actions to enforce the loan or other debt product or to foreclose upon the collateral securing the loan that we would have taken had we been the agent for the loan or other debt product.

Our commitments to lend additional sums to customers may exceed our resources available to fund these commitments, adversely affecting our financial condition and results of operations.

Our contractual commitments to lend additional sums to our customers may exceed our resources available to fund these commitments. Some of our funding sources are only available to fund a portion of a loan and other funding sources may not be immediately available. Our customers’ ability to borrow these funds may be restricted until they are able to demonstrate, among other things, that they have sufficient collateral to secure the requested additional borrowings or that the borrowing conforms to specific uses or meets certain conditions. We may have miscalculated the likelihood that our customers will request additional borrowings in excess of our readily available funds. If our calculations prove incorrect, we will not have the funds to make these loan advances without obtaining additional financing. Our failure to satisfy our full contractual funding commitment to one or more of our customers could create breach of contract or other liabilities for us and damage our reputation in the marketplace, which could then adversely affect our financial condition and results of operations.

Because there is no active trading market for most of the loans and other debt products in our loan portfolio, we might not be able to sell them at a favorable price or at all. The lack of active secondary markets for some of our investments may also create uncertainty as to the value of these investments.

We may seek to dispose of one or more of our loans and other debt products to obtain liquidity or to reduce or limit potential losses with respect to non-performing assets. There is no established trading market for most of our loans and other debt products. In addition, the fair value of other debt products that have lower levels of liquidity or are not publicly-traded may not be readily determinable and may fluctuate significantly on a monthly, quarterly and annual basis. Because these valuations are inherently uncertain, may fluctuate over short periods of time and may be based on estimates, our determinations of fair value may differ materially from the values that we ultimately attain for these debt products or would be able to attain if we have to sell our other debt products. The value of our common stock could be adversely affected if our determinations regarding the fair value of these investments are materially higher than the values that we ultimately realize upon their disposal. In addition,

 

16


Table of Contents

given the limited trading market for our loans and other debt products and the uncertainty as to their fair value at any point in time, if we seek to sell a loan or other debt product to obtain liquidity or reduce or limit losses, we may not be able to do so at a favorable price or at all.

We selectively underwrite transactions that we may be unable to syndicate.

On a selective basis, we commit to underwrite transactions that are significantly larger than our internal hold targets and we then seek to syndicate any amounts in excess of our target. We may syndicate these loans to the NCOF or to other lenders. As part of the syndication process to the NCOF, we must hold the targeted loans for at least 31 days. After 31 days the NCOF may reject the loan should credit deteriorate. If we are unable to syndicate these commitments, we may have to sell the additional exposure on unfavorable terms, which could adversely affect our financial condition or results of operations. In addition, if we must hold a larger portion of a transaction than we would like, we may not be able to complete other transactions and our loan portfolio may become more concentrated, which could affect our business, financial condition and results of operations. If we hold a loan that exceeds our internal hold targets, we obtain a separate credit approval for the excess portion.

Risks Related to Our Funding and Leverage

Our ability to grow our business depends on our ability to obtain external financing. If our lenders terminate any of our credit facilities or if we default on our credit facilities, we may not be able to continue to fund our business.

We require a substantial amount of cash to provide new loans and other debt products and to fund our obligations to existing customers. In the past, we have obtained the cash required for our operations through the issuance of equity interests and by borrowing money through credit facilities, term debt securitizations and repurchase agreements. We may not be able to continue to access these or other sources of funds.

As of December 31, 2009, our $150 million credit facility with Citicorp was subject to an annual liquidity renewal in 2010. The credit facility is scheduled to mature on November 7, 2011. If Citicorp decides not to renew its credit facility with us on the respective annual renewal date, our ability to make new borrowings under that credit facility would terminate. In addition, we have another credit facility with a commitment of $50 million that matures in May 2010. During 2009, we entered into amendments to our credit facilities that reduced the size of the facilities by an aggregate amount of $179 million. Additionally, we converted our Wachovia Capital Markets, LLC facility into a $145.7 million three year secured term debt facility, and entered into an amendment that reduced the commitment amount of our term debt facility with Deutsche Bank AG, New York Branch by $150 million prior to its amortization period. Other key terms of these amendments included lower advance rates and pricing increases. Substantially all of our non-securitized loans and other debt products are held in these facilities. Our credit facilities contain customary representations and warranties, covenants, conditions, events of default and termination events that if breached, not satisfied or triggered, could result in termination of the facility. These events of default and termination events include, but are not limited to, failure to service debt obligations, failure to meet liquidity covenants and tangible net worth covenants, and failure to remain within prescribed facility portfolio delinquency and charge-off levels. Further, all cash flow generated by our loans and other debt products subject to a particular facility would go to pay down our borrowings thereunder rather than to us if we are in default. Additionally, if the facility were terminated due to our breach, noncompliance or default, our lenders could liquidate or sell all or a portion of our loans and other debt products held in that facility. Also, if we trigger a default or there is a termination event under one facility and that default or termination results in a payment default or in the acceleration of that facility’s debt, it may trigger a default or termination event under our other facilities that have cross-acceleration or payment cross-default provisions. Consequently, if one or more of these facilities were to terminate prior to its expected maturity date, our liquidity position would be materially adversely affected, and we may not be able to satisfy our undrawn commitment balances, originate new loans or other debt products or continue to fund our operations. Even if we are able to refinance our debt, we may not be able to do so on favorable terms. If we are not able to obtain additional funding on favorable terms or at all, our ability to grow our business will be impaired.

 

17


Table of Contents

Our deferred financing fees amortize over the contractual life of the related financing facility.

We have recorded deferred financing fees associated with most of our financing facilities. These deferred financing fees amortize over the contractual life of the financing facility. If a financing facility were to terminate before the contractual maturity date, we would be required to accelerate amortization of the remaining balance of the deferred financing fees which could have a negative impact our results of operations and financial condition. For example, in 2010 we used funds from our new term debt securitization to repay our term debt facility with Deutsche Bank, which resulted in the accelerated amortization of deferred financing fees under this facility.

The recent disruptions in the global financial markets may continue to negatively impact our ability to raise additional capital.

On January 5, 2010, we completed a $75.0 million corporate debt financing and on January 7, 2010, we completed a $275.0 million term debt financing, net of a $3.4 million discount. Although we were able to complete these two financings, we expect to continue to experience difficulty and higher cost in securing term debt financing for our loan portfolio as a result of the current economic climate and tightness in the capital markets. The financings we completed in January 2010, and the financings we have renewed and the amendments to existing credit facilities we have obtained in 2009, have been more expensive and provide lower advance rates than similar transactions completed in prior periods. While we believe that we will benefit from these market conditions by re-pricing our existing loans when possible and originating new loans when possible at significantly higher yields and potentially on more favorable terms, we expect to be negatively impacted by the trend toward higher cost of borrowing and lower leverage in 2009 and in future periods.

Our lenders and noteholders could terminate us as servicer of our loans, which would adversely affect our ability to manage our loan portfolio and reduce our net interest income.

Upon the occurrence of specified default events, our lenders under our credit facilities and the holders of the notes issued in our term debt securitizations may elect to terminate us as servicer of the loans and other debt products under the applicable facility and appoint a successor servicer. These default events include, but are not limited to, the loss of any four named members of our senior management, including our Chief Executive Officer and Chief Investment Officer. We do not maintain key man life insurance on any of our senior management nor have we taken any other precautions to offset the financial loss we could incur as a result of any of their departures.

If we are terminated as servicer, we will no longer receive our servicing fee. In addition, because any successor servicer may not be able to service our loan portfolio according to our standards, any transfer of servicing to a successor servicer could result in reduced or delayed collections, delays in processing payments and information regarding the loans and other debt products and a failure to meet all of the servicing procedures required by the applicable servicing agreement. Consequently, the performance of our loans and other debt products could be adversely affected and our income generated from those loans and other debt products significantly reduced.

Our liquidity position could be adversely affected if we were unable to complete additional term debt securitizations in the future, or if the reinvestment periods in our term debt securitizations terminate early, which could create a material adverse affect on our financial condition and results of operations.

We have completed four term debt securitizations to fund our loans and other debt products, all of which we accounted for on our balance sheet, through which we issued $1.5 billion of notes. On January 7, 2010, we completed our first term debt securitization since 2007. Our term debt securitizations consist of asset securitization transactions in which we transfer loans and other debt products to a trust that aggregates our loans and, in turn, sells notes, collateralized by the trust’s assets, to institutional investors. The notes issued by the trusts have been rated by nationally recognized statistical rating organizations. The ratings range from AAA to B by Standard & Poor’s, Inc. and Fitch Ratings, Inc. and Aa2 to Caa2 by Moody’s Investors Service, Inc., depending on the class of notes.

 

18


Table of Contents

We intend to complete additional term debt securitizations in the future. Several factors will affect demand for, and our ability to complete additional term debt securitizations, including:

 

   

disruptions in the capital markets generally, and the asset-backed securities market in particular;

 

   

disruptions in the credit quality and performance of our loan portfolio, particularly that portion which has been previously securitized and serves as collateral for existing term debt securitizations;

 

   

our ability to service our loan portfolio must continue to be perceived as adequate to make the issued securities attractive to investors; and

 

   

any material downgrading or withdrawal of ratings given to securities previously issued in our term debt securitizations.

If we are unable to complete additional term debt securitizations, our ability to obtain the capital needed for us to continue to operate and grow our business would be adversely affected. In addition, our credit facilities are only intended to provide short-term financing for our transactions. If we are unable to finance our transactions over the longer term through our term debt securitizations, our credit facilities may not be renewed. Moreover, our credit facilities typically carry a higher interest rate than our term debt securitizations. Accordingly, our inability to complete additional term debt securitizations in the future could have a material adverse effect on our financial conditions and result of operations. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Market Conditions.”

If a specified default event occurred in a term debt securitization, the reinvestment period would be terminated. This could have an adverse effect on our ability to fund new assets.

The cash flows we receive from the interests we retain in our term debt securitizations could be delayed or reduced due to the requirements of the term debt securitization.

We have retained 100% of the junior-most interests, which we refer to as the trust certificates, issued in the term debt securitizations, totaling $129.4 million in principal amount, issued in each of our three term debt securitizations that we have completed through December 31, 2009. We also retained trust certificates for the junior-most interests, totaling $87.9 million in our most recent securitization completed in January 2010. The notes issued in the term debt securitizations that we did not retain are senior to the trust certificates we did retain. Cash flows generated by the retained interest in these trust certificates were $30.7 million and $39.2 million for the years ended December 31, 2009 and 2008, respectively. Our receipt of future cash flows on the trust certificates is governed by provisions that control the distribution of cash flows from the loans and other debt products included in our term debt securitizations. On a quarterly basis, interest cash flows from the loans and other debt products must first be used to pay the interest on the senior notes and expenses of the term debt securitization. Any funds remaining after the payment of these amounts are distributed to us.

Several factors may influence the timing and amount of the cash flows we receive from loans and other debt products included in our term debt securitizations, including:

 

   

if any loan or other debt product included in a term debt securitization becomes 60 days or more delinquent or is charged off, all funds, after paying expenses and interest to the senior notes, go to a reserve account which then pays down an amount of senior notes equal to the amount of the delinquent loan or other debt product. Except for specified management fees, we will not receive any distributions from funds during this period; and

 

   

if other specified events occur to the trusts, for example an event of default, our cash flows would be used to reduce the outstanding balance of the senior notes and would not be available to us until the full principal balance of the senior notes has been repaid.

 

19


Table of Contents

We have obtained a significant portion of our debt financing through a limited number of financial institutions. This concentration of funding sources exposes us to funding risks.

We have obtained our credit facility financing from a limited number of financial institutions. Our reliance on the underwriters of our debt financing and their affiliates for a significant amount of our funding exposes us to funding risks. If these participating lenders determined to terminate our credit facilities, we would need to establish new lending relationships to satisfy our funding needs.

Risks Related to Our Operations and Financial Results

Our quarterly net interest income and results of operations are difficult to forecast and may fluctuate substantially.

Our quarterly net interest income and results of operations are difficult to forecast. We may experience substantial fluctuations in net interest income and results of operations from quarter to quarter. You should not rely on our results of operations in any prior reporting period to be indicative of our performance in future reporting periods. Many different factors could cause our results of operations to vary from quarter to quarter, including:

 

   

the success of our origination activities;

 

   

pre-payments on our loan portfolio;

 

   

credit losses and default rates;

 

   

our ability to enter into financing arrangements;

 

   

competition;

 

   

seasonal fluctuations in our business, including the timing of transactions;

 

   

costs of compliance with regulatory requirements;

 

   

private equity activity;

 

   

the timing of any future acquisitions;

 

   

personnel changes;

 

   

changes in prevailing interest rates;

 

   

general changes to the U.S. and global economies; and

 

   

political conditions or events.

We base our current and future operating expense levels and our investment plans on estimates of future net interest income, transaction activity and rate of growth. We expect that our expenses will increase in the future, and we may not be able to adjust our spending quickly enough if our net interest income falls short of our expectations. Any shortfalls in our net interest income or in our expected growth rates could result in decreases in our stock price.

Our business is highly dependent on key personnel.

Our future success depends to a significant extent on the continued services of our Chief Executive Officer and our Chief Investment Officer as well as other key personnel. While we entered into new three-year employment agreements with each of these officers in December 2009, if we were to lose the services of any of these executives for any reason, including voluntary resignation or retirement, we may not be able to replace them with someone of equal skill or ability and our business may be adversely affected. Moreover, we may not function well without the continued services of these executives.

 

20


Table of Contents

We may not be able to attract and retain the highly skilled employees we need to support our business.

Our ability to originate and underwrite loans and other debt products is dependent on the experience and expertise of our employees. In order to grow our business, we must attract and retain qualified personnel, especially origination and credit personnel with relationships with referral sources and an understanding of small and middle-market businesses and the industries in which our borrowers operate. Many of the financial institutions with which we compete for experienced personnel may be able to offer more attractive terms of employment. If any of our key origination personnel leave, our new loan and other debt product volume from their business contacts may decline or cease, regardless of the terms of our loan and other debt product offerings or our level of service. In addition, we invest significant time and expense in training our employees, which increases their value to competitors who may seek to recruit them and increases the costs of replacing them. As competition for qualified employees grows, our cost of labor could increase, which could adversely impact our results of operations.

Maintenance of our Investment Company Act exemption imposes limits on our operations.

We intend to conduct our operations so that we are not required to register as an investment company under the Investment Company Act of 1940, as amended, which we refer to as the Investment Company Act. Section 3(a)(1)(C) of the Investment Company Act defines as an investment company any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire investment securities having a value exceeding 40.0% of the value of the issuer’s total assets (exclusive of government securities and cash items) on an unconsolidated basis. Excluded from the term “investment securities” are, among other things, securities issued by majority-owned subsidiaries that are not themselves investment companies and are not relying on the exception from the definition of investment company in Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.

We expect that many of our majority-owned subsidiaries, including those which we have created (or may in the future create) in connection with our term debt securitizations, will rely on exceptions and exemptions from the Investment Company Act available to certain structured finance companies and that our interests in those subsidiaries will not constitute “investment securities” for purposes of the Investment Company Act. Because these exceptions and exemptions may, among other things, limit the types of assets these subsidiaries may purchase or counterparties with which we may deal, we must monitor each subsidiary’s compliance with its applicable exception or exemption.

We must also monitor our loan portfolio to ensure that the value of the investment securities we hold does not exceed 40.0% of our total assets (exclusive of government securities and cash items) on an unconsolidated basis. If the combined value of the investment securities issued by our subsidiaries that are investment companies or that must rely on the exceptions provided by Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act rather than another exception or exemption, together with any other investment securities we may own, exceeds 40.0% of our total assets on an unconsolidated basis, we may be deemed to be an investment company. Because we believe that the interests we hold in our subsidiaries generally will not be investment securities, we do not expect to own nor do we propose to acquire investment securities in excess of 40.0% of the value of our total assets on an unconsolidated basis.

We intend to monitor for compliance with the Investment Company Act on an ongoing basis and may be compelled to take or refrain from taking actions, to acquire additional income or loss generating assets or to forego opportunities that might otherwise be beneficial or advisable, including, but not limited to selling assets that are considered to be investment securities or foregoing sale of assets which are not investment securities, in order to ensure that we (or a subsidiary) may continue to rely on the applicable exceptions or exemptions. These limitations on our freedom of action could have a material adverse effect on our financial condition and results of operations.

 

21


Table of Contents

If we fail to maintain an exemption, exception or other exclusion from registration as an investment company, we could, among other things, be required to substantially change the manner in which we conduct our operations either to avoid being required to register as an investment company or to register as an investment company. If we were required to register as an investment company under the Investment Company Act, we would become subject to substantial regulation with respect to, among other things, our capital structure (including our ability to use leverage), management, operations, transactions with affiliated persons (as defined in the Investment Company Act), portfolio composition, including restrictions with respect to diversification and industry concentration, and our financial condition and results of operations may be adversely affected. Additionally, criminal and civil actions could be brought against us, our contracts would be unenforceable unless a court was to require enforcement, and a court could appoint a receiver to take control of us and liquidate our business.

Risks Related to Our Operating and Trading History

We have incurred losses in the past as a startup company and may not achieve profitability in future periods.

For the years ended December 31, 2009 and 2007, we recorded net losses of $44.3 million and $8.6 million, respectively. For the year ended December 31, 2008, we recorded net income of $22.4 million. The loss for 2009 was primarily due to the specific provision for loan losses of $132.5 million. The loss for 2007 was primarily due to a loss of $30.6 million on our residual interest in a securitization and a loss of $20.3 million due to the recognition of impairments of investments in debt securities. We may not be profitable in future periods for a variety of reasons. If we are unable to achieve, maintain and increase our profitability in the future, the market value of our common stock could further decline.

We have been in operation since June 2004, which may not serve as an adequate time frame to evaluate our business, results of operations and prospects and may increase the risk of your investment.

Because of our limited operating history, our historical results of operations may not provide a meaningful basis for evaluating our business, results of operations and prospects. You should evaluate our business, results of operations and prospects in light of the risks and difficulties we may encounter as an early-stage company in a highly competitive industry, including our potential inability to:

 

   

successfully compete for transaction opportunities;

 

   

raise debt and equity capital on attractive terms;

 

   

continue to grow and manage our growth effectively;

 

   

accurately forecast the level of credit losses that we may experience in our loan portfolio;

 

   

successfully hire and retain key personnel; or

 

   

effectively manage our business.

We may not be able to successfully address these risks and difficulties, which could adversely affect our business, results of operations and prospects.

We are in a highly competitive business and may not be able to compete effectively, which could impact our profitability.

The commercial lending industry is highly competitive and includes a number of competitors who provide similar types of loans to our target customers. Our principal competitors include a variety of:

 

   

specialty and commercial finance companies, including business development companies and real estate investment trusts;

 

   

private investment funds and hedge funds;

 

22


Table of Contents
   

national and regional banks;

 

   

investment banks; and

 

   

insurance companies.

Some of our competitors offer a broader range of financial, lending and banking services than we do and can leverage their existing customer relationships to offer and sell services that compete directly with our products and services. In addition, some of our competitors have greater financial, technical, marketing, origination and other resources than we do. They may also have greater access to capital than we do and at a lower cost than is available to us. For example, if national and regional banks or other large competitors seek to expand within or enter our target markets, they may provide loans at lower interest rates to gain market share, which could force us to lower our rates and result in decreased returns. As a result of competition, we may not be able to attract new customers, retain existing customers or sustain the rate of growth that we have experienced to date, and our ability to expand our loan portfolio and grow future revenue may decline. If our existing customers choose to use competing sources of credit to refinance their debt, our loan portfolio could be adversely affected.

We are subject to regulation and any changes in such regulations could affect our business and our profitability.

We are subject to federal, state and local laws and regulations that govern non-depository commercial lenders and businesses generally. Any changes in such laws or regulations could affect our business and profitability. In addition, if we expand our business into areas or jurisdictions that are subject to, or have adopted, more stringent laws and regulations than those that are currently applicable to us and our business, we may have to incur significant additional expense or restrict our operations in order to comply, which could adversely impact our business, results of operations or prospects.

Our common stock may continue to have a volatile public trading price.

Historically, the market price of our common stock has been highly volatile, and the market for our common stock has experienced significant price and volume fluctuations, some of which are unrelated to our company’s operating performance. Since our common stock began trading publicly on December 14, 2006, the trading price of our stock has fluctuated from a high of $20.85 to a low of $0.61. It is likely that the market price of our common stock will continue to fluctuate in the future. Factors which may have a significant adverse effect on our common stock’s market price include:

 

   

the rate of charge-offs, impairments and non-accruals in our loan portfolio;

 

   

fluctuations in interest rates and the actual or perceived impact of these rates on our current customers and future prospects;

 

   

changes to the regulatory environment in which we operate;

 

   

our ability to raise additional capital and the terms on which we can secure such capital;

 

   

general market and economic conditions; and

 

   

quarterly fluctuations in our revenues and other financial results.

The reported average daily trading volume of our common stock for the twelve-month period ending December 31, 2009 was approximately 117,000 shares, however our trading volume has exceeded 1,000,000 shares on several occasions since our initial public offering. Such a low average trading volume may impact our shareholders’ ability to buy and sell shares of our common stock.

 

23


Table of Contents
Item 1B. Unresolved Staff Comments

None.

 

Item 2. Properties

Our headquarters is located at 500 Boylston Street, Suite 1250, Boston, Massachusetts 02116, where we sublease 15,116 square feet of office space under a sublease which expires in 2013. We also maintain leased offices in Darien, Connecticut, and Chicago, Illinois. We believe our office facilities are suitable and adequate for us to conduct our business.

 

Item 3. Legal Proceedings

The Company from time to time is involved in litigation in the ordinary course of business. We are not currently subject to any material pending legal proceedings.

 

Item 4. Reserved

 

24


Table of Contents

PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

As of March 3, 2010, there were approximately 86 stockholders of record. The number of stockholders does not include individuals or entities who beneficially own shares but whose shares are held of record by a broker or clearing agency, but does include each such broker or clearing agency as one stockholder. American Stock Transfer & Trust Company serves as transfer agent for our shares of common stock.

Our common stock has traded on the NASDAQ Global Market under the symbol “NEWS” since December 14, 2006. The quarterly range of the high and low sales price for our common stock during 2009 and 2008 is presented below:

 

     2009    2008
     High    Low    High    Low

Quarter ended:

           

December 31

   $4.02    $2.32    $8.98    $2.46

September 30

   3.56    1.45    9.78    5.10

June 30

   3.01    1.72    7.04    4.55

March 31

   4.23    0.61    9.58    4.50

On March 3, 2010, the last reported closing price of our common stock on the NASDAQ Global Market was $6.57 per share.

The following graph shows a comparison from December 14, 2006 (the date our common stock commenced trading on the NASDAQ Global Market) through December 31, 2009 of cumulative total return for our common stock, the S&P 500 Index and the S&P Financials Index. The graph assumes a $100 investment at the closing price on December 14, 2006. Such returns are based on historical results and are not intended to suggest future performance. The following information in this Item 5 of this Annual Report on Form 10-K is not deemed to be “soliciting material” or to be “filed” with the SEC or subject to Regulation 14A or 14C under the Securities Exchange Act of 1934 or to the liabilities of Section 18 of the Securities Exchange Act of 1934, and will not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent we specifically incorporate it by reference into such a filing.

LOGO

Dividend Policy

We have never declared or paid cash dividends on our common stock. We do not anticipate paying any cash dividends on our common stock in the foreseeable future. We intend to retain all available funds and any future earnings to reduce debt and fund the development and growth of our business.

 

25


Table of Contents
Item 6. Selected Financial Data

Selected consolidated financial and other data for the periods and at the dates indicated.

 

     Year Ended December 31,  
    2009     2008     2007     2006     2005  
    ($ in thousands, except for share and per share data)  

Statement of Operations Data:

         

Interest income

  $ 136,569      $ 188,770      $ 204,295      $ 116,303      $ 33,883   

Interest expense

    41,927        86,216        109,703        68,728        18,639   
                                       

Net interest income

    94,642        102,554        94,592        47,575        15,244   

Provision for credit losses

    133,093        38,224        19,510        12,535        7,755   
                                       

Net interest income (loss) after provision for credit losses

    (38,451     64,330        75,082        35,040        7,489   

Fee income

    1,657        4,518        15,797        5,849        2,966   

Asset management income

    2,934        6,283        5,304        1,443        16   

Gain on derivatives

    533        2,157        777        909        46   

Gain (loss) on sale of loans and debt securities

    —          282        (4,615     474        114   

Loss on investments in debt securities

    —          (932     (20,303     (597     —     

Loss on residual interest in securitization

    —          (631     (30,556     —          —     

Other income

    5,529        7,253        5,420        1,606        2   
                                       

Total non-interest income

    10,653        18,930        (28,176     9,684        3,144   

Compensation and benefits

    26,403        30,413        45,364        65,079        16,168   

Occupancy and equipment

    3,121        3,286        2,718        1,758        1,124   

General and administrative expenses

    12,911        11,090        9,412        7,445        2,757   
                                       

Total operating expenses

    42,435        44,789        57,494        74,282        20,049   
                                       

Income (loss) before income taxes

    (70,233     38,471        (10,588     (29,558     (9,416

Income tax expense (benefit)

    (24,353     16,073        (1,949     (2,377     (3,517
                                       

Net income (loss) before noncontrolling interest

    (45,880     22,398        (8,639     (27,181     (5,899

Net loss attributable to noncontrolling interest

    1,620        —          —          —          —     
                                       

Net income (loss) attributable to NewStar Financial, Inc. common stockholders

  $ (44,260   $ 22,398      $ (8,639   $ (27,181   $ (5,899
                                       

Income (loss) per share:

         

Basic

  $ (0.90   $ 0.46      $ (0.23   $ (1.65   $ (0.83

Diluted

    (0.90     0.46        (0.23   $ (1.65   $ (0.83

Weighted average shares outstanding:

         

Basic

    49,119,285        48,340,067        36,900,640        16,480,836        7,110,363   

Diluted

    49,119,285        48,340,067        36,900,640        16,480,836        7,110,363   

Outstanding shares of common stock

    49,994,858        48,466,166        43,355,713        36,257,847        —     

 

26


Table of Contents
     December 31,  
     2009     2008     2007  

Balance Sheet Data:

      

Cash and cash equivalents

   $ 39,848      $ 50,279      $ 76,155   

Restricted cash

     136,884        84,163        115,807   

Residual interest in securitization

     —          —          631   

Investments in debt securities, available-for-sale

     4,183        3,025        35,498   

Loans, held-for-sale

     15,736        —          112,944   

Loans, net

     1,878,978        2,328,812        2,201,442   

Other assets

     124,443        105,243        80,288   
                        

Total assets

   $ 2,200,072      $ 2,571,522      $ 2,622,765   
                        

Repurchase agreements

   $ —        $ —        $ 63   

Credit facilities

     91,890        411,267        677,739   

Term debt

     1,523,052        1,524,171        1,364,725   

Other liabilities

     35,010        54,529        77,548   
                        

Total liabilities

     1,649,952        1,989,967        2,120,075   

Total stockholders’ equity

     550,120        581,555        502,690   

Supplemental Data:

      

Investments in debt securities, gross

   $ 6,635      $ 6,839      $ 38,787   

Loans held-for-sale, gross

     15,990        —          115,055   

Loans held-for-investment, gross

     2,013,588        2,402,309        2,248,480   
                        

Loans and investments in debt securities, gross

     2,036,213        2,409,148        2,402,322   

Unused lines of credit

     230,838        339,230        454,837   

Standby letters of credit

     18,771        32,358        20,382   
                        

Total funding commitments

   $ 2,285,822      $ 2,780,736      $ 2,877,541   
                        

Loan portfolio

   $ 2,036,213      $ 2,409,148      $ 2,402,322   

Loans owned by the NCOF

     542,504        561,241        578,272   
                        

Managed loan portfolio

   $ 2,578,717      $ 2,970,389      $ 2,980,594   
                        

Loans held-for-sale, gross

   $ 15,990      $ —        $ 115,055   

Loans held-for-investment, gross

     2,013,588        2,402,309        2,248,480   
                        

Total loans, gross

     2,029,578        2,402,309        2,363,535   

Deferred fees, net

     (20,999     (20,998     (15,762

Allowance for loan losses—general

     (38,485     (36,786     (28,795

Allowance for loan losses—specific

     (75,380     (15,713     (4,592
                        

Total loans, net

   $ 1,894,714      $ 2,328,812      $ 2,314,386   
                        

Average Balances (1):

      

Loans and other debt products, gross

   $ 2,258,237      $ 2,415,436      $ 2,038,678   

Interest earning assets (2)

     2,379,622        2,551,602        2,234,916   

Total assets

     2,397,468        2,612,285        2,243,524   

Interest bearing liabilities

     1,782,105        1,962,796        1,767,993   

Equity

     572,417        566,173        439,650   

 

27


Table of Contents
     Year Ended December 31,  
     2009     2008     2007  

Performance Ratios (3):

      

Return on average assets

   (1.85 )%    0.86   (0.39 )% 

Return on average equity

   (7.73   3.96      (1.97

Net interest margin, before provision

   3.98      4.02      4.23   

Loan portfolio yield

   6.03      7.67      9.63   

Efficiency ratio

   39.69      36.87      86.57   

Credit Quality and Leverage Ratios (4):

      

Delinquent loan rate (at period end)

   6.15   0.69   —     

Delinquent loan rate for accruing loans 60 days or more past due (at period end)

   0.99   —        —     

Non-accrual loan rate (at period end)

   8.08 %   2.52 %   0.97 %

Non-performing asset rate (at period end)

   8.55 %   2.82 %   0.97 %

Net charge off rate (end of period loans)

   3.61 %   0.82 %   0.20 %

Net charge off rate (average period loans)

   3.22 %   0.82 %   0.23 %

Allowance for credit losses ratio (at period end)

   5.68   2.25   1.58

Debt to equity (at period end)

   2.96x      3.33x      4.06x   

Equity to assets (at period end)

   24.87   22.62   19.17

 

(1) Averages are based upon the average daily balance during the period.
(2) Includes loan portfolio, cash, cash equivalents and restricted cash.
(3) See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of the calculation of performance ratios.
(4) See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional information related to our credit quality and leverage ratios.

 

28


Table of Contents
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion contains forward-looking statements. Important factors that may cause actual results and circumstances to differ materially from those described in such statements is contained below and in Item 1A. “Risk Factors” of this report.

Overview

We are a commercial finance company that provides customized debt financing solutions to middle market businesses and commercial real estate borrowers and manages investment funds for large institutional investors. We principally focus on the direct origination of loans that meet our risk and return parameters. Our direct origination efforts target mid-sized companies, private equity sponsors, corporate executives, regional banks, real estate investors and a variety of other financial intermediaries to source transaction opportunities. Direct origination provides direct access to customers’ management, enhances due diligence, and allows significant input into customers’ capital structure and direct negotiation of transaction pricing and terms.

We operate as a single segment and derive revenues from two specialized lending groups:

 

   

Middle Market Corporate, which originates, structures and underwrites senior debt and, to a lesser extent, second lien, mezzanine and subordinated debt, and equity and equity-linked products for companies with annual EBITDA typically between $5 million and $50 million; and

 

   

Commercial Real Estate, which originates, structures and underwrites first mortgage debt and, to a lesser extent, subordinated debt, primarily to finance acquisitions of real estate properties typically valued between $10 million and $50 million.

Subsequent to December 31, 2007, we discontinued the origination of structured products and continue to manage the remaining portfolio within our Middle Market Corporate lending group. As of December 31, 2009, this portfolio had an outstanding balance of $40.7 million.

Market Conditions

While the economy remains weak, economic conditions improved in the second half of 2009, showing signs of improvement as GDP growth resumed following a year of steady contraction. While volumes in the loan market remained low, we are seeing areas of improvement, such as the strong rebound of the high-yield market.

Increasing loan values have also led to some improvement in the term debt securitization, or CLO market where bonds are now trading at higher levels. We expect this favorable trend to continue if there is positive investor sentiment of the macro-economy, default expectations recalibrate, spreads tighten across other types of asset-backed securities and corporate credit continues to improve into 2010.

Although the economy has improved, amendments and renewals of our existing credit facilities obtained in 2009 and the CLO we completed in January of 2010 have been at lower committed amounts, higher interest rates and provide lower advance rates than similar transactions completed in prior periods. While we have been negatively impacted by the trend toward higher cost of borrowing and lower leverage, we believe that we have also benefitted from these market conditions by re-pricing our existing loans when possible, and originating new loans when possible at significantly higher yields and in many cases on more favorable terms.

During the second half of 2009, the negative credit migration in our loan portfolio moderated, but the difficult economic conditions continued to have a negative impact on the financial performance of our borrowers and their ability to make their scheduled payments. As such, we continued to increase our allowance for credit losses. We are closely monitoring the credit quality of our loans. We expect loan delinquencies, non-accruals, and charge offs to remain elevated due to weak economic conditions.

 

29


Table of Contents

As a result of the current market and funding conditions, opportunities in the commercial real estate market have slowed, and the quality of our commercial real estate loans’ underlying collateral has declined. Should we foreclose on any of our commercial real estate loans, our recovery rates would be negatively impacted by these market and funding conditions. Moreover, refinancing current real estate loans has been and will continue to be difficult. We have not originated any new commercial real estate loans since the first quarter of 2008.

Recent Developments

Liquidity

On November 3, 2009, we amended our credit facility with Citicorp North America, Inc. (“Citicorp”), which reduced the commitment amount under the facility to $150 million from $300 million and extended the facility’s liquidity line until November 2010, completing the annual renewal. The amendment was effective as of November 17, 2009. The facility is scheduled to mature on November 7, 2011.

On January 5, 2010, we entered into a note agreement with Fortress Credit Corp., an affiliate of Fortress Investment Group (“Fortress”). Under the terms of the note agreement, Fortress agreed to provide a $75 million revolving credit facility. The credit facility is scheduled to mature on July 5, 2013.

On January 7, 2010, we completed a $275.0 million term debt securitization, net of a $3.4 million discount. As part of the securitization, investors purchased approximately $190.5 million floating-rate asset-backed notes. We retained the remaining $87.9 million of notes. The notes are expected to mature on July 30, 2018. Proceeds from this term debt securitization were used to repay all outstanding borrowings under our term debt facility with Deutsche Bank AG, New York Branch (“Deutsche”) and certain advances under our credit facility with Citicorp North America, Inc.

Stock Repurchase Program

On January 25, 2010, we announced that our Board of Directors has authorized the repurchase of up to $10 million of the Company’s common stock from time to time on the open market or in privately negotiated transactions. The timing and amount of any shares purchased will be determined by our management based on its evaluation of market condition and other factors. The repurchase program, which will expire on January 22, 2011 unless extended by the Board of Directors, may be suspended or discontinued at any time without notice.

Credit

As of December 31, 2009, we had 40 loans with an aggregate outstanding balance of $352.4 million classified as impaired. Nineteen of these impaired loans with an outstanding balance of $162.7 million were on non-accrual status as of December 31, 2009. During the year ended December 31, 2009, we recorded $132.5 million of specific provisions for impaired loans.

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007

NewStar’s basic and diluted loss per share for 2009 was $0.90 on a net loss of $44.3 million compared to basic and diluted income per share of $0.46 on net income of $22.4 million for 2008, and a basic and diluted loss per share of $0.23 on a net loss of $8.6 million for 2007. Our managed loan portfolio was $2.6 billion at December 31, 2009 compared to $3.0 billion at December 31, 2008 and 2007. During 2009, loans owned by the NCOF decreased $18.7 million to $542.5 million at year end.

As further described below, the most significant factors influencing our consolidated results of operations for the year ended December 31, 2009 as compared to the year ended December 31, 2008 were: (i) $132.5 million of specific provisions recorded for impaired loans during 2009; (ii) a decrease in asset management income; (iii) a decrease in syndication and other fee income; and (iv) a decrease in compensation and benefits expense.

 

30


Table of Contents

Loan portfolio yield

Loan portfolio yield, which is interest income on our loans divided by the average balances outstanding of our loans, was 6.03% for 2009, 7.67% for 2008 and 9.63% for 2007. The decrease from 2008 to 2009 in loan portfolio yield was primarily driven by a decrease in three-month LIBOR over the prior year, the increase of loans on non-accrual status and, to a lesser extent, changes in product mix and credit spreads in our loan portfolio. The portfolio yield for accruing loans was 6.41% for 2009. The decrease from 2007 to 2008 in loan portfolio yield was primarily driven by a decrease in prevailing interest rates over the prior year and, to a lesser extent, changes in product mix and credit spreads in our loan portfolio.

Net interest margin

Net interest margin, which is net interest income divided by average interest earning assets, was 3.98% for 2009, 4.02% for 2008 and 4.23% for 2007. The primary factors impacting net interest margin were changes in three-month LIBOR, non-accrual loans, our product mix, debt to equity ratio, credit spreads and cost of borrowings.

Efficiency ratio

Our efficiency ratio, which is total operating expenses divided by net interest income before provision for credit losses plus total non-interest income, was 39.69% for 2009, 36.87% for 2008 and 86.57% for 2007. The increase in our efficiency ratio during 2009 as compared to 2008 was primarily due to a decrease in net interest income and non-interest income during 2009. The decrease in our efficiency ratio during 2008 as compared to 2007 was primarily due to the $30.6 million loss on the residual interest during 2007 and impairment charges on investments in debt securities during 2007, as well as a decline in operating expenses during 2008.

Allowance for credit losses

Allowance for credit losses ratio, which is allowance for credit losses divided by outstanding gross loans excluding loans held-for-sale, was 5.68% at December 31, 2009, 2.25% as of December 31, 2008 and 1.58% as of December 31, 2007. The allowance for credit losses at December 31, 2009 included a specific allowance of $75.4 million and a general allowance of $39.1 million. The allowance for credit losses at December 31, 2008 included specific allowance of $15.7 million and a general allowance of $38.3 million. The allowance for credit losses at December 31, 2007 included a specific allowance of $4.6 million and a general allowance of $30.9 million. The increase in our specific allowance is primarily due to economic conditions negatively impacting our borrowers. During the second quarter of 2009, we adjusted our allowance for credit losses methodology regarding commercial real estate to better reflect deteriorating market conditions, which has increased the probability of default for borrowers with high loan to value ratios. We continually evaluate our allowance for credit losses methodology. If we determine that a change in our allowance for credit losses methodology is advisable, as a result of the rapidly changing economic environment or otherwise, the revised allowance methodology may result in higher levels of allowance. Moreover, if weakened market conditions persist, actual losses under our current or any revised methodology may differ materially from our estimate.

Delinquent loan rate

Delinquent loan rate, which is total delinquent loans that are 60 days or more past due, divided by outstanding gross loans, was 6.15% as of December 31, 2009 as compared to 0.69% as of December 31, 2008. Given prevailing economic and market conditions, we expect the delinquent loan rate to remain elevated as economic conditions negatively impact the financial performance of our borrowers and their ability to meet their obligations on a timely basis.

 

31


Table of Contents

Delinquent loan rate for accruing loans 60 days or more past due

Delinquent loan rate for accruing loans 60 days or more past due, which is total delinquent accruing loans net of charge offs that are 60 days or more past due and less than 90 days past due, divided by outstanding gross loans, was 0.99% as of December 31, 2009 as compared to 0% as of December 31, 2008. Given prevailing economic and market conditions, we expect the delinquent accruing loan rate to remain elevated as economic conditions negatively impact the financial performance of our borrowers and their ability to meet their obligations on a timely basis.

Non-accrual loan rate

Non-accrual loan rate is defined as total balances outstanding of loans on non-accrual status divided by the total outstanding balance of our loans held for investment. Loans are put on non-accrual status if they are 90 days or more past due or if management believes it is probable that the Company will be unable to collect contractual principal and interest in the normal course of business. The non-accrual loan rate was 8.08% as of December 31, 2009 and 2.52% as of December 31, 2008. As of December 31, 2009 and 2008 the aggregate outstanding value of non-accrual loans was $162.7 million and $60.6 million, respectively. Given prevailing economic and market conditions, we expect the non-accrual loan rate to remain elevated as economic conditions impair our borrowers’ ability to fully repay principal and interest under the terms of their loan agreement.

Non-performing asset rate

Non-performing asset rate is defined as the sum of total balances outstanding of loans on non-accrual status and other real estate owned, divided by the sum of the total outstanding balance of our loans held for investment and other real estate owned. The non-performing asset rate was 8.55% as of December 31, 2009 and 2.82% as of December 31, 2008. As of December 31, 2009 and 2008 the sum of the aggregate outstanding value of non-performing assets was $172.1 million and $68.0 million, respectively. Given prevailing economic and market conditions, we expect the non-performing asset rate to remain elevated as economic conditions impair our borrowers’ ability to fully repay principal and interest under the terms of their loan agreements.

Net charge off rate (end of period loans)

Net charge off rate as a percentage of end of period loan portfolio is defined as annualized charge offs net of recoveries divided by the total outstanding balance of our loans held for investment. A charge off occurs when management believes that all or part of the principal of a particular loan is no longer recoverable and will not be repaid. For the years ended December 31, 2009, 2008 and 2007, the net charge off rate was 3.61%, 0.82% and 0.20%, respectively. We expect the net charge off rate (end of period loans) to remain elevated as economic conditions impair our borrowers’ ability to fully repay principal and interest under the terms of their loan agreement.

Net charge off rate (average period loans)

Net charge off rate as a percentage of average period loan portfolio is defined as annualized charge offs net of recoveries divided by the average total outstanding balance of our loans held for investment for the period. For the years ended December 31, 2009, 2008 and 2007, the net charge off rate was 3.22%, 0.82% and 0.23%, respectively. We expect the net charge off rate (average period loans) to remain elevated as economic conditions impair our borrowers’ ability to fully repay principal and interest under the terms of their loan agreement.

Return on average assets

Return on average assets, which is net income divided by average total assets was not meaningful for 2009 and for 2007 as we had net losses. Return on average assets was 0.86% for 2008.

Return on average equity

Return on average equity, which is net income divided by average equity, was not meaningful for 2009 and for 2007 as we had net losses. Return on average equity was 3.96% for 2008.

 

32


Table of Contents

Review of Consolidated Results

A summary of NewStar’s consolidated financial results for the years ended December 31, 2009, 2008 and 2007 follows:

 

     Year Ended December 31,  
     2009     2008     2007  
     ($ in thousands)  

Net interest income:

      

Interest income

   $ 136,569      $ 188,770      $ 204,295   

Interest expense

     41,927        86,216        109,703   
                        

Net interest income

     94,642        102,554        94,592   

Provision for credit losses

     133,093        38,224        19,510   
                        

Net interest income (loss) after provision for credit losses

     (38,451     64,330        75,082   

Non-interest income:

      

Fee income

     1,657        4,518        15,797   

Asset management income

     2,934        6,283        5,304   

Gain on derivatives

     533        2,157        777   

Gain (loss) on sale of loans and debt securities

     —          282        (4,615

Loss on investments in debt securities

     —          (932     (20,303

Loss on residual interest in securitization

     —          (631     (30,556

Other income

     5,529        7,253        5,420   
                        

Total non-interest income

     10,653        18,930        (28,176

Operating expenses:

      

Compensation and benefits

     26,403        30,413        45,364   

Occupancy and equipment

     3,121        3,286        2,718   

General and administrative expenses

     12,911        11,090        9,412   
                        

Total operating expenses

     42,435        44,789        57,494   
                        

Income (loss) before income taxes

     (70,233     38,471        (10,588

Income tax expense (benefit)

     (24,353     16,073        (1,949
                        

Net income (loss) before noncontrolling interest

     (45,880     22,398        (8,639

Net loss attributable to noncontrolling interest

     1,620        —          —     
                        

Net income (loss)

   $ (44,260   $ 22,398      $ (8,639
                        

Comparison of the Years Ended December 31, 2009 and 2008

Interest income. Interest income decreased $52.2 million, to $136.6 million for 2009 from $188.8 million for 2008. The decrease was primarily due to a decrease in the yield on average interest earning assets to 5.74% from 7.40%, primarily driven by a decrease in three-month LIBOR and the increase in loans on non-accrual status. Average three-month LIBOR decreased from 3.23% for the year ended December 31, 2008 to 0.69% for the year ended December 31, 2009.

Interest expense. Interest expense decreased $44.3 million, to $41.9 million for 2009 from $86.2 million for 2008. The decrease was primarily due to a decrease in our cost of borrowings and a decrease in the average balance of our interest bearing liabilities. The decrease in our cost of borrowings, to 2.35% from 4.39%, was primarily attributable to a decrease in three-month LIBOR and increased use of lower cost term debt securitizations. The decrease in the average balance of our interest bearing liabilities is primarily attributable to the reduction of total debt from $1.9 billion as of December 31, 2008 to $1.6 billion as of December 31, 2009.

Net interest margin. Net interest margin decreased to 3.98% for 2009 from 4.02% for 2008. The decrease in net interest margin was primarily due to a decrease in our average yield on interest earning assets and

non-payment of interest income from non-accrual loans, partially offset by an increase in interest yields on 2009

 

33


Table of Contents

new loan originations and re-pricings and a decrease in our average cost of interest bearing liabilities. The decrease in yield and cost is primarily due to a decrease in three-month LIBOR. The net interest spread, the difference between gross yield on our interest earning assets and the total cost of our interest bearing liabilities, increased to 3.39% from 3.01%. The decline in LIBOR negatively impacted the net interest margin, which was partially offset by LIBOR floor provisions included in our customer contracts. At December 31, 2009, 39% of our adjustable rate loans included interest rate floors. Non-accrual loans negatively impacted the net interest margin by 0.25%, which was offset by an increase in interest spreads 0.32%. We expect our net interest margin to be negatively impacted in 2010 by an increase in our cost of funds from the new CLO and new revolving note credit facility with Fortress (both completed in January 2010), and the accelerated amortization of deferred financing fees resulting from the repayment of our Deutsche term debt facility.

The following table summarizes the yield and cost of interest earning assets and interest bearing liabilities for 2009 and 2008:

 

     Year Ended December 31, 2009     Year Ended December 31, 2008  
     ($ in thousands)  
     Average
Balance
   Interest
Income/
Expense
   Average
Yield/
Cost
    Average
Balance
   Interest
Income/
Expense
   Average
Yield/
Cost
 

Total interest earning assets

   $ 2,379,622    $ 136,569    5.74   $ 2,551,602    $ 188,770    7.40

Total interest bearing liabilities

     1,782,105      41,927    2.35        1,962,796      86,216    4.39   
                                

Net interest spread

      $ 94,642    3.39      $ 102,554    3.01
                                

Net interest margin

         3.98         4.02
                        

Provision for credit losses. The provision for credit losses increased to $133.1 million for 2009 from $38.2 million for 2008. The increase in the provision was primarily due to $132.5 million of specific provisions recorded during 2009 for impaired loans. The decrease in the general component of the provision for credit losses to 0.5% of the total provision for 2009, as compared to 19.3% of the total provision for 2008, was principally due to the migration of loans covered by our general allowance for credit losses to impaired loans covered by our specific allowance for credit losses as difficult economic conditions continued to have a negative impact on the financial performance of our borrowers and their ability to make their scheduled payments. Loans subject to our general allowance for credit losses declined to $1.7 billion at December 31, 2009 as compared to $2.3 billion at both December 31, 2008 and 2007. Our general allowance for credit losses covers probable losses in our loan portfolio with respect to loans for which no specific impairment has been identified. A specific provision for credit losses is recorded with respect to loans for which it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the loan agreement for which there is impairment recognized. Impaired loans, which include all of our delinquent loans and all troubled debt restructurings, as a percentage of “Loans, net” increased to 18% as of December 31, 2009 as compared to 5% as of December 31, 2008. In accordance with ASC 310 (formerly SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”), when a loan is classified as impaired, the loan is evaluated for a specific allowance and a specific provision may be recorded, thereby removing it from consideration under the general component of the allowance analysis. Consequently, as the number and aggregate amount of impaired loans have increased and we have added to the specific reserve, the aggregate amount of loans being evaluated under our general allowance analysis has decreased.

In accordance with ASC 310 (formerly SFAS No. 5, Accounting for Contingencies), a base allowance is provided for loans that are not impaired. The Company employs a variety of internally developed and third-party modeling and estimation tools for measuring credit risk, which are used in developing an allowance for loan losses on outstanding loans. The Company’s allowance framework addresses economic conditions, capital market liquidity and industry circumstances from both a top-down and bottom-up perspective. The Company considers and evaluates changes in economic conditions, credit availability, industry and multiple obligor concentrations in assessing both probabilities of default and loss severities as part of the general component of the allowance for loan losses.

 

34


Table of Contents

On at least a quarterly basis, loans are internally risk-rated based on individual credit criteria, including loan type, loan structures (including balloon and bullet structures common in the Company’s Middle Market Corporate and Commercial Real Estate cash flow loans), borrower industry, payment capacity, location and quality of collateral if any (including the Company’s Commercial Real Estate loans). Borrowers provide the Company with financial information on either a monthly or quarterly basis. Ratings, corresponding assumed default rates and assumed loss severities are dynamically updated to reflect any changes in borrower condition or profile.

For Middle Market Corporate loans, the data set used to construct probabilities of default in its allowance for loan losses model, Moody’s CRD Private Firm Database, primarily contains middle market loans that share attributes similar to the Company’s loans. The Company also considers the quality of the loan terms in determining a loan loss in the event of default.

For Commercial Real Estate loans, the Company employs two mechanisms to capture the impact of industry and economic conditions. First, a loan’s risk rating, and thereby its assumed default likelihood, can be adjusted to account for overall commercial real estate market conditions. Second, to the extent that economic or industry trends adversely affect a borrower’s loan-to-value ratio enough to impact its repayment ability, the Company applies a stress multiplier to the loan’s probability of default. The multiplier is designed to account for default characteristics that are difficult to quantify when market conditions cause commercial real estate prices to decline.

Additionally, when determining the amount of the general allowance, the Company supplements the base amount with a judgmental amount which is governed by a score card system comprised of ten individually weighted risk factors. The risk factors are designed based on those outlined in the Comptrollers of the Currency’s Allowance for Loan and Lease Losses Handbook. The Company also performs a ratio analysis of comparable money center banks, regional banks and finance companies. While the Company does not rely on this peer group comparison to set the level of allowance for credit losses, it does assist management in identifying market trends and serves as an overall reasonableness check on the allowance for credit losses computation.

In accordance with ASC 310 (formerly SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”), a loan is considered impaired when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impairment of a loan is based upon (i) the present value of expected future cash flows discounted at the loan’s effective interest rate, (ii) the loan’s observable market price, or (iii) the fair value of the collateral if the loan is collateral dependent, depending on the circumstances and our collection strategy. Impaired loans are identified based on the loan-by-loan risk rating process described above. It is the Company’s policy during the reporting period to record a specific provision for credit losses for all loans for which we have serious doubts as to the ability of the borrowers to comply with the present loan repayment terms.

Impaired loans at December 31, 2009 and 2008 were in both Commercial Real Estate and in Middle Market Corporate, over a range of industries impacted by the then current economic environment including the following: Buildings and Commercial Real Estate, Broadcast and Entertainment, Nondurable Consumer Products, Energy and Chemical Services, Industrial and Other Business Services. For impaired Middle Market Corporate loans, the Company measured impairment based on expected cash flows utilizing relevant information provided by the borrower and consideration of other market conditions or specific factors impacting recoverability. Such amounts are discounted based on original loan terms. For impaired Commercial Real Estate loans, the Company determined that the loans were collateral dependent and measured impairment based on the fair value of the related collateral utilizing recent appraisals from third-party appraisers, as well as internal estimates of market value.

Non-interest income. Non-interest income decreased $8.3 million, to $10.7 million for 2009 from $18.9 million for 2008. The decrease is primarily due to a $2.9 million decrease in fee income, a $3.3 million decrease

 

35


Table of Contents

in asset management income, a $2.3 million decline in fair value of other real estate owned, as well as the loss of $1.6 million attributable to the consolidation of the noncontrolling interest of the entity which owns the other real estate owned, a $1.9 million loss on the sale of other real estate owned, and a $6.9 million gain recognized in connection with the repurchase of debt during 2008, partially offset by a $7.8 million gain recognized in connection with the repurchase of debt during 2009, and a $3.0 million gain on sale of an equity instrument.

Operating expenses. Operating expenses decreased $2.4 million, to $42.4 million for 2009 from $44.8 million for 2008. Employee compensation and benefits decreased $4.0 million primarily due to a decrease in incentive compensation, a decrease in the non-cash compensation charge related to restricted stock grants made since our inception, including equity awards made in connection with the initial public offering and lower headcount, partially offset by severance costs. General and administrative expenses increased $1.8 million due primarily to $1.6 million of acquisition-related costs and loan workout costs of $1.1 million. Occupancy and equipment expenses decreased $0.2 million.

Income taxes. For 2009 and 2008, we provided for income taxes based on an effective tax rate of 34.7% and 41.8%, respectively. Our effective tax rate for 2009 reflects the impact of nondeductible compensation expenses incurred in connection with our initial public offering and the impact of a related discrete item resulting from vesting events in 2009. As of December 31, 2009 and 2008, we had net deferred tax assets of $56.4 million and $31.2 million, respectively.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. We considered all available evidence, both positive and negative, in determining that a valuation allowance of $0.3 million was needed at December 31, 2009. Examples of positive and negative evidence considered include our recent history of taxable income, trends in our earnings, positive financial ratios (including levels of capital that we believe are sufficient to withstand the current economic environment), and the impact of the downturn in the current economic environment (including the impact of credit on allowance and provision for loan losses; and the impact on funding levels) on the Company. We also considered in our assessment the level of income taxes paid in previous periods. We considered the carryback potential in assessing the realizability of our deferred tax asset. We had a net loss of $44.3 million for 2009, pre-tax income of $38.5 million for 2008, and a net loss of $10.6 million for 2007. Additionally, 2007 results reflect the sale of the majority of its structured products securities and loans to a third party in June 2007, which resulted in a loss of $4.4 million, in addition to $48 million of previously incurred impairment losses. Subsequent to December 31, 2007, we discontinued the origination of structured products. We held one investment security available for sale at December 31, 2009 with a carrying value of $4.2 million related to structured products. We noted that these factors, which drove the loss in 2007, lend positive support when added back to pre-tax income. Additionally, we evaluated our business plans and results during our forecast period of future taxable income. Such consideration included liquidity, earnings results (including anticipated level of credit losses over a reasonable period of time), available sources of funding and capital from existing sources. Our forecast utilized in our December 31, 2009 analysis included a sufficient level of earnings over a reasonable period of time.

Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon carryback availability, the reversal of deferred tax liabilities (including the impact of available carryback and carryforward periods), and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences at December 31, 2009. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced.

 

36


Table of Contents

Comparison of the Years Ended December 31, 2008 and 2007

Interest income. Interest income decreased $15.5 million, to $188.8 million for 2008 from $204.3 million for 2007. The decrease was primarily due to a decrease in the yield on average interest earning assets to 7.40% from 9.14% primarily driven by a decrease in three-month LIBOR, partially offset by growth in average interest earning assets of $316.7 million. Average three-month LIBOR decreased from 5.31% for the year ended December 31, 2007 to 3.23% for the year ended December 31, 2008.

Interest expense. Interest expense decreased $23.5 million, to $86.2 million for 2008 from $109.7 million for 2007. The decrease was primarily due to a decrease in our cost of borrowings, partially offset by an increase in average borrowings of $194.8 million from December 31, 2007 to fund growth in interest earning assets. The decrease in our cost of borrowings, to 4.39% from 6.20%, was primarily attributable to a decrease in three-month LIBOR, negotiated lower borrowing spreads on our credit facilities and increased use of lower cost term debt securitizations.

Net interest margin. Net interest margin decreased to 4.02% for 2008 from 4.23% for 2007. The decrease in net interest margin was primarily due to a decrease in our average yield on interest earning assets and non-payment of interest income from non-accrual loans, partially offset by an increase in interest yields on 2008 new loan originations and re-pricings and a decrease in our average cost of interest bearing liabilities. The decrease in yield and cost is primarily due to a decrease in three-month LIBOR. The net interest spread, the difference between gross yield on our interest earning assets and the total cost of our interest bearing liabilities, increased to 3.01% from 2.94% as the decline in three-month LIBOR had a greater impact on the cost of interest bearing liabilities which re-price more frequently than our interest earning assets.

The following table summarizes the yield and cost of interest earning assets and interest bearing liabilities for 2008 and 2007:

 

     Year Ended December 31, 2008     Year Ended December 31, 2007  
     ($ in thousands)  
     Average
Balance
   Interest
Income/
Expense
   Average
Yield/
Cost
    Average
Balance
   Interest
Income/
Expense
   Average
Yield/
Cost
 

Total interest earning assets

   $ 2,551,602    $ 188,770    7.40   $ 2,234,916    $ 204,295    9.14

Total interest bearing liabilities

     1,962,796      86,216    4.39        1,767,993      109,703    6.20   
                                

Net interest spread

      $ 102,554    3.01      $ 94,592    2.94
                                

Net interest margin

         4.02         4.23
                        

Provision for credit losses. The provision for credit losses increased to $38.2 million for 2008 from $19.5 million for 2007. The increase in the provision was primarily due to $30.9 million of specific provisions recorded during 2008 for impaired loans and the growth of our loan portfolio. The decrease in the general component of the provision for credit losses to 19.3% of the total provision for 2008 compared to 54% of the total provision for 2007 was principally due to the migration of loans covered by our general allowance for credit losses to impaired loans covered by our specific allowance for credit losses as difficult economic conditions continued to have a negative impact on the financial performance of our borrowers and their ability to make their scheduled payments. Our general allowance for credit losses covers probable losses in our loan portfolio with respect to loans for which no specific impairment has been identified. A specific provision for credit losses is recorded with respect to loans for which it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the loan agreement for which there is impairment recognized. Impaired loans, which include all of our delinquent loans and all troubled debt restructurings, as a percentage of “Loans, net” increased to 5% as of December 31, 2008 as compared to 1% as of December 31, 2007.

Non-interest income. Non-interest income increased $47.1 million, to $18.9 million for 2008 from negative $28.2 million for 2007. The increase is primarily due to the $30.6 million loss on the residual interest in securitization during 2007, the $20.3 million of impairment charges during 2007 related to our investments in

 

37


Table of Contents

debt securities in our RMBS portfolio, the $4.6 million loss on sale of loans and securities for 2007, the $6.9 million gain recognized in connection with the repurchase of debt during 2008, a $1.4 million increase in gain on derivatives, an increase of $1.0 million in management and performance fees related to the NCOF, $0.3 million gain on sale of loans, partially offset by a $11.3 million decrease in fee income, the $2.4 million loss in fair value of our equity positions, and the $0.9 million loss on investments in debt securities due to net impairments on two of our debt securities and the $0.6 million loss on the residual interest in securitization.

Operating expenses. Operating expenses decreased $12.7 million, to $44.8 million for 2008 from $57.5 million for 2007. Employee compensation and benefits decreased $15.0 million primarily due to a decrease in the non-cash compensation charge related to restricted stock grants made since our inception, including equity awards made in connection with the initial public offering, partially offset by severance costs of $2.1 million during 2008. During 2008, we reduced the number of employees to reflect our anticipated decline in loan origination volumes. General and administrative expenses increased $1.7 million and occupancy and equipment expenses increased $0.6 million.

Income taxes. For 2008 and 2007, we provided for income taxes based on an effective tax rate of 41.8% and 18.4%, respectively. Our effective tax rate for 2008 reflects the impact of timing differences related to the recognition of losses on the residual interest in securitization, the impact of nondeductible compensation expenses incurred in connection with our initial public offering and the impact of a related discrete tax item. Our effective tax benefit rate for 2007 includes two significant items, approximately $1.5 million relating to the impact of nondeductible compensation expense incurred in connection with our initial public offering and $0.8 million resulting from the non-recognition of certain state tax benefits primarily resulting from the phase out of our Structured Products group, including losses incurred on securities sold in our second quarter off-balance sheet transaction. As of December 31, 2008 and 2007 we had net deferred tax assets of $31.2 million and $13.4 million, respectively.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. We considered all available evidence, both positive and negative, in determining that no valuation allowance was needed at December 31, 2008. Examples of positive and negative evidence considered include our recent history of paying taxes, trends in our earnings, positive financial ratios (including levels of capital that we believe are sufficient to withstand the current economic environment), and the impact of the downturn in the current economic environment (including the impact of credit on allowance and provision for loan losses; and the impact on funding levels) on the Company. We also considered in our assessment the level of income taxes paid in previous periods. We considered the carryback potential in assessing the realizability of our deferred tax asset. We had pre-tax income of $38.5 million for the year ended December 31, 2008, and net losses of $10.6 million and $29.6 million for the years ended December 31, 2007 and 2006. Included in these amounts are expenses related to the IPO of $32.3 million in 2006. Additionally, 2007 results reflect the sale of the majority of its structured products securities and loans to a third party in June 2007, which resulted in a loss of $4.4 million, in addition to $48 million of previously incurred impairment losses. Subsequent to December 31, 2007, we discontinued the origination of structured products. We hold one investment security available for sale at December 31, 2008 with a carrying value of $3.0 million related to structured products. We noted that these factors, which drove the losses in 2007 and 2006, reflect positive evidence when added back to pre-tax income. Additionally, we evaluated our business plans and results during our forecast period of future taxable income. Such consideration included liquidity, earnings results (including anticipated level of credit losses over a reasonable period of time), available sources of funding and capital from existing sources. Our forecast utilized in our December 31, 2008 analysis included a sufficient level of earnings over a reasonable period of time.

 

38


Table of Contents

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity consist of cash flow from operations, credit facilities, term debt securitizations and proceeds from equity and debt offerings. We believe these sources will be sufficient to fund our current operations, lending activities and other short-term liquidity needs. Our future liquidity needs will be determined primarily based on the credit performance of our loan portfolio and origination volume. We may need to raise additional capital through the incurrence of indebtedness or issuance of equity based on various factors, including if the level of non-accrual loans increases faster than expected, we are unable to fund certain loans with credit facilities, or if our cash flow from operations is lower than expected. We may not be able to raise debt or equity capital on acceptable terms or at all. The incurrence of additional debt will increase our leverage and interest expense, and the issuance of any debt or equity securities may be dilutive for existing shareholders.

We continue to experience higher costs of borrowing and pressure to reduce leverage. Credit facility renewals and amendments to existing credit facilities in 2009 were, and we expect they will continue to be, more expensive and at lower committed amounts and provide lower advance rates than similar transactions we completed in prior periods. Reduction in advance rates under our warehouse credit facilities in 2009 and 2008 have resulted in or, in the case of our recent amendment to our Citicorp facility, will require the use of cash to repay advances. Lower committed amounts under our credit facilities will limit our ability to borrow funds to support future loan growth.

Cash and Cash Equivalents

As of December 31, 2009 and 2008, we had $39.8 million and $50.3 million, respectively, in cash and cash equivalents. We may invest a portion of cash on hand in short-term liquid investments. From time to time, we may use a portion of our non-restricted cash to pay down our credit facilities.

Restricted Cash

Separately, we had $136.9 million and $84.2 million of restricted cash as of December 31, 2009 and 2008, respectively. The increase in our restricted cash balance is primarily due to restrictions on when we could repay outstanding amounts under the Deutsche Bank A.G., New York Branch term debt facility. We paid off all outstanding borrowings under this facility with the proceeds received from the term debt securitization completed on January 7, 2010. The restricted cash represents the balance of the principal and interest collections accounts and pre-funding amounts in our credit facilities, our term debt securitizations and customer holdbacks and escrows. The use of the principal collection accounts’ cash is limited to funding the growth of our loan portfolio within the facilities or paying down related credit facilities or term debt securitizations. The interest collection account cash is limited to the payment of interest, servicing fees and other expenses of our credit facilities and term debt securitizations and, if either a ratings downgrade or failure to receive ratings confirmation occurs on the rated notes in a term debt securitization at the end of the funding period or if coverage ratios are not met, paying down principal with respect thereto. Cash to fund the growth of our loan portfolio and to pay interest on our term debt securitizations represented a large portion of our restricted cash balance at December 31, 2009.

Asset Quality and Allowance for Loan Losses

If a loan is 90 days or more past due, or if management believes it is probable we will unable to collect contractual principal and interest in the normal course of business, it is our policy to place the loan on non-accrual status. If a loan financed by a term debt securitization is placed on non-accrual status, the loan may remain in the term debt securitization and excess interest spread cash distributions to us will cease until cash accumulated in the term debt securitization equals the outstanding balance of the non-accrual loan. When a loan is on non-accrual status, accrued interest previously recognized as interest income subsequent to the last cash receipt in the current year will be reversed, and the recognition of interest income on that loan will stop until

 

39


Table of Contents

factors indicating doubtful collection no longer exist and the loan has been brought current. We may make exceptions to this policy if the loan is well secured and is in the process of collection. As of December 31, 2009, we had 40 impaired loans with an aggregate outstanding balance of $352.4 million. Twenty-eight of the impaired loans with an aggregate outstanding balance of $257.7 million have been restructured and classified as troubled debt restructurings as defined by ASC 310-40 (formerly SFAS No. 15, Accounting for Debtors and Creditors for Troubled Debt Restructurings). Nineteen of the impaired loans with an aggregate outstanding balance of $162.7 million were on non-accrual status. Fourteen of the impaired loans with an aggregate outstanding balance of $123.9 million were greater than 60 days past due and classified as delinquent. During 2009, we recorded $132.5 million of specific provisions for impaired loans. Included in our specific allowance for impaired loans was $24.9 million related to delinquent loans. Moreover, the economic recession has led to a decline in overall credit quality across the market. We are closely monitoring the credit quality of our loans. We may experience additional loan delinquencies, losses, specific reserves, non-accruals, troubled debt restructurings and charge offs due to current economic conditions and as our portfolio continues to season.

Despite our limited historical loss experience, we have provided an allowance for loan losses to provide for probable losses inherent in our loan portfolio. Our allowance for loan losses as of December 31, 2009 and 2008 was $113.9 million and $52.5 million, or 5.65% and 2.19% of loans, gross, respectively. As of December 31, 2009, we also had a $0.6 million allowance for unfunded commitments, resulting in an allowance for credit losses of 5.68%.

The allowance for credit losses is based on a review of the appropriateness of the allowance for credit losses and its two components on a quarterly basis. The estimate of each component is based on observable information and on market and third-party data believed reflective of the underlying credit losses being estimated.

It is the Company’s policy that during the reporting period to record a specific provision for credit losses for all loans for which we have doubts as to the ability of the borrowers to comply with the present loan repayment terms. Consequently, all of these loans are classified as impaired (if they have not been so classified already as a result of a troubled debt restructuring) and are disclosed in the Allowance for Credit Losses footnote to the financial statements. Please refer to “Critical Accounting Policies—Allowance for credit losses”.

Activity in the allowance for loan losses for the years ended December 31, 2009, 2008 and 2007 was as follows:

 

     Year Ended December 31,  
   2009     2008     2007  
   ($ in thousands)  

Balance as of beginning of period

   $ 52,498      $ 33,387      $ 19,395   

Provision for loan losses

     1,493        7,990        9,593   

Specific provision for loan losses

     132,474        30,855        8,992   

Net charge offs

     (67,600     (19,734     (4,593

Charge offs upon transfer to loans held-for-sale

     (5,000     —          —     
                        

Balance as of end of period

     113,865        52,498        33,387   

Allowance for losses on unfunded loan commitments

     605        1,479        2,100   
                        

Allowance for credit losses

   $ 114,470      $ 53,977      $ 35,487   
                        

During 2009 we recorded a total provision for credit losses of $133.1 million. The Company increased its allowance for credit losses 343 basis points to 5.68% of gross loans at December 31, 2009 from 2.25% at December 31, 2008.

 

40


Table of Contents

Borrowings and Liquidity

As of December 31, 2009 and 2008, we had outstanding borrowings totaling $1.6 billion and $1.9 billion, respectively. Borrowings under our various credit facilities, term debt securitizations and repurchase obligations have supported our loan growth.

Credit facility renewals and amendments to existing credit facilities in 2009 were and we expect they will continue to be more expensive, at lower committed amounts and provide lower advance rates than similar transactions we completed in prior periods. Reduction in advance rates under our warehouse credit facilities in 2009 and 2008 resulted in the use of cash to repay advances. Lower committed amounts under our credit facilities will limit our ability to borrow funds to support future loan growth.

As of December 31, 2009, our funding sources, maximum debt amounts, amounts outstanding and unused debt capacity, subject to certain covenants and conditions, are summarized below:

 

Funding Source

   Maximum Debt
Amount
   Amounts
Outstanding
   Unused Debt
Capacity
   Maturity
   ($ in thousands)

Credit facilities

   $ 211,000    $ 91,890    $ 119,110    2010 – 2011

Term debt (1)

     1,741,345      1,523,052      218,293    2012 – 2022
                       

Total

   $ 1,952,345    $ 1,614,942    $ 337,403   
                       

 

(1) Maturities for term debt are based on contractual maturity dates. Actual maturities may occur earlier.

We must comply with various covenants, the breach of which could result in a termination event, and at December 31, 2009, we were in compliance with all such covenants. These covenants vary depending on the type of facility and are customary for facilities of this type. These covenants include, but are not limited to, failure to service debt obligations, failure to meet liquidity covenants and tangible net worth covenants, and failure to remain within prescribed facility portfolio delinquency and charge-off levels.

Credit facilities

As of December 31, 2009 the Company had three credit facilities: (i) a $150.0 million credit facility with Citicorp North America, Inc. (“Citicorp”), (ii) a $50.0 million facility with NATIXIS Financial Products, Inc. (“NATIXIS”) and (iii) an $11.0 million credit facility with Union Bank of California, N.A.

The Company has a $150.0 million credit facility agreement with Citicorp that had an outstanding balance of $66.7 million and unamortized deferred financing fees of $3.8 million as of December 31, 2009. Interest on this facility accrues at a variable rate per annum, which was 2.80% at December 31, 2009. On November 3, 2009, we entered into an amendment to this credit facility that reduced the commitment amount under the facility to $150 million from $300 million and extended the credit facility’s liquidity line to November 2010, completing the annual renewal. The amendment was effective as of November 17, 2009. Our $150.0 million credit facility with Citicorp is subject to an annual renewal in November 2010. If in the future Citicorp decides not to renew its credit facility with the Company on the annual renewal date, the Company’s ability to make new borrowings under that facility would terminate. This facility is scheduled to mature on November 7, 2011. In addition, the Company issued a demand note to the facility for up to $30.0 million.

The Company has a $50.0 million credit facility agreement with NATIXIS that had an outstanding balance of $15.2 million and unamortized deferred financing fees of $0.3 million as of December 31, 2009. Interest on this facility accrues at a variable rate per annum, which was 5.21% at December 31, 2009. On May 21, 2009, we entered into an amendment to this credit facility that extended the maturity date to May 21, 2010 and reduced the commitment amount under the facility to $50.0 million from $75.0 million.

 

41


Table of Contents

The Company has an $11.0 million credit facility agreement with Union Bank of California, N.A. that had an outstanding balance of $10.0 million as of December 31, 2009. On June 22, 2009, we entered into an amendment to this credit facility which reduced the commitment amount under this facility to $11.0 million from $15.0 million and extended the maturity date to June 21, 2010. Interest on this facility accrues at a variable rate per annum, which was 2.79% at December 31, 2009.

Term Debt Facilities

As of December 31, 2009, the Company had two term debt facilities: (i) a $250 million facility with Deutsche Bank, A.G., New York Branch and (ii) a $145.7 million facility with Wachovia Capital Markets, LLC.

On November 8, 2007, we entered into a $300 million term debt financing agreement with Deutsche Bank, A.G. In connection with the Deutsche term debt financing agreement, we formed a wholly owned subsidiary, NewStar DB Term Funding, LLC, a single-purpose bankruptcy-remote entity, to purchase or hold loans and investments. This term debt financing agreement matures on May 7, 2012. On May 6, 2008, we entered into an amendment to this term debt financing agreement which increased the facility to $400 million. On January 15, 2009 we entered into an amendment to this term debt financing agreement which reduced the commitment amount under the term debt facility to $250 million and will gradually reduce the advance rate from an effective rate of approximately 77% as of January 15, 2009 to no more than 72% pursuant to the terms of the amendment. Interest on this term debt financing agreement accrues at a variable rate per annum, which was 1.95% at December 31, 2009. As of December 31, 2009, the outstanding balance was $152.4 million and unamortized deferred financing fees were $1.9 million. The term debt financing agreement, as amended, has variable advance rates based on the diversification and average rating of the targeted loan collateral. In addition, we must comply with various covenants, the breach of which could result in a termination event. As of December 31, 2009, NewStar DB Term Funding, LLC was in compliance with all such covenants, as amended. This term debt financing agreement began to amortize on May 7, 2009, with all loan principal collections and excess interest spread collections used to pay down the outstanding balance. We receive a loan collateral management fee and expect to receive a principal distribution when the term debt facility is retired. We paid off all outstanding borrowings under this facility with the proceeds received from the term debt securitization completed on January 7, 2010.

On December 31, 2009, we had a $145.7 million facility with Wachovia Capital Markets, LLC. Interest on this facility accrues at a variable rate per annum, which was 3.98% at December 31, 2009. As of December 31, 2009, the outstanding balance was $118.0 million and unamortized deferred financing fees were $2.0 million. On April 17, 2009, we entered into an amendment to the credit facility with Wachovia which reduced the commitment amount under this facility to $200 million from $350 million, reduced the advance rate from an effective rate of 70% to 65%, extended the liquidity line termination date to June 1, 2009 from April 17, 2009 and amended the restriction on the permitted use of advances for the acquisition of collateral to the funding of certain unfunded commitments included in the collateral on or prior to April 17, 2009. On May 21, 2009, we extended the maturity of our annual renewal with Wachovia from June 1, 2009 to July 15, 2009. On July 15, 2009, we amended our credit facility with Wachovia to convert it to a $145.7 million secured term debt facility maturing on July 15, 2012. Wachovia completed a merger with Wells Fargo on December 31, 2008, but this merger did not impact the terms of our agreement.

Term debt securitizations

In August 2005, we completed our first term debt securitization. In conjunction with this transaction, we established a separate single-purpose bankruptcy-remote subsidiary, NewStar Trust 2005-1 (the “2005 CLO Trust”). The notes issued by the 2005 CLO Trust are collateralized by the specific assets, principal collection account cash and principal payment receivables totaling $335.3 million at December 31, 2009. Outstanding drawn notes at December 31, 2009 were $303.7 million and deferred financing fees were $2.2 million. The 2005 CLO Trust has no significant assets other than the collateral. The stated maturity date of the notes is July 25, 2018. However, we expect them to mature earlier assuming, among other things, certain collateral characteristics,

 

42


Table of Contents

certain repayment rates, no refinancing and the exercise of a clean-up call repurchase option. The 2005 CLO Trust permitted reinvestment of collateral principal repayments for a three-year period that ended in October 2008. The 2005 CLO Trust’s organizational documents and the indenture governing the notes contain covenants that limit the 2005 CLO Trust’s ability to, among other things, consolidate with and merge into another entity, transfer or otherwise dispose of any property or assets, incur or otherwise become liable for any indebtedness except for the notes, make distributions and redeem or purchase any equity interest or security. During 2009, we repurchased $1.4 million of the 2005 CLO Trust’s Class D notes and $1.2 million of the Class E notes. During the first quarter of 2009, Moody’s downgraded the Class C notes, the Class D notes and the Class E notes of the 2005 CLO Trust. During the third quarter of 2009, Moody’s downgraded the Class A-1 notes, the Class A-2 notes and Class B notes, and confirmed its ratings of the Class C notes, the Class D notes and the Class E notes of the 2005 CLO Trust. As a result of these downgrades, amortization of the 2005 CLO Trust changed from pro rata to sequential, resulting in scheduled principal payments made in order of the notes seniority until all available funds are exhausted for each payment. We receive a loan collateral management fee and excess interest spread. We expect to receive a principal distribution when the term debt is retired. During the fourth quarter of 2009, certain loan collateral in the 2005 CLO Trust was categorized as defaulted under the terms of the trust indenture. If we do not elect to remove these defaulted loans, the excess interest spread from the 2005 CLO Trust will be trapped and combined with recoveries and will be used to repay the outstanding notes until note redemptions equal the underlying defaulted loan balances. We may have additional defaults in the 2005-1 CLO Trust. If we do not elect to remove any future defaulted loans, we would not expect to receive excess interest spread payments until the undistributed cash plus any recoveries equal the outstanding balances of defaulted loan collateral.

The following table sets forth selected information with respect to the 2005 CLO Trust:

 

     Notes and
certificates

originally
issued
   Outstanding
balance
December 31,
2009
   Borrowing
spread to
LIBOR
    Ratings
(S&P/Moody’s/
Fitch)(1)
   ($ in thousands)    %      

2005 CLO Trust:

          

Class A-1

   $ 156,000    $ 139,483    0.28   AAA/Aa2/AAA

Class A-2

     80,477      71,204    0.30      AAA/Aa2/AAA

Class B

     18,750      18,683    0.50      AA/A2/AA

Class C

     39,375      39,233    0.85      A/Ba1/A

Class D

     24,375      22,857    1.50      BBB/B1/BBB-

Class E

     24,375      12,279    4.75      BB/Caa2/B
                  

Total notes

     343,352      303,739     

Class F (trust certificates)

     31,648      31,538    N/A      N/A
                  

Total for 2005 CLO Trust

   $ 375,000    $ 335,277     
                  

 

(1) The ratings were initially given in August 2005, are unaudited and are subject to change from time to time. Fitch affirmed its ratings on February 24, 2009 and downgraded the Class D notes and Class E notes to the ratings shown above. The Fitch downgrade did not have an impact on the 2005 CLO Trust. During the first quarter of 2009, Moody’s downgraded the Class C notes, the Class D notes and the Class E notes to the ratings shown above. During the third quarter of 2009, Moody’s downgraded the Class A-1 notes, the Class A-2 notes and the Class B notes to the ratings shown above. (source: Bloomberg Finance L.P.).

In June 2006, we completed our second term debt securitization. In conjunction with this transaction, we established a separate single-purpose bankruptcy-remote subsidiary, NewStar Commercial Loan Trust 2006-1 (the “2006 CLO Trust”). The notes issued by the 2006 CLO Trust are collateralized by the specific assets, principal collection account cash and principal payment receivables totaling $478.7 million at December 31, 2009. Outstanding drawn notes at December 31, 2009 were $435.0 million and deferred financing fees were $3.7 million. The 2006 CLO Trust has no significant assets other than the collateral. The stated maturity date of the

 

43


Table of Contents

notes is March 30, 2022. However, we expect them to mature earlier assuming, among other things, certain collateral characteristics, certain prepayment rates, no refinancing and the exercise of a clean-up call repurchase option. The 2006 CLO Trust permits reinvestment of collateral principal repayments for a five-year period ending in June 2011. The 2006 CLO Trust’s organizational documents and the indenture governing the notes contain covenants that limit the 2006 CLO Trust’s ability to, among other things, consolidate with and merge into another entity, transfer or otherwise dispose of any property or assets, incur or otherwise become liable for any indebtedness except for the notes, make distributions and redeem or purchase any equity interest or security. During 2009, we repurchased $6.5 million of the 2006 CLO Trust’s Class D notes and $1.8 million of the Class E notes. During the first quarter of 2009, Moody’s downgraded the Class C notes, the Class D notes and the Class E notes of the 2006 CLO Trust. During the third quarter of 2009, Moody’s downgraded the Class A-1 notes, the Class A-2 notes and Class B notes, and confirmed its ratings of the Class C notes, the Class D notes and the Class E notes of the 2006 CLO Trust. As a result of the downgrade, amortization of the 2006 CLO Trust changed from pro rata to sequential. This will take effect if the Company fails to reinvest collateral principal repayments, if defaulted collateral results in the trapping of excess interest spread, or when the reinvestment period ends, resulting in future scheduled principal payments made in order of the notes seniority until all available funds are exhausted for each payment. We receive a loan collateral management fee and excess interest spread. We expect to receive a principal distribution when the term debt is retired. If loan collateral in the 2006 CLO Trust was in default under the terms of the indenture, the excess interest spread from the 2006 CLO Trust would not be distributed until the undistributed cash plus recoveries equals the outstanding balance of the defaulted loan or if we elected to remove the defaulted collateral. We may have defaults in the 2006-1 CLO Trust. If we do not elect to remove any future defaulted loans, we would not expect to receive excess interest spread payments until the undistributed cash plus any recoveries equal the outstanding balances of any potential defaulted loan collateral.

The following table sets forth the selected information with respect to the 2006 CLO Trust:

 

     Notes and
certificates

originally
issued
   Outstanding
balance
December 31,
2009
   Borrowing
spread to
LIBOR
    Ratings
(S&P/Moody’s/
Fitch)(1)
     ($ in thousands)    %      

2006 CLO Trust:

          

Class A-1

   $ 320,000    $ 319,907    0.27   AAA/Aa2/AAA

Class A-2

     40,000      32,840    0.28      AAA/Aa2/AAA

Class B

     22,500      22,500    0.38      AA/A3/AA

Class C

     35,000      35,000    0.68      A/Ba1/A

Class D

     25,000      15,250    1.35      BBB/B1/BBB

Class E

     13,750      9,500    1.75      BBB-/B2/BBB-
                  

Total notes

     456,250      434,997     

Class F (trust certificates)

     43,750      43,750    N/A      N/A
                  

Total for 2006 CLO Trust

   $ 500,000    $ 478,747     
                  

 

(1) These ratings were initially given in June 2006, are unaudited and are subject to change from time to time. Fitch affirmed its ratings on February 24, 2009. During the first quarter of 2009, Moody’s downgraded the Class C notes, the Class D notes and the Class E notes to the ratings shown above. During the third quarter of 2009, Moody’s downgraded the Class A-1 notes, the Class A-2 notes and the Class B notes to the ratings shown above. (source: Bloomberg Finance L.P.).

In June 2007 we completed our third term debt transaction. In conjunction with this transaction we established a separate single-purpose bankruptcy-remote subsidiary, NewStar Commercial Loan Trust 2007-1 (the “2007-1 CLO Trust”). The notes issued by the 2007 CLO Trust are collateralized by specific assets, principal collection account cash and principal payment receivables totaling $569.0 million at December 31, 2009. Outstanding drawn notes at December 31, 2009 were $513.9 million and deferred financing fees were $4.6 million. The 2007-1 CLO Trust has no significant assets other than the collateral. The stated maturity date of the

 

44


Table of Contents

notes is September 30, 2022. However, we expect them to mature earlier assuming, among other things, certain collateral characteristics, certain prepayment rates, no refinancing and the exercise of a clean-up call repurchase option. The 2007-1 CLO Trust permits reinvestment of collateral principal repayments for a six-year period ending in May 2013. The 2007-1 CLO Trust’s organizational documents and the indenture governing the notes contain covenants that limit the 2007-1 CLO Trust’s ability to, among other things, consolidate with and merge into another entity, transfer or otherwise dispose of any property or assets, incur or otherwise become liable for any indebtedness except for the notes, make distributions and redeem or purchase any equity interest or security. During 2009, we repurchased $1.0 million of the 2007-1 CLO Trust’s Class D notes. During the first quarter of 2009, Moody’s downgraded the Class C notes and the Class D notes of the 2007 CLO Trust. During the third quarter of 2009, Moody’s downgraded the Class A-1 notes, the Class A-2 notes and Class B notes, and confirmed its ratings of the Class C notes, the Class D notes and the Class E notes of the 2007-1 CLO Trust. As a result of the downgrade, amortization of the 2007 CLO Trust changed from pro rata to sequential. This will take effect if the Company fails to reinvest collateral principal repayments, if defaulted collateral results in the trapping of excess interest spread, or when the reinvestment period ends resulting in future scheduled principal payments made in order of the notes seniority until all available funds are exhausted for each payment. We receive a loan collateral management fee and excess interest spread. We expect to receive a principal distribution when the term debt is retired. During the second quarter of 2009, certain loan collateral in the 2007-1 CLO Trust was categorized as defaulted under the terms of the trust indenture. As a result, the excess interest spread from the 2007-1 CLO Trust will be trapped and combined with recoveries and will be used to repay the outstanding notes until note redemptions equal the underlying defaulted loan balances. In February 2010, we elected to purchase $20.6 million of defaulted collateral from the 2007-1 CLO to reduce the amount of excess interest spread that otherwise would have been required to be trapped. We may have additional defaults in the 2007-1 CLO Trust. If we do not elect to remove these anticipated additional defaults, we would not expect to receive excess interest spread payments until the undistributed cash plus any recoveries equal the outstanding balances of the defaulted loan collateral.

The following table sets forth selected information with respect to the 2007-1 CLO Trust:

 

     Notes
originally
issued
   Outstanding
balance
December 31,
2009
   Borrowing
spread to
LIBOR
    Ratings
(S&P/Moody’s/
Fitch)(1)
   ($ in thousands)           

2007-1 CLO Trust

          

Class A-1

   $ 336,500    $ 324,050    0.24   AAA/Aa2/AAA

Class A-2

     100,000      81,391    0.26      AAA/Aa2/AAA

Class B

     24,000      24,000    0.55      AA/A2/AA

Class C

     58,500      58,500    1.30      A/Ba1/A

Class D

     27,000      26,000    2.30      BBB/Ba3/BBB+
                  

Total notes

     546,000      513,941     

Class E (trust certificates)

     29,100      30,164    N/A      N/A

Class F (trust certificates)

     24,900      24,900    N/A      N/A
                  

Total for 2007-1 CLO Trust

   $ 600,000    $ 569,005     
                  

 

(1) These ratings were initially given in June 2007, are unaudited and are subject to change from time to time. Fitch affirmed its ratings on February 24, 2009. During the first quarter of 2009, Moody’s downgraded the Class C notes and the Class D notes to the ratings shown above. During the third quarter of 2009, Moody’s downgraded the Class A-1 notes, the Class A-2 notes and the Class B notes to the ratings shown above. (source: Bloomberg Finance L.P.).

On January 7, 2010, we completed a $275.0 million term debt securitization, net of a $3.4 million discount. The notes offered in the commercial loan obligation were issued by NewStar Commercial Loan Trust 2009-1 (a newly formed subsidiary of the Company) and are primarily backed by a diversified portfolio of commercial

 

45


Table of Contents

loans originated by the Company. Investors purchased approximately $190.5 million of the floating-rate asset-backed notes. This represented approximately 68% of the value of the collateral pool. The Company retained all of the Class C and subordinated notes, which totaled approximately $87.9 million, representing 32% of the value of the collateral pool. The blended pricing of the notes offered was LIBOR plus 4.58%. The notes are expected to mature on July 30, 2018. Proceeds from this term debt securitization were used to repay all outstanding borrowings under our term debt facility with Deutsche Bank AG, New York Branch and certain advances under our credit facility with Citicorp North America, Inc.

The amount, ratings and LIBOR spread of the offered Notes are:

 

Class

   Amount    Rating
(Moody’s)
   Borrowing spread
to LIBOR
 

A

   $ 148.5    Aaa    3.75

B

   $ 42.0    A2    5.00   

C

   $ 31.0    Ba2    5.50   

Subordinated

   $ 56.9    NR    N/A   

Revolving Credit Notes

On January 5, 2010, we entered into a note agreement with Fortress Credit Corp., establishing a $75.0 million revolving credit facility. Under the credit facility, the Company may draw, repay and draw again prior to the maturity date, subject to availability under a borrowing base. The credit facility begins to amortize on July 5, 2011 and is scheduled to mature on July 5, 2013. The Company is permitted to use the proceeds of borrowings under the credit facility, subject to the lesser of 30% of commitments or $20.0 million, for working capital and other general corporate purposes.

Advances under the notes are priced on a grid tied to usage, which was the London Interbank Offered Rate (LIBOR) plus 9.00% at closing. A borrowing base tied to the value of underlying unencumbered assets and the residual equity interest in the Company’s financing subsidiaries governs availability under the credit facility. As of March 3, 2010, we had not drawn any amounts from the revolving credit facility, but we had the ability to draw $75.0 million based on our borrowing base.

Stock Repurchase Program

On January 25, 2010, we announced that our Board of Directors had authorized the repurchase of up to $10 million of the Company’s common stock from time to time on the open market or in privately negotiated transactions. The timing and amount of any shares purchased will be determined by our management based on its evaluation of market condition and other factors and will require the use of cash. The repurchase program, which will expire on January 22, 2011 unless extended by the Board of Directors, may be suspended or discontinued at any time without notice. As of March 3, 2010, we had repurchased 29,000 shares of our common stock under the program at an average price per share of $5.77.

Contractual Obligations

The following table sets forth information relating to our contractual obligations as of December 31, 2009:

 

     Payments due by period     
   Less than 1
year
   1-3 years    3-5 years    More than 5
years
   Total
   ($ in thousands)

Credit facilities (1)

   $ 25,190    $ 66,700    $ —      $ —      $ 91,890

Term debt (1)

     —        270,375      —        1,252,677      1,523,052

Non-cancelable operating leases

     1,342      1,733      82      —        3,157
                                  

Total

   $ 26,532    $ 338,808    $ 82    $ 1,252,677    $ 1,618,099
                                  

 

(1) Amounts for credit facilities and term debt presented represent principal amounts due based on contractual maturity dates and do not include interest amounts owed. The actual timing of payments will ultimately vary from the above data due to future fundings and repayments we expect to occur.

 

46


Table of Contents

DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

We maintain an overall risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings caused by interest rate volatility. Our operations are subject to risks resulting from interest rate fluctuations on our interest-earning assets and our interest-bearing liabilities. We seek to provide maximum levels of net interest income, while maintaining acceptable levels of interest rate and liquidity risk. As such, we enter into interest rate swap and interest rate cap agreements to hedge interest rate exposure to interest rate fluctuations on floating rate funding agreement liabilities that are matched with fixed rate securities. Under the interest rate swap contracts, we agree to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated on an agreed-upon notional principal amount. We record the exchanged amount in net interest income in our statements of operations. Under the interest rate cap contracts, we agree to exchange, at specified intervals, the difference between a specified fixed interest (the cap) and floating interest amounts calculated on an agreed-upon notional principal amount, but only if the floating interest rate exceeds the cap rate. The interest rate caps currently are not matched to specific assets or liabilities and do not qualify for hedge accounting.

We also offer a fixed rate loan program to certain of our customers which utilizes derivative instruments such as interest rate swaps, interest rate caps and interest rate collars. We provide floating interest rate debt to our customers, and to reduce default risk resulting from interest rate fluctuations, we enter into interest rate swap, cap and collar contracts with these customers. Subsequently, we may enter into similar offsetting contracts with third parties, or customer derivatives. These derivatives do not qualify for hedge accounting and are recorded at fair value on our balance sheet.

Gains and losses on derivatives not designated as hedges, including any cash payments made or received, are reported as gain (loss) on derivatives in our consolidated statements of operations.

During 2006, the Company entered into interest rate swap agreements which were designated and qualified as cash flow hedges of the risk of changes in the Company’s interest payments on LIBOR-indexed debt. At December 31, 2009, the interest rate swap agreements had a combined notional value of $12.2 million and had scheduled maturities ranging from April 11, 2010 to October 20, 2013. The Company records the contracted interest rate swap net amounts exchanged in interest expense in the accompanying consolidated statements of operations. During 2009 and 2008, the Company recorded hedge ineffectiveness of $(28,405) and $78,300, which is included in gain on derivatives in the Company’s consolidated statements of operations. The Company estimates that the net amount of existing unrealized losses at December 31, 2009 expected to be classified from accumulated other comprehensive income into earnings within the next 12 months is approximately $0.1 million. The reclassification is expected to result in additional interest expense.

During 2008, we terminated interest rate swaps resulting in a net gain of $1.1 million. Additionally, we had $0.8 million of unrealized losses related to the terminated swaps which will be amortized over the lives of the hedged items. The deferred loss is classified in accumulated other comprehensive loss, net of tax, as a component of equity with the accretion of the deferred losses recognized into earnings.

The table below provides information about our derivative financial instruments, excluding customer derivatives, as of December 31, 2009.

Summary of Derivative Positions at December 31, 2009

 

    2010   2011   2012   2013   2014   Thereafter   Total   Fair
Value
    ($ in thousands)

Interest Rate Derivatives

               

Interest rate swaps:

               

Variable to fixed (average notional expected outstanding)

  $12,118   $3,514   $3,368   $3,202   $ —     $ —     $22,202   $(416)

Average pay rate

  6.77%   8.41%   8.41%   8.41%   —     —      

Average receive rate

  1-mo USD
LIBOR
  1-mo USD
LIBOR
  1-mo USD
LIBOR
  1-mo USD
LIBOR
  1-mo USD
LIBOR
  1-mo USD
LIBOR
   

 

47


Table of Contents

OFF BALANCE SHEET ARRANGEMENTS

We are party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our borrowers. These financial instruments include unfunded commitments, standby letters of credit and interest rate mitigation products. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement we have in particular classes of financial instruments.

Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for standby letters of credit is represented by the contractual amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments.

Unused lines of credit are commitments to lend to a borrower if certain conditions have been met. These commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because certain commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each borrower’s creditworthiness on a case-by-case basis. The amount of collateral required is based on factors that include management’s credit evaluation of the borrower and the borrower’s compliance with financial covenants. Due to their nature, we cannot know with certainty the aggregate amounts that will be required to fund our unfunded commitments. The aggregate amount of these unfunded commitments currently exceeds our available funds and will likely continue to exceed our available funds in the future.

At December 31, 2009, we had $230.8 million of unused lines of credit. Of these unused lines of credit, unfunded commitments related to revolving credit facilities were $185.8 million and unfunded commitments related to delayed draw term loans were $29.6 million. $15.5 million of the unused commitments are unavailable to the borrowers, which may be related to the borrowers’ inability to meet covenant obligations or other similar events.

Revolving credit facilities allow our borrowers to draw up to a specified amount subject to customary borrowing conditions. The unfunded revolving commitments of $185.8 million are further categorized as either contingent or unrestricted. Contingent commitments limit a borrower’s ability to access the revolver unless it meets an enumerated borrowing base covenant or other restrictions. At December 31, 2009, we categorized $75.9 million of the unfunded commitments related to revolving credit facilities as contingent. Unrestricted commitments represent commitments that are currently accessible, assuming the borrower is in compliance with certain customary loan terms and conditions. At December 31, 2009, we had $109.9 million of unfunded unrestricted revolving commitments.

During the three months ended December 31, 2009, revolver usage averaged approximately 39%, which is consistent with historical usage over the past year. Management’s experience indicates that borrowers typically do not seek to exercise their entire available line of credit at any point in time.

Delayed draw credit facilities allow our borrowers to draw predefined amounts of the approved loan commitment at contractually set times, subject to specific conditions, such as capital expenditures in corporate loans or for tenant improvements in commercial real estate loans. Borrowers drew $24.0 million from these credit facilities during 2009.

Standby letters of credit are conditional commitments issued by us to guarantee the performance by a borrower to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending credit to our borrowers. At December 31, 2009 we had $18.8 million of standby letters of credit.

 

48


Table of Contents

Interest rate risk mitigation products are offered to enable customers to meet their financing and risk management objectives. Derivative financial instruments consist predominantly of interest rate swaps, interest rate caps and floors. The interest rate risks to the Company of these customer derivatives is mitigated by entering into similar derivatives having offsetting terms with other counterparties. At December 31, 2009, the notional value of the interest rate mitigation products was $287.9 million.

On June 29, 2007, we completed the sale of securities and loans totaling $187.9 million, including $113.9 million of RMBS holdings to a non-recourse, off-balance sheet financing vehicle and recognized a $4.4 million loss on the sale. We retained a residual interest in the assets sold, which had a fair value of $0 at December 31, 2009. Our valuation of the residual involves two basic assumptions (i) a forecast of cash flows from the underlying collateral, and (ii) a discount rate applied to those cash flows. This rate was established by modeling the pool to create CDO tranches of AAA through BBB, which reflected a mix of debt in place against those assets and reflected an estimated market rate at that time. Changes in the fair value of the residual interest are recorded in the consolidated statement of operations.

Critical Accounting Policies

Accounting policies involving significant estimates and assumptions by management, which have, or could have, a material impact on our financial statements, are considered critical accounting policies. The following are our critical accounting policies:

Allowance for credit losses

The allowance for credit losses is based on a loan-by-loan build-up of inherent losses on loans, gross. We also maintain an allowance for losses on unfunded loan commitments, namely loan commitments and letters of credit that are reported in other liabilities on the balance sheet. The combined balance of the allowance for loan losses and the allowance for unfunded commitments is referred to as the allowance for credit losses. As of December 31, 2009, we had an allowance for credit losses of $114.5 million, with specific allowances totaling $75.4 million.

In accordance with ASC 310 (formerly SFAS No. 5, Accounting for Contingencies), a base allowance is provided for loans that are not impaired. The Company employs a variety of internally developed and third-party modeling and estimation tools for measuring credit risk, which are used in developing an allowance for loan losses on outstanding loans. The Company’s allowance framework addresses economic conditions, capital market liquidity and industry circumstances from both a top-down and bottom-up perspective. The Company considers and evaluates changes in economic conditions, credit availability, industry and multiple obligor concentrations in assessing both probabilities of default and loss severities as part of the general component of the allowance for loan losses.

On at least a quarterly basis, loans are internally risk-rated based on individual credit criteria, including loan type, loan structures (including balloon and bullet structures common in the Company’s Middle Market Corporate and Commercial Real Estate cash flow loans), borrower industry, payment capacity, location and quality of collateral if any (including the Company’s Commercial Real Estate loans). Borrowers provide the Company with financial information on either a monthly or quarterly basis. Ratings, corresponding assumed default rates and assumed loss severities are dynamically updated to reflect any changes in borrower condition or profile.

For Middle Market Corporate loans, the data set used to construct probabilities of default in its allowance for loan losses model, Moody’s CRD Private Firm Database, principally contains middle market corporate loans that share attributes similar to the Company’s loans. The Company also considers the quality of the loan terms in determining a loan loss in the event of default.

 

49


Table of Contents

For Commercial Real Estate loans, the Company employs two mechanisms to capture the impact of industry and economic conditions. First, a loan’s risk rating, and thereby its assumed default likelihood, can be adjusted to account for overall commercial real estate market conditions. Second, to the extent that economic or industry trends adversely affect a borrower’s loan-to-value ratio enough to impact its repayment ability, the Company applies a stress multiplier to the loan’s probability of default. The multiplier is designed to account for default characteristics that are difficult to quantify when market conditions cause commercial real estate prices to decline.

Additionally, when determining the amount of the general allowance, the Company supplements the base amount with a judgmental amount which is governed by a score card system comprised of ten individually weighted risk factors. The risk factors are designed based on those outlined in the Comptrollers of the Currency’s Allowance for Loan and Lease Losses Handbook. The Company also performs a ratio analysis of comparable money center banks, regional banks and finance companies. While the Company does not rely on this peer group comparison to set the level of allowance for credit losses, it does assist management in identifying market trends and serves as an overall reasonable check on the allowance for credit losses computation.

In accordance with ASC 310 (formerly SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”), a loan is considered impaired when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impairment of a loan is based upon either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent, depending on the circumstances and our collection strategy. Impaired loans are identified based on the loan-by-loan risk rating process described above. It is the Company’s policy that during the reporting period to record a specific provision for credit losses for all loans for which we have serious doubts as to the ability of the borrowers to comply with the present loan repayment terms. As of December 31, 2009, we had 40 impaired loans.

Impaired loans at December 31, 2009 were in both Commercial Real Estate and in Middle Market Corporate, over a range of industries impacted by the then current economic environment including the following: Buildings and Commercial Real Estate, Healthcare, Broadcast and Entertainment, Nondurable Consumer Products, Energy and Chemical Services, Industrial and Other Business Services. For impaired Middle Market Corporate loans, the Company measured impairment based on expected cash flows utilizing relevant information provided by the borrower and consideration of other market conditions or specific factors impacting recoverability. Such amounts are discounted based on original loan terms. For impaired Commercial Real Estate loans, the Company determined that the loans were collateral dependent and measured impairment based on the fair value of the related collateral utilizing recent appraisals from third-party appraisers, as well as internal estimates of market value.

Loans deemed to be uncollectible are charged off and deducted from the allowance. The provision for credit losses and recoveries on loans previously charged off are added to the allowance.

Valuation of deferred tax assets

We recognize deferred tax assets and liabilities resulting from the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We regularly review our deferred tax assets to assess their potential realization and whether or not a valuation allowance is necessary. In performing these reviews we make estimates about future profits and tax planning strategies that would affect future taxable income and the realization of these deferred tax assets. A change in these assumptions could result in a difference in valuation and impact our results of operations. At December 31, 2009, we had a valuation allowance of $0.3 million related to our deferred tax asset.

 

50


Table of Contents

On January 1, 2007, the Company adopted ASC 740 (formerly FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—An interpretation of FASB Statement No. 109). ASC 740 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements. A company can only recognize the tax position in the financial statements if the position is more-likely-than-not to be upheld on audit, based only on the technical merits of the tax position. If the recognition threshold is met, the tax benefit is measured at the largest amount that is more than 50% likely of being realized upon ultimate settlement.

ASC 740 also addresses how interest and penalties should be accrued for uncertain tax positions, requiring that interest expense should be recognized in the first period interest would be accrued under the tax law. The Company classifies all interest and penalties on recognized tax benefits as a part of income tax expense. At January 1, 2007, the Company did not have any accrued interest or penalties.

At December 31, 2009, the Company did not have any unrecognized tax benefits, and there have been no material changes since adoption. The Company does not expect any significant changes within the next 12 months.

The Company files U.S. federal and state income tax returns. As of December 31, 2009, the Company’s tax returns for the years ended 2008, 2007 and 2006 remain subject to examination by the Internal Revenue Service and state tax authorities.

Fair Value

The Company utilizes fair value measurements to record fair value adjustments to certain financial instruments and to determine fair value disclosures. ASC 820, Fair Value Measurements (“ASC 820”) differentiates between those assets and liabilities required to be carried at fair value at every reporting period (“recurring”) and those assets and liabilities that are only required to be adjusted to fair value under certain circumstances (“nonrecurring”). Cash and cash equivalents, investments in debt securities, available-for-sale, residual interest in securitization and derivatives are financial instruments recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other financial assets on a nonrecurring basis, such as loans held-for-sale and loans held-for-investment. These nonrecurring fair value adjustments typically involve application of the lower of cost or market accounting or write-downs of individual assets. Further, the notes to the consolidated financial statements include information about the extent to which fair value is used to measure assets and liabilities and the valuation methodologies used.

ASC 820, Fair Value Measurements (“ASC 820”) establishes a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:

 

   

Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

 

   

Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

 

   

Level 3 – inputs to the valuation methodology are unobservable and significant to the fair value measurement.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

For assets and liabilities recorded at fair value, it is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy in ASC 820. When available, the Company utilizes quoted market prices to measure

 

51


Table of Contents

fair value. If market prices are not available, fair value measurement is based upon models that use primarily market-based or independently sourced market parameters, including interest rate yield curves, prepayment speeds, option volatilities and other assumptions. However, in certain cases, when market observable inputs for model-based valuation techniques may not be readily available, the Company is required to make judgments about assumptions market participants would use in estimating the fair value of the financial instrument. The models used by the Company to determine fair value adjustments are periodically evaluated by management for relevance under current facts and circumstances.

The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted market prices or observable market parameters. For financial instruments that trade actively and have quoted market prices or observable market parameters, there is minimal subjectivity involved in measuring fair value. When observable market prices and parameters are not fully available, management judgment is necessary to estimate fair value. In addition, changes in market conditions may reduce the availability of quoted prices or observable data. For example, reduced liquidity in the capital markets or changes in secondary market activities could result in observable market inputs becoming unavailable. Therefore, when market data is not available, the Company would use valuation techniques requiring more management judgment to estimate the appropriate fair value measurement.

As of December 31, 2009, 2.9% of total assets and 72.3% of the assets we measured at fair value used significant unobservable inputs (level 3 assets). During 2009 we recognized losses of $37.7 million in earnings and a gain of $1.4 million in other comprehensive income related to changes in fair value of these level 3 assets. The table below sets forth information regarding our level 3 assets as of December 31, 2009:

 

Description

   Fair Value at
December 31, 2009
     ($ in thousands)

Commercial loans, net:

  

Commercial real estate

   $ 46,182

Other real estate owned

     13,413

Investments in debt securities, available-for-sale:

  

Securities backed by licenses and easements

     4,183

Warrants and equity-linked products

     1
      

Total level 3 assets at fair value

   $ 63,779
      

Revenue recognition

Interest income is recorded on the accrual basis in accordance with the terms of the respective loan and debt product. The accrual of interest on loans and other debt products is discontinued when principal or interest payments are past due by 90 days or more or when, in the opinion of management, it is probable we will be unable to collect contractual principal and interest in the normal course of business. If loans are placed on non-accrual status, all interest previously accrued but not collected is reversed against current period interest income. Interest income on non-accrual loans is subsequently recognized only to the extent that cash is received and the principal balance is deemed collectible.

Nonrefundable fees and related direct costs associated with the origination or purchase of loans and other debt products are deferred and netted against balances outstanding. The net deferred fees or costs are recognized as an adjustment to interest income over the contractual life of the loans using a method which approximates the effective interest method. In connection with the prepayment of a loan or other debt product, a partial amount of the remaining unamortized net deferred fees, costs, premiums or discounts are accelerated and recognized as interest income. The amortization of fees is discontinued on non-accrual loans. Depending on the terms of a loan or other debt product, we may charge a prepayment fee and recognize it in the period of the prepayment. We

 

52


Table of Contents

accrete any discount and amortize any premium from purchased debt products into interest income as a yield adjustment over the contractual life. Syndication, arrangement and structuring fees are recognized in the period the service is completed as a component of non-interest income.

Stock-based compensation

Effective January 1, 2006, we adopted ASC 718 (formerly SFAS 123 (revised 2004), Share-Based Payment), which requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values on the grant date. We adopted ASC 718 using the prospective method.

For awards granted, modified, repurchased or cancelled after January 1, 2006, we estimate the fair value of stock-based awards using the Black-Scholes valuation model, which requires the input of subjective assumptions, including expected term and expected price volatility. Changes in these assumptions can materially affect the calculated fair value of stock-based compensation and the related expense to be recognized. We expect the changes in our stock price during 2009 will impact our 2010 price volatility assumption and could result in an adverse affect to our financial statements. Further, for awards that contain performance measures and conditions, we make an assessment, based on management’s judgment, of the probability of these conditions being satisfied, which affects the timing and the amount of expense to be recognized. If our judgment as to whether these conditions are probable of occurrence are not appropriate, the financial statements could be materially affected.

Valuation of investments in debt securities

We review the fair value of our other debt products quarterly. The fair value of our investments in debt securities, non-investment grade securities and residual securities, are based on independent third-party quoted market prices, when available, at the reporting date for those or similar investments. When no market is available, we estimate fair value using various valuation methodologies, including cash flow analysis and internally generated financial models that incorporate significant assumptions and judgments, as well as qualitative factors.

Even if the general accuracy of our valuation models are validated, there are no assurances that our valuations are accurate because of the high number of variables that affect cash flows associated with these complex cash flow structures, which differ on each securitization. Valuations are highly dependent upon the reasonableness of our assumptions and the predictability of the relationships that drive the results of the model. Because of the inherent uncertainty of determining the fair value of investments that do not have a readily ascertainable market value, the fair value of investments may differ significantly from the values that would have been used had a market existed for the investments, and the differences could be material. In addition, if our estimates or assumptions with respect to these assets prove to be incorrect, we may be required to write down some or all of the value of these assets.

A debt product is considered impaired when the fair value of the debt product declines below its amortized cost. The cost basis of the investment is then written down to fair value. If management determines the impairment to be temporary, it is recorded in other comprehensive income, a component of stockholders’ equity. If management determines the impairment to be other than temporary, it is recorded as an offset to other income on our statements of operations. From time to time we may become aware of cash flow or credit issues with respect to our other debt products and these other debt products are then monitored by management to determine if a write-down is appropriate.

Although we view write-downs of our other debt products as a normal and anticipated aspect of our business, material write-downs of the fair value of our other debt products could adversely affect our results of operations and financial condition. Our allowance for credit losses does not cover write-downs because we classify these assets as available-for-sale and are accounted for under the guidelines of ASC 320.

 

53


Table of Contents

In the past, we invested in the RMBS market and were exposed to changes in the credit performance of the mortgage loans underlying these investment securities. During 2008, we sold $114 million of our RMBS debt products to an off-balance sheet financing vehicle (Please see Note 7 to our consolidated financial statements regarding residual interest). As of December 31, 2008, we had completely written off our remaining RMBS debt products. The performance of our investment securities may be negatively impacted by, among other things, the timing of losses, higher than expected levels of credit losses or prepayment speeds on the underlying mortgages or home equity loans, depending on the specific structure of each securitization. Most of our investments are in classes of securities which are not actively traded in secondary markets or have lower levels of liquidity. The fair value of securities and other investments that have such liquidity characteristics may not be readily ascertained. This situation may be further exacerbated by current market conditions.

The description of certain instruments as “debt securities” is intended to describe the accounting treatment of those instruments and is not a characterization of those instruments as securities for any other purpose.

Valuation of residual interest in securitization

The fair value of our residual interest is based on forecasted cash flows, discount rates, expected credit losses and prepayment speeds for the individual loans and securities. We recognize changes in the fair value of the residual interest as gains or losses on our statement of operations.

In addition, the fair value determined at any time may not be accurate due to a high number of variables that affect cash flows associated with these complex cash flow structures. Our determination of fair value will be highly dependent upon the reasonableness of our assumptions and the predictability of the relationships that drive the results of our internal cash flow model. Because of the inherent uncertainty of determining the fair value of investments that currently may not have a readily ascertainable market value, the fair value of investments may differ significantly from the values that would have been used had a market existed for the residual interest, and the differences could be material.

Our assumptions as to discount rate and future cash flows on the individual assets may be higher or lower than those that might be employed by a third party. To value the assets, we use historical performance data at the time of determination and assumptions about delinquencies, losses, severities and prepayment speeds in the future, including assumptions about the timing of these variables, in arriving at estimates of future cash flows on the individual assets. These assumptions are influenced by historical experience in the respective asset classes and with particular originations and servicers. Within the various RMBS asset classes, assumptions and methodologies used by us are generally consistent among the various assets within each class and generally consistent with past forecasting techniques used by us.

 

54


Table of Contents
Item 7A. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to changes in market values of our loans held-for-sale, which are carried at lower of cost or market, and our investment in debt securities, available-for-sale and derivatives, which are carried at fair value. Fair value is defined as the market price for those securities for which a market quotation is readily available and for all other investments and derivatives, fair value is determined pursuant to a valuation policy and a consistent valuation process. Where a market quotation is not readily available, we estimate fair value using various valuation methodologies, including cash flow analysis, as well as qualitative factors.

As of December 31, 2009 and 2008, investments in debt securities available-for-sale totaled $4.2 million and $3.0 million, respectively. At December 31, 2009 and 2008, our net unrealized loss on those debt securities totaled $0.2 million and $1.5 million, respectively. Any unrealized gain or loss on these investments is included in Other Comprehensive Income in the equity section of the balance sheet, until realized.

Interest rate risk represents a market risk exposure to us. Our goal is to manage interest rate sensitivity so that movements in interest rates do not adversely affect our net interest income. Interest rate risk is measured as the potential volatility to our net interest income caused by changes in market interest rates. During the normal course of business our lending to clients and our investments in debt securities create some interest rate risk as does the impact of ever-changing market conditions. Our management attempts to mitigate this risk through our Asset Liability Committee (“ALCO”) process taking into consideration balance sheet dynamics such as loan and investment growth and pricing, changes in funding mix and maturity characteristics. The ALCO group reviews the overall rate risk position and strategy on an ongoing basis. The ALCO group also reviews the impact on net interest income caused by changes in the shape of the yield curve as well as parallel shifts in the yield curve.

The following table shows the hypothetical estimated change in net interest income for a 12-month period based on changes in the interest rates applied to our portfolio and cash and cash equivalents as of December 31, 2009. Our modeling is based on contractual terms and does not consider prepayment:

 

     Rate Change
(Basis Points)
   Estimated Change in
Net Interest Income
Over 12 Months
 
          ($ in thousands)  

Decrease of

   100    $ 3,700   

Increase of

   100      (3,648

As shown above, we estimate to the best of our ability that a decrease in interest rates of 100 basis points would have resulted in an increase of $3.7 million in our annualized net interest income, and an increase in interest rates of 100 basis points would have resulted in a decrease in our net interest income of $3.6 million. The estimated changes in net interest income reflect the potential effect of interest rate floors on loans totaling approximately $775.0 million. If interest rates rise, the potential impact from interest rate floors would decrease resulting in lower net interest income. The cost of our variable rate debt would increase, while interest income from loans with interest rate floors would not change until interest rates exceed the stated rate of the interest rate floors.

 

55


Table of Contents
Item 8. Financial Statements and Supplementary Data

NEWSTAR FINANCIAL, INC.

INDEX TO FINANCIAL STATEMENTS

 

Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting

   57

Report of Independent Registered Public Accounting Firm

   58

Consolidated Balance Sheets as of December 31, 2009 and December 31, 2008

   59

Consolidated Statements of Operations for the years ended December 31, 2009, 2008 and 2007

   60

Consolidated Statement of Changes in Stockholders’ Equity for the years ended December  31, 2009, 2008 and 2007

   61

Consolidated Statements of Cash Flows for the years ended December 31, 2009, 2008 and 2007

   62

Notes to Consolidated Financial Statements

   63

 

56


Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The Board of Directors

NewStar Financial, Inc.:

We have audited NewStar Financial, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). NewStar Financial, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial 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 internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures 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 statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) 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.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections 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, NewStar Financial, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of NewStar Financial, Inc. as of December 31, 2009 and 2008, and the related consolidated statements of operations, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2009, and our report dated March 8, 2010 expressed an unqualified opinion on those consolidated financial statements.

/s/ KPMG LLP

Boston, Massachusetts

March 8, 2010

 

57


Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors

NewStar Financial, Inc.:

We have audited the accompanying consolidated balance sheets of NewStar Financial, Inc. and subsidiaries (the “Company”) as of December 31, 2009 and 2008, and the related consolidated statements of operations, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2009. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated 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 consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of NewStar Financial, Inc. and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 8, 2010 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/ KPMG LLP

Boston, Massachusetts

March 8, 2010

 

58


Table of Contents

NEWSTAR FINANCIAL, INC.

CONSOLIDATED BALANCE SHEETS

 

     December 31,
2009
    December 31,
2008
 
     ($ in thousands, except share
and par value amounts)
 

Assets:

    

Cash and cash equivalents

   $ 39,848      $ 50,279   

Restricted cash

     136,884        84,163   

Investments in debt securities, available-for-sale

     4,183        3,025   

Loans held-for-sale, net

     15,736        —     

Loans, net

     1,878,978        2,328,812   

Deferred financing costs, net

     18,557        21,003   

Interest receivable

     7,949        10,608   

Property and equipment, net

     976        1,252   

Deferred income taxes, net

     56,449        31,238   

Income tax receivable

     7,260        —     

Other assets

     33,252        41,142   
                

Total assets

   $ 2,200,072      $ 2,571,522   
                

Liabilities:

    

Credit facilities

   $ 91,890      $ 411,267   

Term debt

     1,523,052        1,524,171   

Accrued interest payable

     2,774        9,773   

Accounts payable

     645        1,049   

Income tax payable

     —          353   

Other liabilities

     31,591        43,354   
                

Total liabilities

     1,649,952        1,989,967   
                

Stockholders’ equity and noncontrolling interest:

    

Preferred stock, par value $0.01 per share (5,000,000 shares authorized; no shares outstanding)

     —          —     

Common stock, par value $0.01 per share:

    

Shares authorized: 145,000,000 in 2009 and 2008;

    

Shares outstanding 49,994,858 in 2009 and 48,466,166 in 2008

     500        486   

Additional paid-in capital

     616,762        608,996   

Retained deficit

     (69,083     (24,823

Common stock held in treasury, at cost $0.01 par value; 257,392 in 2009 and 167,677 in 2008

     (1,331     (1,078

Accumulated other comprehensive loss, net

     (786     (2,026
                

Total NewStar Financial, Inc. stockholders’ equity

     546,062        581,555   

Noncontrolling interest

     4,058        —     
                

Total stockholders’ equity

     550,120        581,555   
                

Total liabilities and stockholders’ equity

   $ 2,200,072      $ 2,571,522   
                

The accompanying notes are an integral part of these consolidated financial statements.

 

59


Table of Contents

NEWSTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

 

     Year Ended December 31,  
         2009                 2008                 2007        
   ($ in thousands, except per share amounts)  

Net interest income:

      

Interest income

   $ 136,569      $ 188,770      $ 204,295   

Interest expense

     41,927        86,216        109,703   
                        

Net interest income

     94,642        102,554        94,592   

Provision for credit losses

     133,093        38,224        19,510   
                        

Net interest income (loss) after provision for credit losses

     (38,451     64,330        75,082   

Non-interest income:

      

Fee income

     1,657        4,518        15,797   

Asset management income—related party

     2,934        6,283        5,304   

Gain on derivatives

     533        2,157        777   

Gain (loss) on sale of loans and debt securities

     —          282        (4,615

Loss on investments in debt securities

     —          (932     (20,303

Loss on residual interest in securitization

     —          (631     (30,556

Other income

     5,529        7,253        5,420   
                        

Total non-interest income

     10,653        18,930        (28,176

Operating expenses:

      

Compensation and benefits

     26,403        30,413        45,364   

Occupancy and equipment

     3,121        3,286        2,718   

General and administrative expenses

     12,911        11,090        9,412   
                        

Total operating expenses

     42,435        44,789        57,494   
                        

Income (loss) before income taxes

     (70,233     38,471        (10,588

Income tax expense (benefit)

     (24,353     16,073        (1,949
                        

Net income (loss) before noncontrolling interest

     (45,880     22,398        (8,639

Net loss attributable to noncontrolling interest

     1,620        —          —     
                        

Net income (loss) attributable to NewStar Financial, Inc. common stockholders

   $ (44,260   $ 22,398      $ (8,639
                        

Basic income (loss) per share

   $ (0.90   $ 0.46      $ (0.23

Diluted income (loss) per share

     (0.90     0.46        (0.23

The accompanying notes are an integral part of these consolidated financial statements.

 

60


Table of Contents

NEWSTAR FINANCIAL, INC.

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

 

    NewStar Financial, Inc. Stockholders’ Equity     Noncontrolling
Interest
 
  Preferred
Stock
  Common
Stock
  Additional
Paid-in
Capital
    Retained
Deficit
    Treasury
Stock
    Accumulated
Other
Comprehensive
Loss, net
    Common
Stockholders’
Equity
   
  ($ in thousands)  

Balance at January 1, 2007

  $ —     $ 363   $ 463,925      $ (38,582   $ —        $ (2,291   $ 423,415      $ —     

Net loss

    —       —       —          (8,639     —          —          (8,639     —     

Other comprehensive income (loss):

               

Net unrealized securities losses, net of tax benefit of $5,415

    —       —       —          —          —          (8,247     (8,247     —     

Recognition of net unrealized losses for securities sold net of tax benefit of $6,391

    —       —       —          —          —          9,600        9,600        —     

Net unrealized derivatives losses, net of tax benefit of $322

    —       —       —          —          —          (526     (526     —     
                     

Total comprehensive loss

                (7,812  

Net proceeds from issuance of common stock

    —       71     72,079        —          —          —          72,150        —     

Shares reacquired from employee transactions

    —       —       —          —          (763     —          (763     —     

Amortization of restricted common stock awards

    —       —       12,206        —          —          —          12,206        —     

Amortization of stock option awards

    —       —       3,494        —          —          —          3,494        —     
                                                           

Balance at December 31, 2007

    —       434     551,704        (47,221     (763     (1,464     502,690        —     

Net income

    —       —       —          22,398        —          —          22,398        —     

Other comprehensive income:

               

Net unrealized securities losses, net of tax benefit of $601

    —       —       —          —          —          (915     (915     —     

Recognition of net unrealized losses, net of tax benefit of $322

    —       —       —          —          —          624        624        —     

Net unrealized derivatives gains, net of tax benefit of $194

    —       —       —          —          —          (271     (271     —     
                     

Total comprehensive income

                21,836     

Net proceeds from issuance of common stock

    —       52     48,839        —          —          —          48,891        —     

Shares reacquired from employee transactions

    —       —       —          —          (315     —          (315     —     

Amortization of restricted common stock awards

    —       —       5,889        —          —          —          5,889        —     

Amortization of stock option awards

    —       —       2,564        —          —          —          2,564        —     
                                                           

Balance at December 31, 2008

    —       486     608,996        (24,823     (1,078     (2,026     581,555        —     

Net loss

    —       —       —          (44,260     —          —          (44,260     (1,620

Other comprehensive income:

               

Net unrealized securities gains, net of tax expense of $540

    —       —       —          —          —          822        822     

Net unrealized derivatives gains, net of tax expense of $412

    —       —       —          —          —          418        418        —     
                     

Total comprehensive income

                (43,020  

Contributions from noncontrolling interest

                  5,678   

Issuance of restricted stock

    —       14     (14     —          —          —          —          —     

Shares reacquired from employee transactions

    —       —       —          —          (253     —          (253     —     

Amortization of restricted common stock awards

    —       —       4,364        —          —          —          4,364        —     

Amortization of stock option awards

    —       —       3,416        —          —          —          3,416        —     
                                                           

Balance December 31, 2009

  $ —     $ 500   $ 616,762      $ (69,083   $ (1,331   $ (786   $ 546,062      $ 4,058   
                                                           

The accompanying notes are an integral part of these consolidated financial statements.

 

61


Table of Contents

NEWSTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     Year Ended December 31,  
   2009     2008     2007  
   ($ in thousands)  

Cash flows from operating activities:

      

Net income (loss)

   $ (44,260   $ 22,398      $ (8,639

Adjustments to reconcile net income (loss) to net cash used for operations:

      

Provision for credit losses

     133,093        38,224        19,510   

Depreciation and amortization and accretion

     (12,502     (9,014     (11,294

Amortization of debt issuance costs

     6,803        5,026        3,166   

Equity compensation expense

     7,780        8,453        15,700   

Net loss on investments in debt securities

     —          932        20,303   

Net loss on residual interest in securitization

     —          631        30,556   

Net (gain) loss on sale of loans and securities

     —          (282     4,615   

Gain on repurchase of debt

     (7,822     (6,897     (1,129

Deposits to securitization trust

     —          —          (37,031

Net change in deferred income taxes

     (25,622     (17,400     696   

Net change in loans held-for-sale

     (15,736     79,036        (50,324

Net change in interest receivable

     2,659        3,512        5,729   

Net change in other assets

     (1,378     (8,321     (11,742

Net change in accrued interest payable

     (6,999     (7,764     (5,759

Net change in accounts payable and other liabilities

     (18,617     (15,109     26,297   
                        

Net cash provided by (used in) operating activities

     17,399        93,425        654   
                        

Cash flows from investing activities:

      

Net change in restricted cash

     (52,721     31,644        (75,633

Net change in loans

     336,997        (122,619     (781,915

Proceeds from sale of loans

     —          —          12,704   

Proceeds from sale of other real estate owned

     4,049        —          —     

Purchase of debt securities available-for-sale

     —          —          (31,685

Proceeds from repayments of debt securities available-for-sale

     311        1,340        22,346   

Proceeds from sale of debt securities available-for-sale

     —          29,737        157,007   

Acquisition of property and equipment

     819        (157     (1,111
                        

Net cash provided by (used in) investing activities

     289,455        (60,055     (698,287
                        

Cash flows from financing activities:

      

Proceeds from issuance of common stock

     —          48,891        72,150   

Repayments under repurchase agreements, net

     —          (63     (34,376

Borrowings on credit facilities

     69,139        731,348        1,893,225   

Repayment of borrowings on credit facilities

     (244,567     (997,820     (1,841,396

Issuance of term debt

     —          —          446,000   

Borrowings on term debt

     58,925        444,996        312,500   

Repayment of borrowings on term debt

     (196,172     (278,653     (166,871

Payment of deferred financing costs

     (4,357     (7,630     (9,950

Purchase of treasury stock

     (253     (315     (763
                        

Net cash provided by (used in) financing activities

     (317,285     (59,246     670,519   
                        

Net increase (decrease) in cash during the period

     (10,431     (25,876     (27,114

Cash and cash equivalents at beginning of period

     50,279        76,155        103,269   
                        

Cash and cash equivalents at end of period

   $ 39,848      $ 50,279      $ 76,155   
                        

Supplemental cash flows information:

      

Interest paid

   $ 48,926      $ 93,980      $ 115,461   

Taxes paid

     9,181        29,948        7,270   

Decrease (increase) in fair value of investments in debt securities

     (1,362     1,516        13,662   

Transfers of loans, net to loans held-for-sale

     7,909        —          —     

Transfers of loans held-for-sale to loans, net

     —          33,101        —     

Transfers of loans and loans held-for-sale to other real estate owned

     10,836        —          —     

Transfers of debt from credit facilities to term debt

     143,950        —          —     

The accompanying notes are an integral part of these consolidated financial statements.

 

62


Table of Contents

NEWSTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Organization

NewStar Financial, Inc. (the “Company”), a Delaware corporation, is a commercial finance company that provides customized debt financing solutions to middle market businesses and commercial real estate borrowers and manages investment funds for large institutional investors. The Company principally focuses on the direct origination of loans that meet its risk and return parameters. The Company’s direct origination efforts target mid-sized companies, private equity sponsors, corporate executives, regional banks, real estate investors and a variety of other financial intermediaries to source transaction opportunities. Direct origination provides direct access to customers’ management, enhances due diligence, and allows significant input into customers’ capital structure and direct negotiation of transaction pricing and terms.

The Company operates as a single segment and derives its revenues from two specialized lending groups:

 

   

Middle Market Corporate, which originates, structures and underwrites senior debt and, to a lesser extent, second lien, mezzanine and subordinated debt, and equity and other equity-linked products for companies with annual EBITDA typically between $5 million and $50 million; and

 

   

Commercial Real Estate, which originates, structures and underwrites first mortgage debt and, to a lesser extent, subordinated debt, primarily to finance acquisitions of real estate properties typically valued between $10 million and $50 million.

Subsequent to December 31, 2007, the Company discontinued the origination of structured products. The Company manages its remaining structured products portfolio within its Middle Market Corporate lending group. As of December 31, 2009, this portfolio had an outstanding balance of $40.7 million.

The Company has not originated any new commercial real estate loans since the first quarter of 2008.

Note 2. Summary of Significant Accounting Policies

Consolidation

The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “NewStar”) and have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). All significant intercompany transactions have been eliminated in consolidation.

Noncontrolling Interest

During 2009, the Company, as part of the resolution of a commercial real estate loan, created along with an investment vehicle of the NewStar Credit Opportunities Fund, Ltd. (“NCOF”), a limited liability company to take control of the underlying commercial real estate property. The Company maintains a majority and controlling interest in the limited liability company with a fair value of $5.7 million, net of the noncontrolling interest, as of December 31, 2009, as other real estate owned (“OREO”).

The consolidated financial statements include the results of operations of the Company as well as the NCOF’s noncontrolling interest of the limited liability company which owns the OREO. All significant intercompany balances and transactions have been eliminated in consolidation. The noncontrolling interest represents the minority partner’s equity and accumulated earnings in the limited liability company. The NCOF’s noncontrolling interest has no recourse to the Company.

 

63


Table of Contents

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect certain reported amounts and disclosure of contingent assets and liabilities. Actual results could differ from those estimates. Estimates most susceptible to change in the near-term are the Company’s estimates of their allowance for credit losses, impairment of loans and recorded amounts of deferred income taxes.

Cash and Cash Equivalents

Cash and cash equivalents include all demand deposits held in banks and certain highly liquid instruments with original maturities of 90 days or less.

Investments in Debt Securities

Management determines the classification of securities at the time of purchase. If management has the intent and the Company has the ability at the time of purchase to hold securities until maturity, they are classified as held-to-maturity. Investment securities held-to-maturity are stated at amortized cost. Securities to be held for indefinite periods of time, but not necessarily to be held-to-maturity or on a long-term basis, are classified as available-for-sale and carried at fair value with unrealized gains or losses reported as a separate component of stockholders’ equity in other comprehensive income, net of applicable income taxes. The carrying values of all securities are adjusted for amortization of premiums and accretion of discounts over the shorter of the period to call or maturity of the related security using a method that approximates the interest method. Realized gains or losses on the sale of securities, if any, are determined using the amortized cost of the specific securities sold. If a decline in the fair value of a security below its amortized cost is judged by management to be other than temporary, the cost basis of the security is written down to fair value and the amount of the write-down is included in operations. The fair value of debt securities are based on quoted market prices, when available, at the reporting date for those or similar investments. When no market is available, the Company estimates fair value using various valuation tools, including cash flow analyses that utilize financial statements, business plans, as well as qualitative factors.

Residual Interest in Securitization

The fair value of our residual interest is based on forecasted cash flows, discount rates, expected credit losses and prepayment speeds for the individual loans and securities. We recognize changes in the fair value of the residual interest as gains or losses on our statement of operations.

In addition, the fair value determined at any time may not be accurate due to a high number of variables that affect cash flows associated with these complex cash flow structures. Our determination of fair value will be highly dependent upon the reasonableness of our assumptions and the predictability of the relationships that drive the results of our internal cash flow model. Because of the inherent uncertainty of determining the fair value of investments that currently may not have a readily ascertainable market value, the fair value of investments may differ significantly from the values that would have been used had a market existed for the residual interest, and the differences could be material. In addition, if our estimates or assumptions with respect to these assets prove to be incorrect, we may be required to write down some or all of the value of the residual interest which would adversely affect our results of operations and financial condition.

Our assumptions as to discount rate and future cash flows on the individual assets may be higher or lower than those that might be employed by a third party. To value the assets, we use historical performance data at the time of determination and assumptions about delinquencies, losses, severities and prepayment speeds in the future, including assumptions about the timing of these variables, in arriving at estimates of future cash flows on

 

64


Table of Contents

the individual assets. These assumptions are influenced by historical experience in the respective asset classes and with particular originations and servicers. Within the various RMBS asset classes, assumptions and methodologies used by us are generally consistent among the various assets within each class and generally consistent with past forecasting techniques used by us.

Loans Held-for-Sale

Loans classified as held-for-sale consist of loans originated by the Company, intended to be sold or syndicated to third parties. These loans are carried at the lower of aggregate cost, net of any deferred origination costs or fees, or market value.

Loans

Loans are stated at the principal amount outstanding. Interest income is recorded on the accrual basis in accordance with the terms of the respective loan. Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. The accrual of interest on loans is discontinued when principal or interest payments are past due 90 days or when, in the opinion of management, it is probable it will be unable to collect contractual principal and interest in the normal course of business. When loans are placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. Income on nonaccrual loans is subsequently recognized only to the extent that cash is received and the loan’s principal balance is deemed collectible.

Nonrefundable loan fees and related direct costs associated with the origination or purchase of loans are deferred and included in loans, net in the consolidated balance sheet. The net deferred fees or costs are recognized as an adjustment to interest income over the contractual life of the loans using a method which approximates the interest method or taken into income when the related loans are paid off or sold. The Company accretes any discount from purchased loans into loan fee income as a yield adjustment over the contractual life of the loan. The amortization of loan fees is discontinued on non-accrual loans.

Provision and Allowance for Credit Losses

The allowance for credit losses is based on a loan-by-loan build-up of inherent losses on loans, gross. The Company also maintains an allowance for losses on unfunded loan commitments, namely loan commitments and letters of credit that are reported in other liabilities on the balance sheet. The combined balance of the allowance for loan losses and the allowance for unfunded commitments is referred to as the allowance for credit losses. Provision expense is recorded for both the allowance for loan losses and the allowance for losses on unfunded loan commitments.

In accordance with ASC 310 (formerly SFAS No. 5, Accounting for Contingencies), a general allowance is provided for loans that are not impaired. The Company employs a variety of internally developed and third-party modeling and estimation tools for measuring credit risk, which are used in developing an allowance for loan losses on outstanding loans. The Company’s allowance framework addresses economic conditions, capital market liquidity and industry circumstances from both a top-down and bottom-up perspective. The Company considers and evaluates changes in economic conditions, credit availability, industry and multiple obligor concentrations in assessing both probabilities of default and loss severities as part of the general component of the allowance for loan losses.

On at least a quarterly basis, loans are internally risk-rated based on individual credit criteria, including loan type, loan structures (including balloon and bullet structures common in the Company’s Middle Market Corporate and Commercial Real Estate cash flow loans), borrower industry, payment capacity, location and quality of collateral if any (including the Company’s Commercial Real Estate loans). Borrowers provide the Company with financial information on either a monthly or quarterly basis. Ratings, corresponding assumed default rates and assumed loss severities are dynamically updated to reflect any changes in borrower condition or profile.

 

65


Table of Contents

For Middle Market Corporate loans, the data set used to construct probabilities of default in its allowance for loan losses model, Moody’s CRD Private Firm Database, principally contains middle market corporate loans that share attributes similar to the Company’s loans. The Company also considers the quality of the loan terms in determining a loan loss in the event of default.

For Commercial Real Estate loans, the Company employs two mechanisms to capture the impact of industry and economic conditions. First, a loan’s risk rating, and thereby its assumed default likelihood, can be adjusted to account for overall commercial real estate market conditions. Second, to the extent that economic or industry trends adversely affect a borrower’s loan-to-value ratio enough to impact its repayment ability, the Company applies a stress multiplier to the loan’s probability of default. The multiplier is designed to account for default characteristics that are difficult to quantify when market conditions cause commercial real estate prices to decline.

Additionally, when determining the amount of the general allowance, the Company supplements the base amount with a judgmental amount which is governed by a score card system comprised of ten individually weighted risk factors. The risk factors are designed based on those outlined in the Comptrollers of the Currency’s Allowance for Loan and Lease Losses Handbook. The Company also performs a ratio analysis of comparable money center banks, regional banks and finance companies. While the Company does not rely on this peer group comparison to set the level of allowance for credit losses, it does assist management in identifying market trends and serves as an overall reasonable check on the allowance for credit losses computation.

In accordance with ASC 310 (formerly SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”), a loan is considered impaired when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impairment of a loan is based upon either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent, depending on the circumstances and our collection strategy. Impaired loans are identified based on the loan-by-loan risk rating process described above. It is the Company’s policy during the reporting period to record a specific provision for credit losses for all loans for which we have serious doubts as to the ability of the borrowers to comply with the present loan repayment terms.

Impaired loans at December 31, 2009 were in both Commercial Real Estate and in Middle Market Corporate, over a range of industries impacted by the then current economic environment including the following: Buildings and Commercial Real Estate, Healthcare, Broadcast and Entertainment, Nondurable Consumer Products, Energy and Chemical Services, Industrial and Other Business Services. For impaired Middle Market Corporate loans, the Company measured impairment based on expected cash flows utilizing relevant information provided by the borrower and consideration of other market conditions or specific factors impacting recoverability. Such amounts are discounted based on original loan terms. For impaired Commercial Real Estate loans, the Company determined that the loans were collateral dependent and measured impairment based on the fair value of the related collateral.

Loans deemed to be uncollectible are charged off and deducted from the allowance. The provision for credit losses and recoveries on loans previously charged off are added to the allowance.

Deferred Financing Costs

Deferred financing costs represent fees and other direct incremental costs incurred in connection with borrowings. These amounts are amortized using the straight-line method into earnings as interest expense ratably over the contractual term of the facility.

 

66


Table of Contents

Property and Equipment

Property and equipment are carried at cost and are depreciated or amortized on a straight-line basis over the following useful lives:

 

Leasehold improvements

   Shorter of estimated life or remaining lease term

Computer equipment and software

   3 years

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

Derivative Instruments and Hedging Activities

The Company accounts for derivatives and hedging activities in accordance with ASC 815 (formerly SFAS No. 133, Accounting for Derivative Instruments and Certain Hedging Activities, as amended), which requires that all derivative instruments be recorded on the balance sheet at their respective fair values. The Company records all derivatives in either other assets or other liabilities at fair value in the consolidated balance sheet.

On the date a derivative contract is entered into, the Company designates the derivative as either (1) a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge) or as (2) a derivative trading instrument. For all hedging relationships the Company formally documents the hedging relationship and its risk-management objective and strategy for undertaking the hedge, the hedging instrument, the item, the nature of the risk being hedged, how the hedging instrument’s effectiveness in offsetting the hedged risk will be assessed, and a description of the method of measuring ineffectiveness. This process includes linking all derivatives that are designated as hedges to specific assets and liabilities on the balance sheet or to forecasted transactions. The Company also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in cash flows of hedged items. Changes in the fair value of a derivative that is highly effective and that is designated and qualifies as a cash-flow hedge are recorded in other comprehensive income to the extent that the derivative is effective as a hedge, until earnings are affected by the variability in cash flows of the designated hedged item. The ineffective portion of the change in fair value of a derivative instrument that qualifies as a cash-flow hedge is reported in earnings.

The Company discontinues hedge accounting prospectively when it is determined that the derivative is no longer effective in offsetting changes in the cash flows of the hedged item, the derivative expires or is sold, terminated, or exercised, the derivative is de-designated as a hedging instrument because it is unlikely that a forecasted transaction will occur, or management determines that designation of the derivative as a hedging instrument is no longer appropriate. In all situations in which hedge accounting is discontinued, the Company continues to carry the derivative at its fair value on the balance sheet and recognizes any subsequent changes in its fair value in earnings. When hedge accounting is discontinued because it is probable that a forecasted transaction will not occur by the date (or within the time period) originally specified or within an additional two-month period of time thereafter, the Company recognizes immediately in earnings gains and losses that were accumulated in other comprehensive income. Gains and losses on derivatives not designated as hedges, including any cash payments made or received, are reported as gain (loss) on derivatives in the accompanying consolidated statements of operations.

 

67


Table of Contents

Comprehensive Income (Loss), net of tax

The Company records the change in fair value of cash flow hedge derivatives and unrealized gains and losses on available-for-sale securities in comprehensive income. Gains and losses on available-for-sale securities are reclassified to net income as the gains and losses are realized upon sale of the securities. Other than temporary impairment charges are reclassified to earnings at the time of the charge.

Fee Income Recognition

Origination fees and costs are deferred and amortized as yield adjustments over the contractual life of the loans and investments. In connection with the prepayment of a loan or other debt product, any remaining unamortized net deferred fees for that loan are accelerated and, depending on the terms of the loan, there may be an additional fee charged based upon the prepayment and recognized in the period of the prepayment. Syndication and structuring fees are recognized in the period the service is completed as fee income.

Asset Management Income

NewStar Financial, Inc. earns asset management income for investment management services performed for the NewStar Credit Opportunities Fund, Ltd. NewStar accrues this income when earned, on a monthly basis, and classifies it as asset management income in the consolidated statements of operations.

Stock Based Compensation

The Company accounts for stock-based compensation under the guideline of ASC 718.

Prior to January 1, 2006, the Company accounted for stock-based compensation under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations (“APB 25”), as permitted by Statement of Financial Accounting Standard No. 123, Accounting for Stock-Based Compensation (“SFAS 123”).

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123R), which replaces SFAS No. 123 and supersedes APB 25. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their grant date fair values.

Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123R for all share-based payments, using the prospective transition method. As such, SFAS 123R is applied only to awards granted, modified, repurchased, or cancelled after January 1, 2006. The prospective method of adoption does not permit SFAS 123R to be applied to the nonvested portion of awards outstanding at the date of initial application. In accordance with the prospective transition method, the Company’s consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R.

The Company recognizes compensation cost on a tranche-by tranche basis over the vesting period of the equity award.

Gain on sale of loans

All loans sold to date have been sold without recourse. When loans are sold, a gain or loss is recognized to the extent that the sales proceeds plus unamortized fees and costs exceed or are less than the carrying value of the loans. Gains and losses are determined using the specific identification method.

Income Tax Interest and Penalties

The Company classifies all interest and penalties on recognized tax benefits as a part of income tax expense. As of December 31, 2009, the Company did not have any accrued interest or penalties.

 

68


Table of Contents

Recently Adopted Accounting Standards

On June 29, 2009, the FASB issued Accounting Standards Codification (“ASC”) 105-10 (formerly SFAS No. 168), The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles (“ASC 105-10”), which establishes the FASB Accounting Standards Codification (“Codification”) as the source of authoritative accounting principles to be applied in the preparation of financial statements in conformity with GAAP. ASC 105-10 became effective for interim and annual periods ending after September 15, 2009. At that date, all then-existing non-SEC accounting and reporting standards were superseded by the Codification. The Company adopted ASC 105-10 for the interim period ending September 30, 2009. Adoption did not have any effect on the Company’s accounting policies or financial statement presentation. However, because the Codification changed the basis for reference to authoritative GAAP guidance, the Company’s footnote disclosures that reference such guidance have been updated to reflect appropriate references to the Codification.

In December 2007, the FASB issued ASC 805 (formerly SFAS No. 141(R)), Business Combinations (“ASC 805”). ASC 805 retains the underlying concepts of SFAS No. 141 in that all business combinations are still required to be accounted for at fair value under the acquisition method of accounting. ASC 805 established principles and requirements for financial reporting concerning business combinations. ASC 805 will require that: (1) for all business combinations, the acquirer records all assets and liabilities of the acquired business, including goodwill, generally at their fair values; (2) certain contingent assets and liabilities acquired be recognized at their fair values on the acquisition date; (3) contingent consideration be recognized at its fair value on the acquisition date and, for certain arrangements, changes in fair value will be recognized in earnings until settled; (4) acquisition-related transaction and restructuring costs be expensed rather than treated as part of the cost of the acquisition and included in the amount recorded for assets acquired; (5) in step acquisitions, previous equity interests in an acquiree held prior to obtaining control be re-measured to their acquisition-date fair values, with any gain or loss recognized in earnings; and (6) when making adjustments to finalize initial accounting, companies revise any previously issued post-acquisition financial information in future financial statements to reflect any adjustments as if they had been recorded on the acquisition date. ASC 805 is effective on a prospective basis for all business combinations for which the acquisition date is on or after the beginning of the first annual period subsequent to December 15, 2008, with the exception of the accounting for valuation allowances on deferred taxes and acquired tax contingencies. ASC 805 amends SFAS No. 109 such that adjustments made to valuation allowances on deferred taxes and acquired tax contingencies associated with acquisitions that closed prior to the effective date of this statement should also apply the provisions of ASC 805. Implementation of the standard resulted in the Company recognizing $1.6 million during 2009 of costs incurred in connection with the previously contemplated acquisition of Southern Commerce Bank.

In December 2007, the FASB issued ASC 810 (formerly SFAS No. 160), Noncontrolling Interests in Consolidated Financial Statements, an Amendment of ARB 51 (“ASC 810”). ASC 810 amends ARB 51 to establish new standards that will govern the accounting and reporting of noncontrolling interests in partially owned consolidated subsidiaries and the loss of control of subsidiaries. Also, ASC 810 requires that: (1) noncontrolling interest, previously referred to as minority interest, be reported as part of equity in the consolidated financial statements; (2) losses be allocated to the noncontrolling interest even when such allocation might result in a deficit balance, reducing the losses attributed to the controlling interest; (3) changes in ownership interests be treated as equity transactions if control is maintained; and, (4) upon a loss of control, any gain or loss on the interest sold be recognized in earnings. ASC 810 is effective for financial statements issued for fiscal years, beginning on or after December 15, 2008, except for the presentation and disclosure requirements, which will be applied retrospectively. Implementation of the standard did not have a material effect on the Company’s results from operations or financial position.

In March 2008, the FASB issued ASC 815 (formerly SFAS No. 161), Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133 (“ASC 815”). ASC 815 requires enhanced disclosures about an entity’s derivative and hedging activities, and is effective for financial statements

 

69


Table of Contents

issued for fiscal years beginning after November 15, 2008, with early application encouraged. Since ASC 815 only requires additional disclosures concerning derivatives and hedging activities, adoption of the standard did not affect the Company’s results from operations or financial position.

In June 2008, the FASB issued ASC 260 (formerly Staff Position No. EITF 03-6-1), Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities (“ASC 260”). ASC 260 requires unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) to be considered participating securities, as defined in EITF 03-6, Participating Securities and the Two-Class Method under FASB Statement No. 128. ASC 260 was effective for the Company on January 1, 2009 and implementation did not have a material effect on the Company’s results from operation or financial position.

In January 2009, the FASB issued ASC 310 (formerly Staff Position No. EITF 99-20-1), Amendments to the Impairment Guidance of EITF Issue No. 99-20 (“ASC 310”). ASC 310 amends the impairment guidance of Emerging Issues Task Force Issue No. 99-20, “Recognition of Interest Income and Impairment of Purchased Beneficial Interest and Beneficial Interest that Continue to Be Held by a Transferor in Securitized Financial Assets,” by removing the exclusive reliance upon market participant assumptions about future cash flows when evaluating impairment of securities within its scope. ASC 310 requires companies to follow the impairment guidance in SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, which permits the use of reasonable management judgment of the probability that the holder will be unable to collect all amounts due. ASC 310 is effective prospectively for interim and annual reporting periods ending after December 15, 2008. As of December 31, 2008, the Company had one debt security with a carrying value of $3.0 million. The Company determined that the debt security did not have a probable adverse change in its estimated cash flows. The Company adopted ASC 310 on January 1, 2009, and the adoption did not have a material effect on the Company’s results from operation or financial position.

In April 2009, the FASB issued ASC 805 (formerly Staff Position No. FAS 141(R)-1), Accounting for Assets Acquired and Liabilities Assumed in a Business Combination that Arises from Contingencies (“ASC 805”). ASC 805 requires changes to the initial recognition and measurement, subsequent measurement and accounting, and disclosure of transaction costs, certain contingent assets and liabilities, and other balances in a business combination. ASC 805 was effective for the Company on January 1, 2009, and implementation did not have a material effect on the Company’s results from operation or financial position.

In April 2009, the FASB issued ASC 820 (formerly Staff Position No. 157-4), Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (“ASC 820”), which became effective for interim and annual periods ending after June 15, 2009. ASC 820 provides additional guidance for determining fair value and requires new disclosures regarding the categories of fair value instruments, as well as the inputs and valuation techniques utilized to determine fair value and any changes to the inputs and valuation techniques during the period. Implementation of ASC 820 did not materially affect the Company’s results from operations or financial position.

In April 2009, the FASB issued ASC 825 (formerly Staff Position No.107-1 and APB 28-1), Interim Disclosures About Fair Value of Financial Instruments (“ASC 825”), effective for interim and annual periods ending after June 15, 2009. ASC 825 requires fair value disclosures of financial instruments on a quarterly basis, as well as new disclosures regarding the methodology and significant assumptions underlying the fair value measures and any changes to the methodology and assumptions during the reporting period.

In April 2009, the FASB issued ASC 320 (formerly FSP No. FAS 115-2 and FAS 124-2), Recognition and Presentation of Other-Than-Temporary Impairments (“ASC 320”). ASC 320 amends the other-than-temporary impairment (“OTTI”) guidance for debt securities by establishing new criteria for the recognition of OTTI on debt securities and also requiring additional disclosure of OTTI on debt and equity securities in the financial

 

70


Table of Contents

statements. ASC 320 does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities. Implementation of ASC 320 did not materially affect the Company’s results from operations or financial position.

As of December 31, 2009, the Company had one debt security that was in an unrealized loss position. Prior to the date of adoption of ASC 320, no other than temporary impairment had been recorded on this one security based on an evaluation of expected cash flows. The fair value of the debt security was based on expected cash flows of the underlying contracts considering prepayments, interest rates, market discount rates, other contractual terms, and expected defaults of the underlying contracts. The Company compared the expected discounted cash flows to the carrying value of the security to determine if there was impairment.

The Company does not currently intend to sell this debt security prior to maturity or recovery. The Company also determined that it is not more likely than not that it will be required to sell the security before the recovery of its amortized cost basis. Furthermore, there has not been any previously recorded other than temporary impairment related to the debt security. The Company concluded that there has not been an adverse change in cash flows expected to be collected.

On May 28, 2009, the FASB issued ASC 855-10 (formerly SFAS No. 165), Subsequent Events (“ASC 855-10”). ASC 855-10 defines the period after the balance sheet date during which a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, the circumstances under which a reporting entity should recognize events or transaction occurring after the balance sheet date and the disclosures required for events or transactions that occurred after the balance sheet date. Subsequent events that provide additional evidence about conditions that existed at the balance sheet date are to be recognized in the financial statements. Subsequent events that are conditions that arose after the balance sheet date but prior to the issuance of the financial statements are not recognized in the financial statements, but should be disclosed if failure to do so would render the financial statements misleading. For subsequent events not recognized, disclosures should include a description of the nature of the event and either an estimate of its financial effect or a statement that such an estimate cannot be made. The Company adopted ASC 855-10 effective June 30, 2009. Adoption did not affect the recognition or disclosure of subsequent events. The Company evaluates subsequent events up to the date it files its Form 10-K with the Securities and Exchange Commission for its financial statements.

Recently Issued Accounting Standards

On June 12, 2009, the FASB issued ASC 860 (formerly SFAS 166, Accounting for Transfers of Financial Assets) and ASC 810 (formerly SFAS 167, Amendments to FASB Interpretation No. 46(R)). ASC 860 eliminates the concept of a qualifying special-purpose entity (“QSPE”) and, accordingly, any existing QSPE must be evaluated for consolidation upon adoption of ASC 860. Under ASC 860, the appropriateness of derecognition is evaluated based on whether or not the transferor has surrendered control of the transferred assets. The evaluation must consider any continuing involvement by the transferor. ASC 810 amends FIN 46R to require a reporting entity to perform an analysis to determine if its variable interests give it a controlling financial interest in a variable interest entity (“VIE”). The analysis required under ASC 810 identifies the primary beneficiary of a VIE as the entity having both of the following: (1) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and (2) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE.

In addition, a reporting entity must assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining if it has the power to direct the activities of the VIE that most significantly affect the entity’s economic performance. ASC 810 amends FIN 46R to require ongoing reassessments of whether a reporting entity is the primary beneficiary of a VIE. Specifically, the list of reconsideration events includes a change in facts and circumstances where the holders of an equity investment at

 

71


Table of Contents

risk as a group lose the power to direct the activities of the entity that most significantly affect the entity’s economic performance. In addition, a troubled debt-restructuring is now defined as a reconsideration event. Both statements expand required disclosures and are effective as of the beginning of the first annual reporting period that begins after November 15, 2009. The Company does not believe adoption of ASC 860 and ASC 810 will have a material effect on its results from operation or financial position.

Note 3. Fair Value

ASC 820, Fair Value Measurements (“ASC 820”) establishes a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:

 

   

Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

 

   

Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

 

   

Level 3 – inputs to the valuation methodology are unobservable and significant to the fair value measurement.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

The following is a description of the valuation methodologies used for instruments measured at fair value, including the general classification of such instruments pursuant to the valuation hierarchy.

Investments in debt securities, available-for-sale

Investments in debt securities available-for-sale are recorded at fair value on a recurring basis. The fair value measurement of investments in debt securities is based on either broker quotes or by using internally developed financial models. For securities in less liquid markets where there is limited activity and little transparency around broker quotes used to value such securities, the Company classifies securities valued using broker quotes as level 3. If quoted prices are not available, then fair value is estimated by using internally developed financial models. These securities are not actively traded and require a private sale, and the valuation involves application of significant management judgment. Inputs into the model- based valuations can include changes in market indexes, selling prices of similar securities, management’s assumptions related to the credit rating of the security, prepayment assumptions and other factors such as credit loss assumptions and management’s assessment of the current market conditions. Such securities are classified as level 3, as the valuation models are based on significant inputs that are unobservable in the market.

Residual interest in securitization

The residual interest in securitization is recorded at fair value on a recurring basis and fair value is based on the present value of expected future cash flows calculated by using independent pricing models or other model-based valuation techniques and management’s best estimates of key assumptions. The valuation of residual interest in securitization is classified as level 3 as it relies significantly on unobservable inputs.

Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. If it is probable that payment of interest and principal on a loan will not be made in accordance with the contractual terms of the loan agreement, then it is

 

72


Table of Contents

considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC 310 (formerly SFAS No. 114, Accounting by Creditors for Impairment of a Loan). The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral equals or exceeds the recorded investments in such loans. Impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as level 3.

Loans held-for-sale

Loans held-for-sale are not recorded at fair value on a recurring basis and are carried at the lower of cost or market value. Fair values for loans held-for-sale are based on quoted prices, where available, or are determined by discounting estimated cash flows using model-based valuation techniques. Inputs into the model-based valuations can include changes in market indexes, selling prices of similar loans, management’s assumption related to credit rating of the loan, prepayment assumptions and other factors, such as credit loss assumptions. Where quoted prices are available in an active market, loans held-for-sale are classified as level 1. Level 1 loans include instruments where the fair value is based on a contracted selling price. Loans are classified as level 3 in instances where valuation models are based on significant inputs that are unobservable in the market.

Other real estate owned

The Company does not record other real estate owned at fair value on a recurring basis. The fair value of other real estate owned is estimated using one of several methods, including collateral value, market value of similar properties, liquidation value and discounted cash flows. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price or inputs, the Company records the other real estate owned as level 3.

Fair value of derivative instruments

Derivatives are recorded at fair value on a recurring basis. Substantially all derivative instruments held or issued by the Company for risk management or customer-initiated activities are traded in over-the-counter markets where quoted market prices are not readily available. For those derivatives, the Company measures fair value using broker quotes or financial models that use primarily market observable inputs, such as yield curves and option volatilities, and include the value associated with the counterparty credit risk. The Company classifies derivative instruments held or issued for risk management or customer-initiated activities as level 2. Examples of level 2 derivatives are interest rate swaps and interest rate cap contracts.

The Company also holds a portfolio of warrants for generally non-marketable equity securities. These warrants are primarily from non-public companies obtained as part of the loan origination process. Warrants which contain a net exercise provision are required to be accounted for as derivatives and recorded at fair value. The fair value of the derivative warrant portfolio is reviewed quarterly and adjustments to the fair value are recorded in current earnings. Fair value is determined using internally developed valuation models. Where sufficient data exists, a market approach method is utilized to estimate the current value of the underlying company. The estimated fair value of the underlying securities for warrants requiring valuation at fair value were adjusted for discounts related to lack of liquidity. The Company classifies warrants accounted for as derivatives as level 3.

 

73


Table of Contents

The following table presents recorded amounts of assets and liabilities measured at fair value on a recurring and nonrecurring basis as of December 31, 2009, by caption in the consolidated balance sheet and by ASC 820 valuation hierarchy (as described above).

 

     Quoted Prices
in Active
Markets for
Identical Assets

(Level 1)
   Significant
Other
Observable
Inputs

(Level 2)
   Significant
Unobservable
Inputs

(Level 3)
   Total
Carrying
Value in
Consolidated
Balance Sheet
     ($ in thousands)

Recurring Basis:

           

Investments in debt securities, available-for-sale

   $ —      $ —      $ 4,183    $ 4,183

Warrants

     —        —        1      1

Derivatives (assets)

     —        7,458      —        7,458
                           

Total assets recorded at fair value on a recurring basis

   $ —      $ 7,458    $ 4,184    $ 11,642
                           

Derivatives (liabilities)

   $ —      $ 7,853    $ —      $ 7,853
                           

Nonrecurring Basis:

           

Loans, net

   $ —      $ —