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Rialto Investments Segment
9 Months Ended
Aug. 31, 2013
Rialto Investments Segment [Abstract]  
Rialto Investments Segment
Rialto Investments Segment
The assets and liabilities related to the Rialto segment were as follows:
(In thousands)
August 31,
2013
 
November 30,
2012
Assets:
 
 
 
Cash and cash equivalents
$
72,024

 
105,310

Defeasance cash to retire notes payable
78,032

 
223,813

Loans receivable, net
328,667

 
436,535

Loans held-for-sale (1)
244,666

 

Real estate owned - held-for-sale
198,609

 
134,161

Real estate owned - held-and-used, net
440,656

 
601,022

Investments in unconsolidated entities
125,263

 
108,140

Investments held-to-maturity
15,791

 
15,012

Other (2)
50,432

 
23,367

 
$
1,554,140

 
1,647,360

Liabilities:
 
 
 
Notes and other debts payable (3)
$
346,627

 
574,480

Other (4)
44,444

 
26,122

 
$
391,071

 
600,602


(1)
Loans held-for-sale relate to unsold loans originated by Rialto Mortgage Finance carried at fair value.
(2)
Other assets include interest rate swap futures and credit default swaps carried at fair value of $0.6 million and $9.1 million, respectively, as of August 31, 2013.
(3)
As of August 31, 2013 notes and other debts payable includes $110.0 million of notes payable related to the FDIC portfolios and $133.1 million related to the RMF warehouse repurchase financing agreement. As of November 30, 2012, notes and other debts payable includes $470.0 million of notes payable related to the FDIC portfolios.
(4)
Other liabilities include interest rate swap futures carried at fair value of $0.7 million as of August 31, 2013.

Rialto’s operating earnings were as follows:
 
Three Months Ended
 
Nine Months Ended
 
August 31,
 
August 31,
(In thousands)
2013
 
2012
 
2013
 
2012
Revenues
$
27,808

 
37,194

 
79,114

 
102,874

Costs and expenses
34,167

 
46,396

 
94,243

 
109,964

Rialto Investments equity in earnings from unconsolidated entities
5,199

 
13,551

 
15,877

 
37,578

Rialto Investments other income (expense), net
1,837

 
(10,063
)
 
9,810

 
(23,675
)
Operating earnings (loss) (1)
$
677

 
(5,714
)
 
10,558

 
6,813

(1)
Operating earnings (loss) for the three and nine months ended August 31, 2013 include net earnings (loss) attributable to noncontrolling interests of ($0.8) million and $4.6 million, respectively. Operating earnings (loss) for the three and nine months ended August 31, 2012 include net earnings (loss) attributable to noncontrolling interests of ($13.4) million and ($14.6) million, respectively.
The following is a detail of Rialto Investments other income (expense), net for the periods indicated:
 
Three Months Ended
 
Nine Months Ended
 
August 31,
 
August 31,
(In thousands)
2013
 
2012
 
2013
 
2012
Realized gains on REO sales, net
$
9,651

 
2,418

 
36,857

 
10,857

Unrealized loss on transfer of loans receivable to REO, net
(2,373
)
 
(4,690
)
 
(8,683
)
 
(5,923
)
REO expenses
(10,267
)
 
(12,035
)
 
(33,171
)
 
(40,758
)
Rental income
4,826

 
4,244

 
14,807

 
12,149

Rialto Investments other income (expense), net
$
1,837

 
(10,063
)
 
9,810

 
(23,675
)

Loans Receivable
In February 2010, the Rialto segment acquired indirectly 40% managing member equity interests in two limited liability companies (“LLCs”), in partnership with the FDIC. The LLCs hold performing and non-performing loans formerly owned by 22 failed financial institutions and when the Rialto segment acquired its interests in the LLCs, the two portfolios consisted of approximately 5,500 distressed residential and commercial real estate loans (“FDIC Portfolios”). The FDIC retained 60% equity interests in the LLCs and provided $626.9 million of financing with 0% interest, which is non-recourse to the Company and the LLCs. As of August 31, 2013 and November 30, 2012, the notes payable balance was $110.0 million and $470.0 million, respectively; however, as of August 31, 2013 and November 30, 2012, $78.0 million and $223.8 million, respectively, of cash collections on loans in excess of expenses were deposited in a defeasance account, established for the repayment of the notes payable, under the agreement with the FDIC. The funds in the defeasance account are being and will be used to retire the notes payable upon their maturity. During the nine months ended August 31, 2013, the LLCs retired $360.0 million principal amount of the notes payable under the agreement with the FDIC through the defeasance account.
The LLCs met the accounting definition of VIEs and since the Company was determined to be the primary beneficiary, the Company consolidated the LLCs. At August 31, 2013, these consolidated LLCs had total combined assets and liabilities of $880.0 million and $133.2 million, respectively. At November 30, 2012, these consolidated LLCs had total combined assets and liabilities of $1,236.4 million and $493.4 million, respectively.
In September 2010, the Rialto segment acquired approximately 400 distressed residential and commercial real estate loans (“Bank Portfolios”) and over 300 REO properties from three financial institutions. The Company paid $310 million for the distressed real estate and real estate related assets of which $124 million was financed through a 5-year senior unsecured note provided by one of the selling institutions of which $33.0 million of principal amount was retired in 2012. As of both August 31, 2013 and November 30, 2012, there was $90.9 million outstanding.
The following table displays the loans receivable by aggregate collateral type:
(In thousands)
August 31,
2013
 
November 30,
2012
Land
$
181,755

 
216,095

Single family homes
65,765

 
93,207

Commercial properties
62,798

 
96,226

Multi-family homes
5,000

 
12,776

Other
13,349

 
18,231

Loans receivable, net
$
328,667

 
436,535



With regard to loans accounted for under ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, (“ASC 310-30”), the Rialto segment estimated the cash flows, at acquisition, it expected to collect on the FDIC Portfolios and Bank Portfolios. In accordance with ASC 310-30, the difference between the contractually required payments and the cash flows expected to be collected at acquisition is referred to as the nonaccretable difference. This difference is neither accreted into income nor recorded on the Company’s condensed consolidated balance sheets. The excess of cash flows expected to be collected over the cost of the loans acquired is referred to as the accretable yield and is recognized in interest income over the remaining life of the loans using the effective yield method.
The Rialto segment periodically evaluates its estimate of cash flows expected to be collected on its FDIC Portfolios and Bank Portfolios. These evaluations require the continued use of key assumptions and estimates, similar to those used in the initial estimate of fair value of the loans to allocate purchase price. Subsequent changes in the estimated cash flows expected to be collected may result in changes in the accretable yield and nonaccretable difference or reclassifications from nonaccretable yield to accretable yield. Increases in the cash flows expected to be collected will generally result in an increase in interest income over the remaining life of the loan or pool of loans. Decreases in expected cash flows due to further credit deterioration will generally result in an impairment charge recognized as a provision for loan losses, resulting in an increase to the allowance for loan losses.
The outstanding balance and carrying value of loans accounted for under ASC 310-30 was as follows:
(In thousands)
August 31,
2013
 
November 30,
2012
Outstanding principal balance
$
659,638

 
812,187

Carrying value
$
311,655

 
396,200


The activity in the accretable yield for the FDIC Portfolios and Bank Portfolios during the nine months ended August 31, 2013 and 2012 were as follows:
(In thousands)
August 31,
2013
 
August 31,
2012
Accretable yield, beginning of period
$
112,899

 
209,480

Additions
53,652

 
43,306

Deletions
(38,263
)
 
(71,830
)
Accretions
(38,455
)
 
(58,108
)
Accretable yield, end of period
$
89,833

 
122,848


Additions primarily represent reclasses from nonaccretable yield to accretable yield on the portfolios. Deletions represent loan impairments and disposal of loans, which includes foreclosure of underlying collateral and result in the removal of the loans from the accretable yield portfolios.
When forecasted principal and interest cannot be reasonably estimated at the loan acquisition date, management classifies the loan as nonaccrual and accounts for these assets in accordance with ASC 310-10, Receivables (“ASC 310-10”). When a loan is classified as nonaccrual, any subsequent cash receipt is accounted for using the cost recovery method. In accordance with ASC 310-10, a loan is considered impaired when based on current information and events it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. Although these loans met the definition of ASC 310-10, these loans were not considered impaired relative to the Company’s recorded investment at the time of acquisition since they were acquired at a substantial discount to their unpaid principal balance. A provision for loan losses is recognized when the recorded investment in the loan is in excess of its fair value. The fair value of the loan is determined by using either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral less estimated costs to sell.
The following tables represent nonaccrual loans in the FDIC Portfolios and Bank Portfolios accounted for under ASC 310-10 aggregated by collateral type:
August 31, 2013
 
 
 
Recorded Investment
 
 
(In thousands)
Unpaid
Principal Balance
 
With
Allowance
 
Without
Allowance
 
Total  Recorded
Investment
Land
$
7,486

 
221

 
2,903

 
3,124

Single family homes
16,615

 
1,716

 
3,815

 
5,531

Commercial properties
14,694

 
554

 
7,803

 
8,357

Loans receivable
$
38,795

 
2,491

 
14,521

 
17,012

November 30, 2012
 
 
 
Recorded Investment
 
 
(In thousands)
Unpaid
Principal  Balance
 
With
Allowance
 
Without
Allowance
 
Total  Recorded
Investment
Land
$
23,163

 
4,983

 
2,844

 
7,827

Single family homes
18,966

 
8,311

 
2,244

 
10,555

Commercial properties
35,996

 
1,006

 
20,947

 
21,953

Loans receivable
$
78,125

 
14,300

 
26,035

 
40,335

The average recorded investment in impaired loans totaled approximately $29 million and $62 million for the nine months ended August 31, 2013 and 2012, respectively.
The loans receivable portfolios consist of loans acquired at a discount. Based on the nature of these loans, the portfolios are managed by assessing the risks related to the likelihood of collection of payments from borrowers and guarantors, as well as monitoring the value of the underlying collateral. The following are the risk categories for the loans receivable portfolios:
Accrual — Loans in which forecasted cash flows under the loan agreement, as it might be modified from time to time, can be reasonably estimated at the date of acquisition. The risk associated with loans in this category relates to the possible default by the borrower with respect to principal and interest payments and the possible decline in value of the underlying collateral and thus, both could cause a decline in the forecasted cash flows used to determine accretable yield income and the recognition of an impairment through an allowance for loan losses. As of August 31, 2013, the Company had an allowance on these loans of $20.1 million. During the three and nine months ended August 31, 2013, the Company recorded $3.3 million and $12.8 million, respectively, of provision for loan losses offset by charge-offs of $1.9 million and $4.9 million, respectively, upon resolution of the loans. During both the three and nine months ended August 31, 2012, the Company recorded $17.1 million of provision for loan losses offset by charge-offs of $3.0 million upon foreclosure of these loans. As of November 30, 2012, the Company had an allowance on these loans of $12.2 million.
Nonaccrual — Loans in which forecasted principal and interest could not be reasonably estimated at the date of acquisition. Although the Company believes the recorded investment balance will ultimately be realized, the risk of nonaccrual loans relates to a decline in the value of the collateral securing the outstanding obligation and the recognition of an impairment through an allowance for loan losses if the recorded investment in the loan exceeds the fair value of the collateral less estimated cost to sell. As of August 31, 2013 and November 30, 2012, the Company had an allowance on these loans of $0.9 million and $3.7 million, respectively. During the three and nine months ended August 31, 2013, the Company recorded $0.1 million and $1.2 million, respectively, of provision for loan losses offset by charge-offs of $1.0 million and $4.0 million, respectively, upon foreclosure of the loans. During the three and nine months ended August 31, 2012, the Company recorded $3.2 million and $5.5 million, respectively, of provision for loan losses offset by charge-offs of $0.4 million and $3.3 million, respectively, upon foreclosure of the loans.
Accrual and nonaccrual loans receivable by risk categories were as follows:
August 31, 2013
(In thousands)
Accrual
 
Nonaccrual
 
Total
Land
$
178,631

 
3,124

 
181,755

Single family homes
60,234

 
5,531

 
65,765

Commercial properties
54,441

 
8,357

 
62,798

Multi-family homes
5,000

 

 
5,000

Other
13,349

 

 
13,349

Loans receivable
$
311,655

 
17,012

 
328,667

November 30, 2012
(In thousands)
Accrual
 
Nonaccrual
 
Total
Land
$
208,268

 
7,827

 
216,095

Single family homes
82,652

 
10,555

 
93,207

Commercial properties
74,273

 
21,953

 
96,226

Multi-family homes
12,776

 

 
12,776

Other
18,231

 

 
18,231

Loans receivable
$
396,200

 
40,335

 
436,535


In order to assess the risk associated with each risk category, the Rialto segment evaluates the forecasted cash flows and the value of the underlying collateral securing loans receivable on a quarterly basis or when an event occurs that suggests a decline in the collateral’s fair value.
Real Estate Owned
The acquisition of properties acquired through, or in lieu of, loan foreclosure are reported within the condensed consolidated balance sheets as REO held-and-used, net and REO held-for-sale. When a property is determined to be held-and-used, net, the asset is recorded at fair value and depreciated over its useful life using the straight line method. When certain criteria set forth in ASC 360, Property, Plant and Equipment, are met, the property is classified as held-for-sale. When a real estate asset is classified as held-for-sale, the property is recorded at the lower of its cost basis or fair value less estimated costs to sell. The fair value of REO held-for-sale are determined in part by placing reliance on third party appraisals of the properties and/or internally prepared analyses of recent offers or prices on comparable properties in the proximate vicinity.
Upon the acquisition of REO through loan foreclosure, gains and losses are recorded in Rialto Investments other income (expense), net. The amount by which the recorded investment in the loan is less than the REO’s fair value (net of estimated cost to sell if held-for-sale), is recorded as an unrealized gain upon foreclosure. The amount by which the recorded investment in the loan is greater than the REO’s fair value (net of estimated cost to sell if held-for-sale) is generally recorded as a provision for loan losses.
At times, the Company may foreclose on a loan from an accrual loan pool in which the removal of the loan does not cause an overall decrease in the expected cash flows of the loan pool, and as such, no provision for loan losses is required to be recorded. However, the amount by which the recorded investment in the loan is greater than the REO’s fair value (net of estimated cost to sell if held-for-sale) is recorded as an unrealized loss upon foreclosure.
The following tables present the activity in REO
 
Three Months Ended
 
Nine Months Ended
 
August 31,
 
August 31,
(In thousands)
2013
 
2012
 
2013
 
2012
REO - held-for-sale, beginning of period
$
204,385

 
113,115

 
134,161

 
143,677

Additions
14,833

 
6,428

 
16,166

 
7,783

Improvements
1,949

 
1,439

 
4,466

 
7,438

Sales
(68,087
)
 
(27,956
)
 
(145,363
)
 
(110,010
)
Impairments
(169
)
 
(810
)
 
(4,353
)
 
(2,432
)
Transfers to Lennar Homebuilding
(430
)
 
(7,431
)
 
(430
)
 
(11,335
)
Transfers from held-and-used, net (1)
46,128

 
30,933

 
193,962

 
80,597

REO - held-for-sale, end of period
$
198,609

 
115,718

 
198,609

 
115,718

 
Three Months Ended
 
Nine Months Ended
 
August 31,
 
August 31,
(In thousands)
2013
 
2012
 
2013
 
2012
REO - held-and-used, net, beginning of period
$
478,314

 
634,401

 
601,022

 
582,111

Additions
14,154

 
44,958

 
38,882

 
154,633

Improvements
517

 
2,070

 
3,396

 
2,850

Sales

 

 

 
(981
)
Impairments
(5,126
)
 
(1,880
)
 
(5,529
)
 
(5,153
)
Depreciation
(1,075
)
 
(1,389
)
 
(3,153
)
 
(5,636
)
Transfers to held-for-sale (1)
(46,128
)
 
(30,933
)
 
(193,962
)
 
(80,597
)
REO - held-and-used, net, end of period
$
440,656

 
647,227

 
440,656

 
647,227

(1)
During the three and nine months ended August 31, 2013 and 2012, the Rialto segment transferred certain properties from REO held-and-used, net to REO held-for-sale as a result of changes in the disposition strategy of the real estate assets.
For the three and nine months ended August 31, 2013, the Company recorded $9.7 million and $36.9 million, respectively, of net gains from sales of REO. For the three and nine months ended August 31, 2012, the Company recorded $2.4 million and $10.9 million, respectively, of net gains from sales of REO. For the three and nine months ended August 31, 2013, the Company recorded net gains of $2.9 million and $1.2 million, respectively, from acquisitions of REO through foreclosure. For the three and nine months ended August 31, 2012, the Company recorded net gains (losses) of ($2.0) million and $1.7 million, respectively, from acquisitions of REO through foreclosure. These net gains (losses) are recorded in Rialto Investments other income (expense), net.
Rialto Mortgage Finance
During the third quarter of 2013, Rialto Mortgage Finance (“RMF”) was formed to originate and securitize five, seven and ten year commercial first mortgage loans, generally with principal amounts between $2 million and $75 million, which will be secured by income producing properties. As of August 31, 2013, RMF has originated loans with a total principal balance of $245.2 million. In September 2013, RMF sold $198 million of these loans in a securitization. As of August 31, 2013, RMF had a $250 million warehouse repurchase financing agreement of which $133.1 million was outstanding.
Investments
In 2010, the Rialto segment invested in approximately $43 million of non-investment grade commercial mortgage-backed securities (“CMBS”) for $19.4 million, representing a 55% discount to par value. The CMBS have a stated and assumed final distribution date of November 2020 and a stated maturity date of October 2057. The Rialto segment reviews changes in estimated cash flows periodically, to determine if other-than-temporary impairment has occurred on its investment securities. Based on the Rialto segment’s assessment, no impairment charges were recorded during both the three and nine months ended August 31, 2013 and 2012. The carrying value of the investment securities at August 31, 2013 and November 30, 2012, was $15.8 million and $15.0 million, respectively. The Rialto segment classified these securities as held-to-maturity based on its intent and ability to hold the securities until maturity.
In 2010, 2011 and 2012, the Rialto segment obtained investors in Fund I who made equity commitments of $700 million (including $75 million committed by the Company). All capital commitments have been called and funded, and Fund I is closed to additional commitments. Fund I was determined to have the attributes of an investment company in accordance with ASC 946, Financial Services – Investment Companies, the attributes of which are different from the attributes that would cause a company to be an investment company for purposes of the Investment Company Act of 1940. As a result, Fund I’s assets and liabilities are recorded at fair value with increases/decreases in fair value recorded in the statement of operations of Fund I, the Company’s share of which are recorded in the Rialto Investments equity in earnings from unconsolidated entities financial statement line item.
During the three and nine months ended August 31, 2013, the Company received distributions of $2.7 million and $39.8 million, respectively, as a return of capital from Fund I. During the three and nine months ended August 31, 2012, the Company contributed $8.8 million and $26.8 million to Fund I. Of these amounts contributed, $13.9 million was distributed back to the Company during the nine months ended August 31, 2012 as a return of capital contributions due to a securitization within Fund I. As of August 31, 2013 and November 30, 2012, the carrying value of the Company’s investment in Fund I was $73.9 million and $98.9 million, respectively. For the three and nine months ended August 31, 2013, the Company’s share of earnings from Fund I was $3.7 million and $14.8 million, respectively. For the three and nine months ended August 31, 2012, the Company’s share of earnings from Fund I was $6.2 million and $16.8 million, respectively.
In December 2012, the Rialto segment completed the first closing of the Real Estate Fund II, LP ("Fund II") with initial equity commitments of approximately $260 million, including $100 million committed by the Company. No cash was funded at the time of the closing. Fund II's objective during its three-year investment period is to invest in distressed real estate assets and other related investments that fit Fund II's investment parameters. As of August 31, 2013, the equity commitments of Fund II were $643 million. During the nine months ended August 31, 2013, $240 million of the $643 million in equity commitments was called, of which, the Company contributed its portion of $37.4 million. As of August 31, 2013, the carrying value of the Company's investment in Fund II was $38.3 million. For the three and nine months ended August 31, 2013, the Company’s share of earnings from Fund II was $1.4 million and 0.9 million, respectively.
In the third quarter of 2013, the Rialto segment started raising capital and investing in mezzanine commercial loans creating the Rialto Mezzanine Partners Fund (the “Mezzanine Fund”) with a target of raising $300 million in capital to invest in performing mezzanine commercial loans. These loans have expected durations of one to two years and are secured by equity interests in the borrowing entity owning the real estate. As of August 31, 2013, the Mezzanine Fund had total equity commitments of $82 million, including $25 million committed by the Company. As of August 31, 2013, total invested capital was $13.5 million, including $4.1 million invested by the Company.
Additionally, another subsidiary in the Rialto segment has approximately a 5% investment in a service and infrastructure provider to the residential home loan market (the “Servicer Provider”), which provides services to the consolidated LLCs, among others. As of August 31, 2013 and November 30, 2012, the carrying value of the Company’s investment in the Servicer Provider was $8.3 million and $8.4 million, respectively.

Summarized condensed financial information on a combined 100% basis related to Rialto’s investments in unconsolidated entities that are accounted for by the equity method was as follows:
Balance Sheets
(In thousands)
August 31,
2013
 
November 30,
2012
Assets:
 
 
 
Cash and cash equivalents
$
107,918

 
299,172

Loans receivable
406,473

 
361,286

Real estate owned
247,389

 
161,964

Investment securities
352,237

 
182,399

Investments in real estate partnerships
114,258

 
72,903

Other assets
186,760

 
199,839

 
$
1,415,035

 
1,277,563

Liabilities and equity:
 
 
 
Accounts payable and other liabilities
$
167,813

 
155,928

Notes payable
231,960

 
120,431

Partner loans
163,940

 
163,516

Equity
851,322

 
837,688

 
$
1,415,035

 
1,277,563


Statements of Operations
 
Three Months Ended
 
Nine Months Ended
 
August 31,
 
August 31,
(In thousands)
2013
 
2012
 
2013
 
2012
Revenues
$
69,856

 
115,800

 
189,155

 
357,328

Costs and expenses
65,357

 
75,233

 
190,066

 
178,414

Other income, net (1)
34,186

 
366,696

 
128,973

 
670,471

Net earnings of unconsolidated entities
$
38,685

 
407,263

 
128,062

 
849,385

Rialto Investments equity in earnings from unconsolidated entities
$
5,199

 
13,551

 
15,877

 
37,578


(1)
Other income, net, for the three and nine months ended August 31, 2012 includes the AB PPIP Fund's mark-to-market unrealized gains and unrealized losses, of which the Company’s portion was a small percentage.