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EX-31.1 - EXHIBIT 31.1 - Ready Capital Corpv422702_ex31-1.htm
EX-32.1 - EXHIBIT 32.1 - Ready Capital Corpv422702_ex32-1.htm
EX-31.2 - EXHIBIT 31.2 - Ready Capital Corpv422702_ex31-2.htm
EX-32.2 - EXHIBIT 32.2 - Ready Capital Corpv422702_ex32-2.htm

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2015
Commission File Number: 001-35808

 

ZAIS FINANCIAL CORP.

(Exact Name of Registrant as Specified in its Charter)

 

Maryland 90-0729143
(State or Other Jurisdiction of Incorporation or Organization) (IRS Employer Identification No.)

 

Two Bridge Avenue, Suite 322, Red Bank, New Jersey 07701-1106

(Address of Principal Executive Offices, Including Zip Code)

 

(732) 978-7518

(Registrant's Telephone Number, Including Area Code)

 

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 Web site, 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 x No ¨

 

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 "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Smaller reporting company ¨
      (Do not check if a 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

 

Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date:

 

The Company has 7,970,886 shares of common stock, par value $0.0001 per share, outstanding as of November 4, 2015.

 

 

 

 

TABLE OF CONTENTS

  

PART I.    FINANCIAL INFORMATION 1
   
Item 1.    Financial Statements 1
   
Item 1A.    Forward-Looking Statements 41
   
Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations 43
   
Item 3.    Quantitative and Qualitative Disclosures about Market Risk 64
   
Item 4.    Controls and Procedures 67
   
PART II.    OTHER INFORMATION 68
   
Item 1.    Legal Proceedings 68
   
Item 1A.     Risk Factors 68
   
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds 68
   
Item 3.    Defaults Upon Senior Securities 68
   
Item 4.    Mine Safety Disclosures 68
   
Item 5.    Other Information 68
   
Item 6.    Exhibits 68
   
SIGNATURES 70

 

EXHIBIT 31.1 CERTIFICATIONS
 
EXHIBIT 31.2 CERTIFICATIONS
 
EXHIBIT 32.1 CERTIFICATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002, 10 U.S.C. SECTION 1350
 
EXHIBIT 32.2 CERTIFICATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002, 10 U.S.C. SECTION 1350

  

 

 

 

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

ZAIS Financial Corp. and Subsidiaries
Consolidated Balance Sheets (unaudited)

 

   September 30, 2015   December 31, 2014 
        
   (Expressed in United States Dollars) 
Assets          
Cash  $29,366,231   $33,791,013 
Restricted cash   4,026,267    7,143,078 
Mortgage loans held for investment, at fair value – $399,301,401 and $415,814,067 pledged as collateral, respectively   401,206,350    415,959,838 
Mortgage loans held for sale, at fair value – $114,303,003 and $97,690,960 pledged as collateral   114,670,811    97,690,960 
Mortgage loans held for investment, at cost   1,074,313    1,338,935 
Real estate securities, at fair value – $99,239,271 and $135,779,193 pledged as collateral, respectively   113,220,076    148,585,733 
Other investment securities, at fair value – $0 and $2,040,532 pledged as collateral, respectively   15,209,050    2,040,532 
Loans eligible for repurchase from Ginnie Mae   28,479,596    21,710,284 
Mortgage servicing rights, at fair value   42,044,651    33,378,978 
Derivative assets, at fair value   3,528,739    2,485,100 
Other assets   7,013,304    6,092,863 
Goodwill   14,183,537    16,512,680 
Intangible Assets   5,077,355    5,668,611 
Total assets  $779,100,280   $792,398,605 
Liabilities          
Warehouse lines of credit  $104,216,594   $89,417,564 
Loan repurchase facilities   295,315,030    300,092,293 
Securities repurchase agreements   74,520,999    103,014,105 
Exchangeable Senior Notes   56,240,664    55,474,741 
Contingent consideration   12,612,664    11,430,413 
Derivative liabilities, at fair value   2,593,972    2,585,184 
Dividends and distributions payable   3,559,120    3,559,120 
Accounts payable and other liabilities   18,389,845    11,731,089 
Liability for loans eligible for repurchase from Ginnie Mae   28,479,596    21,710,284 
Total liabilities   595,928,484    599,014,793 
           
Commitments and Contingencies (Note 22)          
           
Equity          
12.5% Series A cumulative non-voting preferred stock, $0.0001 par value; 50,000,000 shares authorized; zero shares issued and outstanding        
Common stock, $0.0001 par value; 500,000,000 shares authorized; 7,970,886 shares issued and outstanding   798    798 
Additional paid-in capital   164,207,617    164,207,617 
(Accumulated deficit) / retained earnings   (148,270)   9,029,947 
Total stockholders' equity, ZAIS Financial Corp.   164,060,145    173,238,362 
Non-controlling interests   19,111,651    20,145,450 
Total equity   183,171,796    193,383,812 
Total liabilities and equity  $779,100,280   $792,398,605 

 

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

 

 - 1 - 

 

  

ZAIS Financial Corp. and Subsidiaries
Consolidated Statements of Operations (unaudited)

 

    Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
    2015     2014     2015     2014  
    (Expressed in United States Dollars)  
Interest income                                
Mortgage loans held for investment   $ 6,447,802     $ 6,837,318     $ 19,497,295     $ 19,306,825  
Mortgage loans held for sale     986,239             2,387,695        
Real estate securities     1,985,913       3,976,315       6,687,328       11,549,506  
Other investment securities     230,998       186,986       327,379       468,541  
Total interest income     9,650,952       11,000,619       28,899,697       31,324,872  
Interest expense                                
Warehouse lines of credit     574,977             1,647,268        
Loan repurchase facilities     2,329,993       2,390,022       7,054,210       6,481,009  
Securities repurchase agreements     357,408       677,159       1,154,459       2,074,851  
Exchangeable Senior Notes     1,449,476       1,424,497       4,329,143       4,256,155  
Total interest expense     4,711,854       4,491,678       14,185,080       12,812,015  
Net interest income     4,939,098       6,508,941       14,714,617       18,512,857  
Non-interest income                                
Mortgage banking activities, net     13,068,360             36,323,742        
Loan servicing fee income, net of direct costs     1,740,107             5,044,841        
Change in fair value of mortgage servicing rights     (5,881,088 )           (5,658,280 )      
Other income     15,668             39,725        
Total non-interest income     8,943,047             35,750,028        
Other gains/(losses)                                
Change in unrealized gain or loss on mortgage loans held for investment     (5,650,924 )     915,797       (5,603,683 )     23,566,322  
Change in unrealized gain or loss on real estate securities     (2,119,917 )     (2,319,287 )     (4,262,990 )     1,964,966  
Change in unrealized gain or loss on other investment securities     (420,796 )     (892,336 )     (276,269 )     384,290  
Change in unrealized gain or loss on real estate owned     97,917       (3,169 )     106,485       (3,169 )
Realized gain on mortgage loans held for investment     500,967       564,842       1,117,818       972,246  
Realized (loss)/gain on real estate securities     (56,949 )     446,153       18,710       519,772  
Realized loss on other investment securities                 (39,360 )      
Realized loss on real estate owned     (159,570 )           (163,482 )      
Gain/(loss) on derivative instruments related to investment portfolio     (177,670 )     (517,117 )     316,697       (5,528,747 )
Total other gains/(losses)     (7,986,942 )     (1,805,117 )     (8,786,074 )     21,875,680  
Expenses                                
Advisory fee – related party     760,066       718,372       2,188,354       2,131,690  
Salaries, commissions and benefits     7,681,983             23,171,648        
Operating expenses     3,461,155       1,666,169       10,333,959       5,360,686  
Other expenses     953,908       1,039,485       3,065,370       3,261,369  
Total expenses     12,857,112       3,424,026       38,759,331       10,753,745  
Net (loss) income before income tax benefit (expense)     (6,961,909 )     1,279,798       2,919,240       29,634,792  
Income tax benefit (expense)     250,491             (2,503,896 )      
Net (loss) income     (6,711,418 )     1,279,798       415,344       29,634,792  
Net (loss) income allocated to non-controlling interests     (670,672 )     130,301       28,499       3,087,159  
Net (loss) income attributable to ZAIS Financial Corp. common stockholders   $ (6,040,746 )   $ 1,149,497     $ 386,845     $ 26,547,633  
Net (loss) income per share applicable to common stockholders:                                
Basic   $ (.76 )   $ 0.14     $ .05     $ 3.33  
Diluted   $ (.76 )   $ 0.14     $ .05     $ 2.99  
Weighted average number of shares of common stock:                                
Basic     7,970,886       7,970,886       7,970,886       7,970,886  
Diluted     8,897,800       8,897,800       8,897,800       10,677,360  

 

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

 

 - 2 - 

 

 

 

ZAIS Financial Corp. and Subsidiaries
Consolidated Statements of Equity (unaudited)

 

   Preferred Stock   Common Stock                     
    Shares of Preferred Stock    Preferred
Stock at
Par
    Shares of
Common
Stock
    Common
Stock at
Par
    Additional
Paid-in
Capital
    (Accumulated
Deficit)/Retained
Earnings
    Total
Stockholders'
Equity, ZAIS
Financial
Corp.
    Non-Controlling
Interests
    Total
Equity
 
Nine months ended September 30, 2014                                     
                                              
Balance at December 31, 2013       $    7,970,886   $798   $164,207,617   $(4,958,607)  $159,249,808   $18,518,754   $177,768,562 
Distributions on OP units                                (1,112,298)   (1,112,298)
Dividends on common stock                        (9,565,062)   (9,565,062)       (9,565,062)
Net income                        26,547,633    26,547,633    3,087,159    29,634,792 

Balance at September 30, 2014

      $    7,970,886   $798   $164,207,617   $12,023,964   $176,232,379   $20,493,615   $196,725,994 
                                              
Nine months ended September 30, 2015                                             
                                              
Balance at December 31, 2014       $    7,970,886   $798   $164,207,617   $9,029,947   $173,238,362   $20,145,450   $193,383,812 
Distributions on OP units                                (1,112,298)   (1,112,298)
Dividends on common stock                        (9,565,062)   (9,565,062)       (9,565,062)
Contributions                                50,000    50,000 
Net income                        386,845    386,845    28,499    415,344 
Balance at September 30, 2015      $    7,970,886   $798   $164,207,617   $(148,270)  $164,060,145   $19,111,651   $183,171,796 

 

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

 

 - 3 - 

 

 

ZAIS Financial Corp. and Subsidiaries
Consolidated Statements of Cash Flows (unaudited)

 

   Nine Months Ended September 30, 
   2015   2014 
   (Expressed in United States Dollars) 
Cash flows from operating activities          
Net income  $415,344   $29,634,792 
Adjustments to reconcile net income to net cash used in operating activities          
Net (accretion)/amortization of (discounts) premiums related to mortgage loans held for investment   (5,892,239)   (5,420,968)
Net (accretion)/amortization of (discounts)/premiums related to real estate securities   (3,263,205)   (4,197,196)
Net (accretion)/amortization of (discounts)/premiums related to other investment securities   (124,204)   (129,307)
Change in unrealized gain or loss on mortgage loans held for investment   5,603,683    (23,566,322)
Change in unrealized gain or loss on real estate securities   4,262,990    (1,964,966)
Change in unrealized gain or loss on other investment securities   276,269    (384,290)
Change in unrealized gain or loss on real estate owned   (106,485)   3,169 
Change in fair value of mortgage servicing rights   5,658,280     
Realized gain on mortgage loans held for investment   (1,117,818)   (972,246)
Realized gain on real estate securities   (18,710)   (519,772)
Realized loss on other investment securities   39,360     
Realized loss on real estate owned   163,482     
Change in unrealized gain or loss on derivative instruments related to investment portfolio   (1,034,851)   5,168,243 
Amortization of Exchangeable Senior Notes discount   765,923    692,922 
Depreciation and amortization expense   655,047     
Proceeds from sales and principal payments on mortgage loans held for sale   1,481,473,208     
Originations and repurchases of mortgage loans held for sale   (1,449,538,666)    
Gain on sale of mortgage loans held for sale   (48,848,410)    
Capitalization of originated mortgage servicing rights   (14,323,953)    
Changes in operating assets and liabilities          
Decrease in other assets   1,478,487    1,537,640 
Increase in accounts payable and other liabilities   6,918,026    2,503,012 
Increase in contingent consideration   1,182,251     
Net cash (used in)/provided by operating activities   (15,376,191)   2,384,711 
           
Cash flows from investing activities          
Origination of mortgage loans held for investment   (5,604,431)    
Acquisitions of mortgage loans held for investment   (6,025,503)   (84,795,975)
Proceeds from principal repayments on mortgage loans held for investment   25,854,329    16,274,473 
Acquisitions of real estate securities   (6,362,138)   (47,034,324)
Proceeds from principal repayments on real estate securities   13,975,960    23,648,183 
Proceeds from sales of real estate securities   26,770,760    12,318,845 
Acquisitions of other investment securities   (15,601,330)   (12,926,954)
Proceeds from sales of other investment securities   2,241,387     
Purchase of swaption       (4,803,750)
Proceeds received for the final reconciliation of purchase price relating to the acquisition of GMFS   1,684,263     
Restricted cash provided by/(used in) investment activities   3,116,811    (4,908,782)
Net cash provided by/(used in) investing activities   40,050,108    (102,228,284)
           
Cash flows from financing activities          
Net borrowings under warehouse lines of credit   14,799,030     
Net (repayments)/borrowings under loan repurchase facilities   (4,777,263)   57,119,292 
Borrowings from securities repurchase agreements   3,764,081    105,218,260 
Repayments of securities repurchase agreements   (32,257,187)   (78,206,477)
Dividends on common stock and distributions on OP units (net of change in dividends and distributions payable)   (10,677,360)   (15,571,150)
Contributions from non-controlling interests   50,000     
Net cash (used in)/provided by financing activities   (29,098,699)   68,559,925 
           
Net decrease in cash   (4,424,782)   (31,283,648)
Cash          
Beginning of period   33,791,013    57,060,806 
End of period  $29,366,231   $25,777,158 
Supplemental disclosure of cash flow information          
Interest paid on warehouse lines of credit, loan repurchase facilities, securities repurchase agreements and Exchangeable Senior Notes  $12,113,395   $11,405,140 
Taxes paid  $   $ 
Supplemental disclosure of non-cash investing and financing activities          
Accrued dividends and distributions payable  $3,559,120   $3,559,120 
Conversion of mortgage loans held for investment to real estate owned  $2,134,106   $169,406 

 

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

 

 - 4 - 

 

 

ZAIS FINANCIAL CORP. AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1. Formation and Organization

 

ZAIS Financial Corp. (the "Company") is a Maryland corporation that originates, acquires, finances, sells, services and manages residential mortgage loans. GMFS, LLC (“GMFS”), a mortgage banking platform the Company acquired in October 2014, originates, sells and services mortgage loans and the Company acquires performing, re-performing and newly originated loans through other channels. The Company also invests in, finances and manages residential mortgage-backed securities ("RMBS") that are not issued or guaranteed by a federally chartered corporation, such as the Federal National Mortgage Association ("Fannie Mae"), the Federal Home Loan Mortgage Corporation ("Freddie Mac"), or an agency of the U.S. Government, such as Government National Mortgage Association ("Ginnie Mae") ("non-Agency RMBS"), with an emphasis on securities that, when originally issued, were rated in the highest rating category by one or more of the nationally recognized statistical rating organizations. The Company also has the discretion to invest in RMBS that are issued or guaranteed by a federally chartered corporation or a U.S. Government agency ("Agency RMBS"), including through To-Be-Announced ("TBA") contracts, and in other real estate-related and financial assets, such as interest only strips created from RMBS ("IOs"), commercial mortgage-backed securities ("CMBS") and asset-backed securities ("ABS"). The Company refers collectively to the assets it targets as its target assets.

 

The Company's income is generated primarily by the net spread between the income it earns on its assets and the cost of its financing and hedging activities in its residential mortgage investments segment, and the origination, sale and servicing of residential mortgage loans in its residential mortgage banking segment. The Company's objective is to provide attractive risk-adjusted returns to its stockholders, primarily through quarterly dividend distributions and secondarily through capital appreciation.

 

The Company was incorporated in Maryland on May 24, 2011, and has elected to be taxed and to qualify as a real estate investment trust ("REIT") beginning with the taxable year ended December 31, 2011. The Company completed its formation transaction and commenced operations on July 29, 2011. On February 13, 2013, the Company completed its initial public offering ("IPO"), pursuant to which the Company sold 5,650,000 shares of its common stock at a price of $21.25 per share for gross proceeds of $120.1 million. Net proceeds, after the payment of offering costs of $1.2 million, were $118.9 million.

 

The Company's charter authorizes the issuance of up to 500,000,000 shares of common stock with a par value of $0.0001 per share, and 50,000,000 shares of preferred stock, with a par value of $0.0001 per share. The Company's board of directors is authorized to amend its charter, without the approval of stockholders, to increase the aggregate number of authorized shares of capital stock or the number of shares of any class or series of capital stock or to classify and reclassify any unissued shares of its capital stock into other classes or series of stock that the Company has the authority to issue.

 

The Company is the sole general partner of, and conducts substantially all of its business through, ZAIS Financial Partners, L.P., the Company's consolidated operating partnership subsidiary (the "Operating Partnership"). The Company is externally managed by ZAIS REIT Management, LLC (the "Advisor"), a subsidiary of ZAIS Group, LLC ("ZAIS"), and has no employees except for those employed by GMFS. At September 30, 2015, GMFS had 240 employees.

 

2. Basis of Quarterly Presentation

 

The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("U.S. GAAP") as contained within the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") and the rules and regulations of the U.S. Securities and Exchange Commission ("SEC") for interim reporting. In the opinion of management, all adjustments considered necessary for a fair statement of the Company's financial position, results of operations and cash flows have been included and are of a normal and recurring nature. The operating results presented for the interim periods are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. GAAP as contained in the ASC have been condensed or omitted from the unaudited interim consolidated financial statements according to the SEC rules and regulations. The information and disclosures contained in the unaudited interim consolidated financial statements and notes should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2014. Professional fees, transaction costs, loan servicing fees and general and administrative expenses reported in the prior period have been reclassified to operating expenses and other expenses to conform to the current period's presentation. During the nine months ended September 30, 2015, the Company recorded an out of period adjustment, in the amount of $96,000, to Mortgage Banking activities, net, to reverse the reported unrealized gains relating to certain Mortgage loans held for sale, at fair value, that were previously sold. Management believes that previously issued financial statements are not materially misstated.

 

 - 5 - 

 

 

The Company operates in two business segments: residential mortgage investments and residential mortgage banking.

 

Estimates

 

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results may ultimately differ from those estimates.

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of the Company, the Operating Partnership, all of the wholly owned subsidiaries of the Operating Partnership (including its taxable REIT subsidiaries (“TRS”) and subsidiaries in which the Company has a controlling financial interest. All intercompany balances have been eliminated in consolidation.

 

The Company, which serves as the sole general partner of and conducts substantially all of its business through the Operating Partnership, holds approximately 89.6% of the operating partnership units ("OP units") in the Operating Partnership at September 30, 2015 and December 31, 2014. The Operating Partnership in turn holds directly or indirectly all of the equity interests in its subsidiaries.

 

Changes in the Company's ownership interest (and transactions with non-controlling interests in its consolidated subsidiaries) while the Company retains its controlling interest in the subsidiaries, are accounted for as equity transactions. The carrying amount of the non-controlling interest is adjusted to reflect the change in its ownership interest in the subsidiaries, with the offset to equity attributable to the Company.

 

Variable Interest Entities

 

A variable interest entity ("VIE") is an entity that lacks one or more of the characteristics of a voting interest entity. The Company evaluates each of its investments to determine whether it is a VIE based on: (1) the sufficiency of the entity's equity investment at risk to finance its activities without additional subordinated financial support provided by any parties, including the equity holders; (2) whether as a group the holders of the equity investment at risk have (a) the power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impacts the entity's economic performance, (b) the obligation to absorb the expected losses of the legal entity or the right to receive the expected residual returns of the legal entity; and (3) whether the voting rights of these investors are proportional to their obligations to absorb the expected losses of the entity, their rights to receive the expected returns of their equity, or both, and whether substantially all of the entity's activities involve or are conducted on behalf of an investor that has disproportionately fewer voting rights. An investment that lacks one or more of the above three characteristics is considered to be a VIE. The Company reassesses its initial evaluation of an entity as a VIE upon the occurrence of certain reconsideration events.

 

A VIE is subject to consolidation if the equity investors either do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support, are unable to direct the entity's activities, or are not exposed to the entity's losses or entitled to its residual returns. VIEs are required to be consolidated by their primary beneficiary. The primary beneficiary of a VIE is determined to be the party that has both the power to direct the activities of a VIE that most significantly impact the VIE's economic performance and the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. This determination can sometimes involve complex and subjective analyses.

 

 - 6 - 

 

 

The Company's mortgage loans held for sale are sold predominantly to Fannie Mae and Freddie Mac, which are government sponsored enterprises ("GSEs" or "Agencies"). The Company also issues Ginnie Mae securities by pooling eligible loans through a pool custodian and assigning rights to the loans to Ginnie Mae. Fannie Mae, Freddie Mac and Ginnie Mae provide credit enhancement of the loans through certain guarantee provisions. The Company also purchases RMBS from securitization trusts or similar vehicles. These securitizations involve VIEs as the trusts or similar vehicles, by design, have the characteristics of a VIE.

 

The Company has evaluated its interests in its real estate investment securities and its interests in the securitizations discussed in the preceding paragraph to determine if each represents a variable interest in a VIE. The Company monitors these investments and its investment in the securities and analyzes them for potential consolidation. The Company determined that it was not the primary beneficiary of the VIEs and therefore none of the VIEs were consolidated at September 30, 2015 or December 31, 2014. The maximum exposure of the Company to VIEs is limited to the fair value of its investments in real estate securities and MSRs as disclosed in the Company's consolidated balance sheets.

 

Other Investment Securities

 

The Company held Freddie Mac Structured Agency Credit Risk Notes ("FMSA Notes") at September 30, 2015 and December 31, 2014 and Fannie Mae's Risk Transfer Notes (“FMSA Notes”) at September 30, 2015 (collectively, the “Other Investment Securities”). The Other Investment Securities represent unsecured general obligations of Fannie Mae and Freddie Mac and are structured to be subject to the performance of a certain pool of residential mortgage loans.

 

Income Taxes

 

The Company has elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended (the "Code"), commencing with its taxable year ended December 31, 2011. The Company was organized and has operated and intends to continue to operate in a manner that will enable it to qualify to be taxed as a REIT. To qualify as a REIT, the Company must meet certain organizational and operational requirements, including a requirement to distribute at least 90% of the Company's annual REIT taxable income to its stockholders (which is computed without regard to the dividends paid deduction or net capital gains and which does not necessarily equal net income as calculated in accordance with U.S. GAAP). As long as the Company qualifies as a REIT, the Company generally will not be subject to U.S. federal income taxes on its taxable income to the extent it annually distributes its net taxable income to stockholders and does not engage in prohibited transactions. The majority of States also recognize the Company's REIT status. If the Company fails to qualify as a REIT in any taxable year, it will be subject to federal income tax on its taxable income at regular corporate income tax rates and generally will not be permitted to qualify for treatment as a REIT for federal income tax purposes for the four taxable years following the year during which qualification is lost unless the Internal Revenue Service ("IRS") grants the Company relief under certain statutory provisions. Such an event could materially adversely affect the Company's net income under U.S. GAAP and net cash available for distribution to stockholders. However, it is assumed that the Company will retain its REIT status and will incur no REIT level taxation as it intends to comply with the REIT regulations and annual distribution requirements.

 

The Company has separately made joint elections with three of its subsidiaries, ZFC Funding Inc., ZFC Trust TRS I, LLC and ZFC Honeybee TRS, LLC, to treat such subsidiaries as taxable REIT subsidiaries (the "TRS entities"). The Company may perform certain activities through these TRS entities that could adversely impact the Company's REIT qualification if performed other than through a TRS entity. The Company's TRS entities file separate tax returns and are taxed as standalone U.S. C-Corporations irrespective of the dividends-paid deduction available to REITs for federal income tax purposes.

 

The Company assesses its tax positions for all open tax years and records tax benefits only if tax positions meet a more-likely-than-not threshold in accordance with U.S. GAAP for guidance on accounting for uncertainty in income taxes.

 

 - 7 - 

 

 

Significant Accounting Policies

 

See "Notes to Consolidated Financial Statements, Note 2 - Summary of Significant Accounting Policies" included in Item 8, "Financial Statements and Supplementary Data," included in the Company's annual report on Form 10-K for the year ended December 31, 2014 for the Company's Significant Accounting Policies.

 

Recent Accounting Pronouncements

 

In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers" ("ASU 2014-09"). The objective of the guidance is to clarify the principles for recognizing revenue. ASU 2014-09 supersedes most current revenue recognition guidance, including industry-specific guidance, and also enhances disclosure requirements around revenue recognition and the related cash flows. The guidance is to be applied retrospectively to all prior periods presented or through a cumulative adjustment in the year of adoption, for interim and annual periods beginning after December 15, 2017. Earlier application is permitted only as of annual reporting periods beginning after December 31, 2016, including interim reporting periods within that reporting period. The Company is currently evaluating the impact of adopting this new standard.

 

In August 2014, the FASB issued ASU No. 2014-15, "Presentation of Financial Statements – Going Concern (Subtopic 205-04) Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern" ("ASU 2014-15"), which requires management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the Company's ability to continue as a going concern within one year after the date the financial statements are issued. If conditions or events indicate it is probable that an entity will be unable to meet its obligations as they become due within one year after the financial statements are issued, the update requires additional disclosures. The update is effective for periods beginning after December 15, 2016 with early adoption permitted. Adoption of ASU 2014-15 is not expected to have a material effect on the Company's consolidated financial statements.

 

In February 2015, the FASB issued ASU 2015-02, "Consolidation: Amendments to the Consolidation Analysis" ("ASU 2015-02"). ASU 2015-02 makes changes to both the variable interest model and the voting model. The guidance is effective for annual and interim periods beginning after December 15, 2015. Early adoption is permitted, including adoption in an interim period. The Company is currently evaluating the impact of adopting this new standard.

 

In April 2015 the FASB issued ASU 2015-03, "Interest - Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs" ("ASU 2015-03"). ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The guidance is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted for financial statements that have not been previously issued. Adoption of ASU 2015-03 is not expected to have a material effect on the Company's consolidated financial statements.

 

In September 2015, the FASB issued ASU 2015-16, “Business Combinations (Topic 805)” (ASU 2015-16). The amendments in ASU 2015-16 require that an acquirer recognize adjustments to estimated amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The amendments require that the acquirer record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the estimated amounts, calculated as if the accounting had been completed at the acquisition date. The amendments also require an entity to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the estimated amounts had been recognized as of the acquisition date. ASU 2015-16 is effective for public business entities for fiscal years beginning after December 15, 2015, including interim periods within those fiscal years. The amendments should be applied prospectively to adjustments to provisional amounts that occur after the effective date with earlier application permitted for financial statements that have not been issued. The Company is currently evaluating the impact of adopting this new standard.

 

 - 8 - 

 

 

3. GMFS Transaction

 

On August 5, 2014, the Company, in its capacity as guarantor, entered into an agreement and plan of merger (the "Merger Agreement") among ZFC Honeybee TRS, LLC, an indirect subsidiary of the Company, ZFC Honeybee Acquisitions, LLC ("Honeybee Acquisitions"), a wholly owned subsidiary of ZFC Honeybee TRS, LLC, GMFS and Honeyrep, LLC, solely in its capacity as the security holder representative. GMFS is an origination platform that primarily originates and services agency and government guaranteed residential mortgage loans in the southern United States. On October 31, 2014, the Company completed its acquisition of GMFS. Honeybee Acquisitions was merged with and into GMFS (the "Merger"), with GMFS surviving the Merger as an indirect subsidiary of the Company. The final purchase price was approximately $61.2 million.

 

The Merger Agreement contained customary representations and warranties by the parties, as well as customary covenants, including non-competition and non-solicitation covenants by GMFS's key managers and indemnification covenants by both parties, subject to stated thresholds and limitations.

 

The preliminary purchase price was approximately $62.8 million at closing which was comprised of (i) the estimated fair market value of GMFS's MSR portfolio, (ii) the estimated value of GMFS's net tangible assets at October 31, 2014 and (iii) a purchase price premium. In addition to cash paid at closing, two contingent $1 million deferred premium payments payable in cash over two years, plus potential additional consideration based on future loan production and profits will be payable over a four-year period if certain conditions are met. The $2 million of deferred premium payments is contingent on GMFS remaining profitable and retaining certain key employees. The additional contingent consideration is dependent on GMFS achieving certain profitability and loan production goals and is capped at $20 million. Up to 50% of the additional contingent consideration may be paid in common stock of the Company, at the Company's option. The Company funded the closing cash payment through a combination of available cash and the liquidation of a portion of its non-Agency RMBS portfolio.

 

Total preliminary consideration at closing was as follows:

 

Cash paid to owners of GMFS  $62,847,452 
Contingent consideration   11,430,413 
Total preliminary consideration  $74,277,865 

 

Contingent consideration represents the estimated present value of future earn-out payments as defined in the Merger Agreement. Contingent consideration was estimated at closing based on future earnings projections of GMFS over the four year earn-out period and is re-measured to fair value at each reporting date until the contingency is resolved. The changes in fair value are recognized in earnings. The final consideration paid could be materially different from the estimate and the difference will be recorded through earnings in the consolidated statements of operations. For the three and nine months ended September 30, 2015, the Company recorded an increase in contingent consideration of $333,019 and $1,182,251 due to the passage of time. Such amount is included in operating expenses in the consolidated statements of operations.

 

Under the acquisition method of accounting, the total purchase price allocated to the identifiable tangible and intangible assets acquired and the liabilities assumed is based on management's preliminary valuation of GMFS's tangible and intangible assets acquired by the Company and GMFS's liabilities assumed by the Company as of October 31, 2014. A preliminary valuation of the net assets acquired is summarized as follows (the final purchase price allocation in June 2015 did not result in material changes):

 

 - 9 - 

 

 

Fair value of Assets:     
Cash and cash equivalents  $13,304,612 
Mortgage loans held for sale   92,512,390 
Mortgage loans held for investment   1,098,897 
Derivative assets   1,590,160 
Other assets   2,713,950 
MSRs   32,300,337 
Goodwill   16,512,680 
Intangible Assets   5,800,000 
Loans eligible for repurchase from Ginnie Mae   21,169,329 
Total assets acquired  $187,002,355 
Fair value of Liabilities:     
Warehouse lines of credit  $85,840,705 
Accounts payable and other liabilities   5,714,456 
Liability for loans eligible for repurchase from Ginnie Mae   21,169,329 
Total liabilities assumed  $112,724,490 
Fair value of net assets acquired  $74,277,865 

 

Goodwill

 

Goodwill represents the excess of the purchase price over the fair value of the net assets acquired and liabilities assumed and is primarily made up of expected synergies and the assembled workforce of GMFS. This determination of goodwill at the time of closing was preliminary and was as follows:

 

Total purchase price  $74,277,865 
Less: Preliminary estimate of the fair value of the net assets acquired   (57,765,185)
Goodwill  $16,512,680 

 

Pursuant to the terms of the Merger Agreement, based on the final reconciliation of the October 31, 2014 values, the Company received a net settlement of $1,684,263 in June 2015 from an escrow account established at the time of the closing and updated its allocation of the purchase price to the assets and liabilities acquired. The final purchase price of the acquisition (before contingent consideration) was $61,163,189 as a result of this net settlement. The updated allocation, combined with the receipt of escrow funds resulted in a reduction of goodwill of $1,943,533 and a reduction of accrued expenses of $259,269. Additionally, goodwill was reduced by $385,610 relating to the reversal of a liability existing as of the date of the acquisition. These adjustments were recorded based on information obtained subsequent to the acquisition date that related to information that existed as of the acquisition date. Additional adjustments may be recorded during the allocation period specified by U.S. GAAP as additional information becomes available.

 

The changes in the carrying amount of the goodwill for the nine months ended September 30, 2015 is as follows:

 

Balance at December 31, 2014  $16,512,680 
Less:     
Reversal of a liability existing as of the date of acquisition   (385,610)
Finalization of purchase price based upon final reconciliation   (1,943,533)
Balance at September 30, 2015  $14,183,537 

 

No impairment losses relating to goodwill were recorded for the three and nine months ended September 30, 2015. The Company did not have any goodwill prior to the acquisition of GMFS on October 31, 2014.

 

Goodwill has been allocated to the Company's residential mortgage banking segment. Additionally, goodwill is expected to be deductible for tax purposes over a 15-year life.

 

 - 10 - 

 

 

Other Intangible Assets

 

The following table presents information about the intangible assets acquired by the Company:

 

    Estimated Fair
Value
    Estimated Useful
Life
 
Trade name  $ 2.0 million    10 years 
Customer relationships   1.3 million    10 years 
Licenses   1.0 million    3 years 
Favorable lease   1.5 million    12 years 
Total Intangible assets  $ 5.8 million      

 

Amortization expense related to the intangible assets acquired for the three and nine months ended September 30, 2015 was as follows:

 

   Three Months Ended
September 30, 2015
   Nine Months Ended
September 30, 2015
 
Amortization expense  $197,085   $591,256 

 

Such amounts are recorded as other expenses in the consolidated statements of operations.

 

At September 30, 2015 and December 31, 2014, accumulated amortization is as follows:

 

   September 30
2015
   December 31
2014
 
Trade name  $183,337   $33,333 
Customer relationships   119,163    21,666 
Licenses   305,558    55,556 
Favorable lease   114,587    20,834 
Total accumulated amortization  $722,645   $131,389 

 

Amortization expense related to the intangible assets for the period October 1, 2015 to December 31, 2015 and for the five years subsequent to December 31, 2015 is as follows:

 

October 1, 2015 – December 31, 2015  $197,085 
2016  $788,340 
2017  $732,776 
2018  $455,004 
2019  $455,004 
2020  $455,004 

 

4. Fair Value

 

Fair Value Measurement

 

Financial assets and liabilities recorded at fair value on a recurring basis are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

 

 - 11 - 

 

 

The following table presents the Company's financial instruments that were accounted for at fair value on a recurring basis at September 30, 2015, by level within the fair value hierarchy:

 

   Assets and Liabilities at Fair Value 
   Level 1   Level 2   Level 3   Total 
                 
Assets                    
Mortgage loans held for investment  $   $   $401,206,350   $401,206,350 
Mortgage loans held for sale       114,670,811        114,670,811 
Non-Agency RMBS           113,220,076    113,220,076 
Other Investment Securities           15,209,050    15,209,050 
MSRs           42,044,651    42,044,651 
Derivative assets           3,528,739    3,528,739 
Total  $   $114,670,811   $575,208,866   $689,879,677 
Liabilities                    
Derivative liabilities  $   $2,593,972   $   $2,593,972 
Total  $   $2,593,972   $   $2,593,972 

 

The following table presents the Company's financial instruments that were accounted for at fair value on a recurring basis at December 31, 2014, by level within the fair value hierarchy:

 

   Assets and Liabilities at Fair Value 
   Level 1   Level 2   Level 3   Total 
                 
Assets                    
Mortgage loans held for investment  $   $   $415,959,838   $415,959,838 
Mortgage loans held for sale       97,690,960        97,690,960 
Non-Agency RMBS           148,585,733    148,585,733 
Other Investment Securities           2,040,532    2,040,532 
MSRs           33,378,978    33,378,978 
Derivative assets           2,485,100    2,485,100 
Total  $   $97,690,960   $602,450,181   $700,141,141 
Liabilities                    
Derivative liabilities  $   $2,585,184   $   $2,585,184 
Total  $   $2,585,184   $   $2,585,184 

 

 - 12 - 

 

 

The following tables present additional information about the Company's financial instruments which are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value:

 

Mortgage Loans Held for Investment, RMBS and Other Investment Securities

  

   Nine Months Ended September 30, 2015   Nine Months Ended September 30, 2014 
   Mortgage
Loans Held
for
Investment
   Non-Agency
RMBS
   Other
Investment
Securities
   Mortgage
Loans Held
for
Investment
   Non-Agency
RMBS
   Other
Investment
Securities
 
Beginning balance  $415,959,838   $148,585,733   $2,040,532   $331,785,542   $226,155,221   $ 
Originations/acquisitions   11,359,110    6,362,138    15,601,330    84,795,975    47,034,324    12,926,954 
Proceeds from sales   -    (26,770,760)   (2,241,387)       (12,318,845)    
Amortization of premiums   (2,388)                    
Net accretion of discounts   5,894,627    3,263,205    124,204    5,420,778    4,197,196    129,307 
Proceeds from principal repayments   (25,384,866)   (13,975,960)       (16,274,473)   (23,648,183)    
Conversion of mortgage loans to REO   (2,134,106)           (169,406)        
Total losses (realized/unrealized) included in earnings   (15,316,984)   (5,485,768)   (539,285)   (6,319,913)   (2,031,595)   (52,950)
Total gains (realized/unrealized) included in earnings   10,831,119    1,241,488    223,656    30,858,481    4,516,333    437,240 
Ending balance  $401,206,350   $113,220,076   $15,209,050   $430,096,984   $243,904,451   $13,440,551 
The amount of total gains or (losses) for the period included in earnings attributable to the change in unrealized gains or losses relating to assets or liabilities still held at the reporting date  $(5,664,885)  $(3,554,935)  $(449,755)  $23,744,752   $2,104,672   $384,290 

 

Derivative Instruments

  

   Nine Months Ended 
September 30, 2015
   Nine Months Ended 
September 30, 2014
 
   Loan Purchase
Commitments
   Interest Rate
Lock
Commitments
   Loan Purchase
Commitments
   Interest Rate
Lock
Commitments
 
Beginning balance  $4,037   $2,481,063   $   $ 
Change in unrealized gain or loss   51,443    992,196         
Ending balance  $55,480   $3,473,259   $   $ 
The amount of total gains or (losses) for the period included in earnings attributable to the change in unrealized gains or losses relating to assets or liabilities still held at the reporting date  $51,443   $992,196   $   $ 

 

MSR

  

   Nine Months Ended 
   September 30,
2015
   September 30,
2014
 
The amount of total gains or (losses) for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at the reporting date  $(3,571,775)  $ 

 

See Note 8 – "Mortgage Servicing Rights, at fair value" for additional information about the Company's MSRs.

 

There were no financial assets or liabilities that were accounted for at fair value on a nonrecurring basis at September 30, 2015 or December 31, 2014. During the nine months ended September 30, 2015 and September 30, 2014, mortgage loans held for investment were transferred out of Level 3 when the properties were foreclosed and were classified as real estate owned. There were no other transfers into or out of Level 1, Level 2 or Level 3 during the nine months ended September 30, 2015 or September 30, 2014.

 

 - 13 - 

 

 

The following tables present quantitative information about the Company's assets which are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value:

 

   Fair Value at
September 30,
2015
   Valuation
Technique(s)
  Unobservable
Input
  Min   Max   Weighted
Average
 

Mortgage loans held for Investment(1)

  $401,206,350   Discounted cash flow model  Constant voluntary prepayment   1.9%   5.0%   3.3%
           Constant default rate   1.0%   4.6%   2.9%
           Loss severity   6.2%   37.2%   22.4%
           Delinquency   5.6%   11.8%   10.3%
Non-Agency RMBS(2)                          
Alternative – A  $36,656,809   Broker quotes/comparable trades  Constant
voluntary prepayment
   2.5%   18.4%   12.9%
           Constant default rate   0.2%   7.1%   2.8%
           Loss severity   0.0%   100.5%   19.6%
           Delinquency   1.3%   21.2%   8.8%
Pay option adjustable rate   33,553,550   Broker quotes/comparable trades  Constant
voluntary prepayment
   2.1%   14.0%   7.2%
           Constant default rate   1.2%   11.9%   3.7%
           Loss severity   0.0%   88.8%   42.2%
           Delinquency   4.5%   24.9%   12.4%
Prime   34,238,383   Broker quotes/comparable trades  Constant voluntary prepayment   3.3%   18.4%   8.1%
           Constant default rate   1.2%   12.6%   3.8%
           Loss severity   0.0%   92.4%   30.3%
           Delinquency   3.8%   25.4%   11.9%
Subprime   8,771,334   Broker quotes/comparable trades  Constant voluntary prepayment   1.2%   7.5%   3.8%
          Constant default rate   3.0%   8.0%   6.2%
           Loss severity   14.0%   102.0%   61.4%
           Delinquency   17.5%   26.0%   22.3%
Total Non-Agency RMBS  $113,220,076                      
                           
Other Investment Securities(2)  $15,209,050   Broker quotes/comparable trades  Constant voluntary prepayment   3.9%   18.8%   6.6%
                           
MSRs  $42,044,651   Discounted cash flow model  Constant voluntary prepayment   9.8%   11.0%   10.5%
           Cost of servicing  $77   $109   $91 
           Discount rate   9.0%   10.0%   9.4%

 

 

(1)The fair value of the mortgage loans held for investment are determined either by (i) a proprietary model (distressed and re-performing loans at the time of purchase) or (ii) secondary-market prices (newly originated loans at the time of purchase).
(2)The Company uses an independent third party as its principal valuation source to estimate the fair value of its real estate securities. The Company substantiates these prices by using a variety of methods, including comparing prices to internally estimated prices and corroborating the prices by reference to other independent market data, such as relevant benchmark indices and prices of similar instruments. In certain instances, the Company may use a price other than that provided by the principal valuation source based on the aforementioned market data. Where the Company has disclosed unobservable inputs, those inputs are based on the Company's validations performed at the security level.

 

Derivative Financial Instruments

 

The Company estimates the fair value of interest rate lock commitments ("IRLC") based on quoted Agency MBS prices, its estimate of the fair value of the MSRs it expects to receive in the sale of the loans and the probability that the mortgage loan will be purchased as a percentage of the commitments it has made (the "pull-through rate"). The Company categorizes IRLCs as a "Level 3" financial statement item.

 

The significant unobservable inputs used in the fair value measurement of the Company's IRLCs are the pull-through rate and the MSR component of the Company's estimate of the value of the mortgage loans it has committed to purchase. Significant changes in the pull-through rate and the MSR component of the IRLCs, in isolation, may result in a significant change in fair value. The financial effects of changes in these assumptions are generally inversely correlated as increasing interest rates have a positive effect on the fair value of the MSR component of IRLC value, but increase the pull-through rate for loans that have decreased in fair value.

 

 - 14 - 

 

 

The following is a quantitative summary of key unobservable inputs used in the valuation of IRLCs at September 30, 2015:

 

Pull-through rate     
Range    60.8% - 100.0%
Weighted average   84.2%
MSR value expressed as:     
Servicing fee multiple     
Range   0.5% - 6.1%
Weighted average   4.4%
Percentage of unpaid principal balance     
Range   0.2% - 1.9%
Weighted average   1.1%

 

The fair value measurements of these assets are sensitive to changes in assumptions regarding prepayment, probability of default, loss severity in the event of default, forecasts of home prices, and significant activity or developments in the real estate market. Significant changes in any of those inputs in isolation may result in significantly higher or lower fair value measurements. Generally, an increase in the probability of default and loss severity in the event of default would result in a lower fair value measurement. A decrease in these assumptions would have the opposite effect. Conversely, an assumption that the home prices will increase would result in a higher fair value measurement. A decrease in the assumption for home prices would have the opposite effect.

 

Fair Value Option

 

Changes in fair value for assets and liabilities for which the fair value option was elected are recognized in earnings as they occur. The fair value option may be elected on an instrument-by-instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.

 

The following table presents the difference between the fair value and the aggregate unpaid principal amount and/or notional balance of assets for which the fair value option was elected at September 30, 2015 and December 31, 2014:

 

   September 30, 2015   December 31, 2014 
   Fair Value  

Unpaid Principal
and/or Notional
Balance(2)

   Difference   Fair Value  

Unpaid Principal
and/or Notional
Balance(2)

   Difference 
Financial instruments, at fair value                              
Mortgage loans held for investment(1)  $401,206,350   $447,058,784   $(45,852,434)  $415,959,838   $464,877,028   $(48,917,190)
Mortgage loans held for sale   114,670,811    108,361,961    6,308,850    97,690,960    92,917,659    4,773,301 
Non-Agency RMBS   113,220,076    174,098,738    (60,878,662)   148,585,733    226,501,915    (77,916,182)
Other Investment Securities   15,209,050    15,914,000    (704,950)   2,040,532    2,250,000    (209,468)
MSRs   42,044,651    3,916,159,002    (3,874,114,351)   33,378,978    3,078,974,342    (3,045,595,364)

 

 

(1)Balance comprised of loans that are (i) distressed and re-performing at the time of purchase and (ii) newly originated at the time of purchase.
(2)Non-Agency RMBS includes an IO with a notional balance of $35.9 million and $48.6 million at September 30, 2015 and December 31, 2014, respectively.

 

Fair Value of Other Financial Instruments

 

In addition to the above disclosures regarding assets or liabilities which are recorded at fair value, U.S. GAAP requires disclosure about the fair value of all other financial instruments. Estimated fair value of financial instruments was determined by the Company using available market information and appropriate valuation methodologies. Considerable judgment is necessary to interpret market data and develop estimated fair values. The use of different market assumptions and/or estimation methodologies may have a material effect on estimated fair values.

 

 - 15 - 

 

 

The following table summarizes the estimated fair value and carrying value for all other financial instruments at September 30, 2015 and December 31, 2014:

 

   September 30, 2015   December 31, 2014 
   Fair Value   Carrying Value   Fair Value   Carrying Value 
Other financial instruments                    
Assets                    
Cash  $29,366,231   $29,366,231   $33,791,013   $33,791,013 
Restricted cash   4,026,267    4,026,267    7,143,078    7,143,078 
Mortgage loans held for investment, at cost   1,020,597    1,074,313    1,310,544    1,338,935 
Liabilities                    
Warehouse lines of credit  $104,216,594   $104,216,594   $89,417,564   $89,417,564 
Loan repurchase facilities   295,315,030    295,315,030    300,092,293    300,092,293 
Securities repurchase agreements   74,520,999    74,520,999    103,014,105    103,014,105 
Exchangeable Senior Notes   57,006,650    56,240,664    59,933,400    55,474,741 
Contingent consideration   12,612,664    12,612,664    11,430,413    11,430,413 

 

Cash includes cash on hand for which fair value equals carrying value (a Level 1 measurement). Restricted cash represents the Company's cash held by counterparties as collateral against the Company's derivatives, loan repurchase facilities and securities repurchase agreements. Due to the short-term nature of the restrictions, fair value approximates carrying value (a Level 1 measurement). The fair value of the mortgage loans held for investment is determined, where possible using secondary-market prices. If no such quoted price exists, the fair value of a loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan. Accordingly, mortgage loans held for investment, at cost are classified as Level 2 in the fair value hierarchy. The fair value of the Company's warehouse lines of credit and repurchase agreements related to the GMFS origination platform, loan repurchase facilities and securities repurchase agreements is based on an expected present value technique using observable market interest rates. As such, the Company considers the estimated fair value to be a Level 2 measurement. This method discounts future estimated cash flows using rates the Company determined best reflect current market interest rates that would be offered for loans with similar characteristics and credit quality. The fair value of the Exchangeable Senior Notes (see Note 12) is based on observable market prices (a Level 2 measurement). The fair value of the contingent consideration represents the estimated present value of future earn-out payments related to the GMFS acquisition. The estimated present value is determined based on future earnings projections and market discount rates (a Level 3 measurement).

 

The differences reflected in the table for mortgage loans held for investment are not necessarily indicative of cumulative gains or losses related to loans because it does not take into account the fair value of the loans at the date of acquisition.

 

5. Mortgage Loans Held for Investment, at Fair Value

 

Distressed and re-performing loans at the time of purchase

 

During the three and nine months ended September 30, 2015, the Company did not acquire any mortgage loans held for investment which showed evidence of credit deterioration at the time of purchase.

 

During the three and nine months ended September 30, 2014, the Company's acquisition of mortgage loans held for investment which showed evidence of credit deterioration at the time of purchase was as follows:

 

   Three Months Ended
September 30, 2014
   Nine Months Ended
September 30, 2014
 
Aggregate Unpaid Principal Balance  $   $100,422,418 
Loan Repurchase Facilities Used       60,557,196 

 

 - 16 - 

 

 

The following tables present certain information regarding the Company's mortgage loans held for investment at September 30, 2015 and December 31, 2014 which showed evidence of credit deterioration at the time of purchase:

 

September 30, 2015

 

              

Gross Unrealized(1)

   Difference
Between Fair
Value and
Aggregate
   Weighted Average 
   Unpaid 
Principal
Balance
   Premium
(Discount)
   Amortized
Cost
   Gains   Losses   Fair 
Value
   Unpaid 
Principal
Balance
   Coupon   Unleveraged
Yield
 
Mortgage Loans Held for Investment                                             
Performing                                             
Fixed  $243,798,190   $(45,739,123)  $198,059,067   $25,830,480   $(1,801,124)  $222,088,423   $(21,709,767)   4.67%   7.51%
ARM   149,729,350    (17,322,646)   132,406,704    6,123,469    (2,972,583)   135,557,590    (14,171,760)   3.56    7.15 
Total performing   393,527,540    (63,061,769)   330,465,771    31,953,949    (4,773,707)   357,646,013    (35,881,527)   4.25    7.36 
Non-performing(2)   41,621,277    (7,445,729)   34,175,548    1,095,706    (3,855,056)   31,416,198    (10,205,079)   4.90    7.52 
Total Mortgage Loans Held for Investment  $435,148,817   $(70,507,498)  $364,641,319   $33,049,655   $(8,628,763)  $389,062,211   $(46,086,606)   4.31%   7.38%

 

 

(1)The Company has elected the fair value option pursuant to ASC 825 for these mortgage loans held for investment. The Company recorded the following as change in unrealized gain or loss on mortgage loans held for investment in the consolidated statements of operations:

 

Three Months Ended   Nine Months Ended 
September 30, 2015   September 30, 2014   September 30, 2015   September 30, 2014 
$(5,753,002)  $915,797   $(5,632,684)  $23,566,322 

 

(2)Loans that are delinquent for 60 days or more are considered non-performing.

 

December 31, 2014

 

              

Gross Unrealized(1)

   Difference
Between Fair
Value and
Aggregate
   Weighted Average 
   Unpaid
 Principal
Balance
   Premium
(Discount)
   Amortized
 Cost
   Gains   Losses   Fair 
Value
   Unpaid
Principal
Balance
   Coupon   Unleveraged
Yield
 
Mortgage Loans Held for Investment                                             
Performing                                             
Fixed  $265,306,697   $(51,501,092)  $213,805,605   $26,732,362   $(1,383,524)  $239,154,443   $(26,152,254)   4.50%   7.28%
ARM   162,858,201    (21,343,046)   141,515,155    9,568,296    (1,441,035)   149,642,416    (13,215,785)   3.59    7.10 
Total performing   428,164,898    (72,844,138)   355,320,760    36,300,658    (2,824,559)   388,796,859    (39,368,039)   4.15    7.21 
Non-performing(2)   35,945,165    (6,039,073)   29,906,092    840,097    (4,369,886)   26,376,303    (9,568,862)   5.48    7.13 
Total Mortgage Loans Held for Investment  $464,110,063   $(78,883,211)  $385,226,852   $37,140,755   $(7,194,445)  $415,173,162   $(48,936,901)   4.26%   7.20%

 

 

(1)The Company has elected the fair value option pursuant to ASC 825 for these mortgage loans held for investment.
(2)Loans that are delinquent for 60 days or more are considered non-performing.

 

The following table presents the change in accretable yield for the Company's mortgages held for investment which had shown evidence of credit deterioration since origination at the time of purchase for the nine months ended September 30, 2015 and September 30, 2014 is as follows:

 

   Nine Months Ended 
   September 30, 2015   September 30, 2014 
Accretable yield, beginning of period  $267,509,905   $223,401,697 
Acquisitions       55,532,098 
Accretion   (19,347,512)   (19,306,825)
Reclassifications from nonaccretable difference   7,760,664    15,683,166 
Accretable yield, end of period  $255,923,057   $275,310,136 

 

 - 17 - 

 

 

Newly originated loans at the time of purchase

 

During the three and nine months ended September 30, 2015, the Company's acquisition of mortgage loans held for investment which were newly originated at the time of purchase was as follows:

 

   Three Months Ended
September 30, 2015
   Nine Months Ended
September 30, 2015
 
Aggregate Unpaid Principal Balance  $8,291,350   $11,171,269 
Loan Repurchase Facilities Used   7,265,036    9,746,638 

 

During the three and nine months ended September 30, 2014, the Company did not acquire any mortgage loans held for investment which were newly originated at the time of purchase.

 

The following tables present certain information regarding the Company's mortgage loans held for investment at September 30, 2015 and December 31, 2014 which were newly originated at the time of purchase and sourced through its loan purchase program:

 

September 30, 2015

 

               Gross Unrealized(1)       Weighted Average 
   Unpaid
Principal
Balance
   Premium   Amortized
Cost
   Gains   Losses   Fair Value   Coupon   Unleveraged
Yield
 
Performing                                        
Fixed  $11,909,967   $201,633   $12,111,600   $60,915   $(28,376)  $12,144,139    4.97%   4.82%
Total Mortgage Loans Held for Investment  $11,909,967   $201,633   $12,111,600   $60,915   $(28,376)  $12,144,139    4.97%   4.82%

 

 

(1)The Company has elected the fair value option pursuant to ASC 825 for these mortgage loans held for investment. The Company recorded the following as change in unrealized gain or loss on mortgage loans held for investment in the consolidated statements of operations:

 

Three Months Ended
September 30, 2015
   Nine Months Ended
September 30, 2015
 
$102,078   $29,001 

 

The Company did not hold any mortgage loans held for investment which were newly originated at the time of purchase during the three and nine months ended September 30, 2014.

 

December 31, 2014

 

              

Gross Unrealized(1)

       Weighted Average 
   Unpaid
Principal
Balance
   Premium
(Discount)
   Amortized
Cost
   Gains   Losses   Fair Value   Coupon   Unleveraged Yield 
Performing                                         
Fixed   $766,965   $16,173   $783,138   $3,538   $   $786,676    4.38%   4.20%
Total Mortgage Loans Held for Investment   $766,965   $16,173   $783,138   $3,538   $   $786,676    4.38%   4.20%

 

 

(1)The Company has elected the fair value option pursuant to ASC 825 for these mortgage loans held for investment.

 

 - 18 - 

 

 

Concentrations

 

The Company's mortgage loans held for investment, at fair value consists of mortgage loans on residential real estate located throughout the United States. The following is a summary of certain concentrations of credit risk in the mortgage loan portfolio at September 30, 2015 and December 31, 2014:

 

   September 30,
2015
   December 31,
2014
 
         
Percentage of fair value of mortgage loans with unpaid principal balance to current property value in excess of 100%    46.4%   55.7%
Percentage of fair value of mortgage loans secured by properties in the following states:          
           
Each representing 10% or more of fair value:          
California    25.8%   26.2%
Florida    16.2%   16.6%
Additional state representing more than 5% of fair value:          
Georgia    6.2%   5.7%
New York    4.9%   5.1%
Percentage of unpaid principal balance of mortgage loans carrying mortgage insurance    8.5%   10.3%

 

The range of interest rates and contractual maturities of the Company's mortgage loans held for investment at September 30, 2015 and December 31, 2014 were as follows:

 

   September 30,
2015
  December 31,
 2014
Interest rates   1.75% - 12.20%  1.75% - 12.20%
Contractual maturities   1 – 45 years  1 - 46 years

 

REO

 

At September 30, 2015 and December 31, 2014, the Company held REO with a net realizable value of $1,235,973 and $1,282,669, respectively. Such amounts are included in other assets in the Company's consolidated balance sheets.

 

Additionally, at September 30, 2015 and December 31, 2014 the carrying amount of mortgage loans held for investment secured by residential real estate properties for which formal foreclosure proceedings are in process according to local requirements of the applicable jurisdiction is $7,248,620 and $4,762,509, respectively.

 

6. Mortgage Loans Held for Sale, at Fair Value

 

During the nine months ended September 30, 2015, the Company's mortgage loans held for sale activity was as follows:

 

Balance at beginning of year   $97,690,960 
Originations and repurchases    1,449,538,666 
Proceeds from sales and principal payments    (1,481,473,208)
Transfers from mortgage loans held for investment, at cost    65,983 
Gain on sale    48,848,410 
Balance at end of period   $114,670,811 

 

 - 19 - 

 

 

Mortgage loans held for sale, at fair value at September 30, 2015 and December 31, 2014 is as follows:

 

   September 30, 2015   December 31, 2014 
   Unpaid
Principal
Balance
   Fair Value   Unpaid
Principal
Balance
   Fair Value 
Conventional   $69,909,078   $72,741,840   $55,073,645   $57,058,195 
Governmental    19,679,800    21,635,672    13,407,781    14,601,797 
United States Department of Agriculture loans    12,106,292    12,811,911    16,105,088    17,069,138 
United States Department of Veteran Affairs loan    5,237,807    5,887,721    6,730,696    7,196,278 
Reverse mortgage    1,428,984    1,593,667    1,600,449    1,765,552 
Total   $108,361,961   $114,670,811   $92,917,659   $97,690,960 

 

The Company did not have mortgage loans held for sale prior to the acquisition of GMFS on October 31, 2014.

 

7. Real Estate Securities and Other Investment Securities, at Fair Value

 

The Company's non-Agency RMBS portfolio is not issued or guaranteed by Fannie Mae, Freddie Mac or any other U.S. Government agency or a federally chartered corporation and is therefore subject to additional credit risks.

 

The following tables present certain information regarding the Company's non-Agency RMBS and Other Investment Securities at September 30, 2015 and December 31, 2014:

 

September 30, 2015

 

              

Gross Unrealized(2)

       Weighted Average 
   Principal or                             
   Notional
Balance
   Premium
(Discount)
   Amortized 
Cost
   Gains   Losses   Fair Value   Coupon   Unleveraged
Yield
 
Real estate securities                                         
Non-Agency RMBS:                                        
Alternative – A   $78,316,001   $(41,385,821)  $36,930,180   $868,563   $(1,141,934)  $36,656,809    2.03%   6.24%
Pay option adjustable rate    43,749,469    (7,725,888)   36,023,581    13,024    (2,483,055)   33,553,550    0.97    5.98 
Prime    39,083,582    (5,013,131)   34,070,451    725,167    (557,235)   34,238,383    3.64    5.92 
Subprime    12,949,686    (4,159,493)   8,790,193    73,602    (92,461)   8,771,334    0.70    6.77 
Total non-Agency RMBS   $174,098,738   $(58,284,333)  $115,814,405   $1,680,356   $(4,274,685)  $113,220,076    2.03%   6.11%
Other Investment Securities(1)   $15,914,000   $(202,457)  $15,711,543   $1,027   $(503,520)  $15,209,050    4.39%   6.62%

 

 

(1)See Note 2 – Basis of Quarterly Presentation, “Other Investment Securities".
  

(2)The Company has elected the fair value option pursuant to ASC 825 for real estate securities. The Company recorded the following changes in unrealized gain or loss in the consolidated statements of operations.

 

   Three Months Ended   Nine Months Ended 
   September 30,
 2015
   September 30,
2014
   September 30,
2015
   September 30,
2014
 
Real estate securities   $(2,119,917)  $(2,319,287)  $(4,262,990)  $1,964,966 
Other Investment Securities    (420,796)   (892,336)   (276,269)   384,290 

 

December 31, 2014

 

              

Gross Unrealized(2)

       Weighted Average 
   Principal or                             
   Notional
Balance
   Premium
(Discount)
   Amortized
Cost
   Gains   Losses   Fair Value   Coupon   Unleveraged
Yield
 
Real estate securities                                        
Non-Agency RMBS:                                        
Alternative – A   $118,547,109   $(58,583,222)  $59,963,887   $1,916,611   $(583,958)  $61,296,540    3.44%   7.03%
Pay option adjustable rate    58,122,808    (11,491,663)   46,631,145    80,848    (1,170,668)   45,541,325    0.93    6.12 
Prime    43,803,995    (6,219,091)   37,584,904    1,545,452    (65,280)   39,065,076    3.60    6.79 
Subprime    6,028,003    (3,290,867)   2,737,136        (54,344)   2,682,792    0.33    16.98 
Total non-Agency RMBS   $226,501,915   $(79,584,843)  $146,917,072   $3,542,911   $(1,874,250)  $148,585,733    2.62%   6.96%
Other Investment Securities(1)   $2,250,000   $16,756   $2,266,756   $   $(226,224)  $2,040,532    3.92%   5.90%

 

 

(1)See Note 2 – Basis of Quarterly Presentation, "Other Investment Securities".

(2)The Company has elected the fair value option pursuant to ASC 825 for its real estate securities and Other Investment Securities.

 

 - 20 - 

 

 

   September 30, 2015   December 31, 2014 
   Non-Agency RMBS   Other Investment
Securities
   Non-Agency RMBS   Other Investment
Securities
 
Notional balance of IO included in Alternative A   $35,938,418       $48,569,423     
Contractual maturities (range)    18.3 to 31.5 years    8.7 to 12.1 years    20.3 to 32.3 years    9.7 years 
Weighted average maturity    24.6 years    9.9 years    24.9 years    9.7 years 

 

Actual maturities are generally shorter than stated contractual maturities. Maturities are affected by the contractual lives of the associated mortgage collateral, periodic payments of principal, prepayments of principal and credit losses.

 

All real estate securities and Other Investment Securities held by the Company at September 30, 2015 and December 31, 2014 were issued by issuers based in the United States.

 

There were no realized losses from other than temporary impairments on non-Agency RMBS or Other Investment Securities for the three months ended September 30, 2015 or September 30, 2014 or for the nine months ended September 30, 2015 or September 30, 2014.

 

8. Mortgage Servicing Rights, at Fair Value

 

The Company's MSRs consist of conforming conventional loans sold to Fannie Mae and Freddie Mac or loans securitized in Ginnie Mae securities. Similarly, the government loans serviced by the Company are secured through Ginnie Mae, whereby the Company is insured against loss by the FHA or partially guaranteed against loss by the VA.

 

The activity of MSRs for the nine months ended September 30, 2015 is as follows:

 

Balance at beginning of year   $33,378,978 
Additions due to loans sold, servicing retained    14,323,953 
Change in fair value of MSRs(1)      
 Changes in values of market related inputs or assumptions used in a valuation model(2)    (3,571,775)
 Other changes(3)    (2,086,505)
 Total - Change in fair value of MSRs    (5,658,280)
      
Balance at end of period   $42,044,651 

 

 

(1)Included in change in fair value of MSRs in the Company's consolidated statements of operations.

(2)Primarily reflects changes in values of prepayment assumptions due to changes in interest rates.

(3)Represents decrease in value due to passage of time, including the impact from both regularly scheduled loan principal payments and loans that were paid off or paid down during the period.

 

The Company did not have MSRs prior to the acquisition of GMFS on October 31, 2014.

 

 - 21 - 

 

 

The Company's MSR portfolio at September 30, 2015 and December 31, 2014 is as follows:

 

   September 30, 2015   December 31, 2014 
   Unpaid Principal
Balance
   Fair Value   Unpaid Principal
Balance
   Fair Value 
Fannie Mae   $1,834,356,909   $18,737,561   $1,640,799,719   $17,078,181 
Ginnie Mae    1,404,614,765    16,332,072    1,146,234,768    13,102,076 
Freddie Mac    677,187,328    6,975,018    291,939,855    3,198,721 
Total   $3,916,159,002   $42,044,651   $3,078,974,342   $33,378,978 

 

The following is a quantitative summary of key input assumptions and their related impact on the estimated fair value of the MSRs from adverse changes in those assumptions (weighted averages are based upon unpaid principal balance):

 

Discount rate     
Range    6.55% - 12.16%
Weighted average    9.36%
      
Effect on fair value of adverse change of:     
5%  $(796,288)
10%  $(1,564,127)
20%  $(3,020,068)
      
Prepayment speed(1)      
Range    7.67% - 13.52%
Weighted average    10.45%
      
Effect on fair value of adverse change of:     
5%  $(662,003)
10%  $(1,694,287)
20%  $(3,287,807)
      
Per-loan annual cost of servicing     
Range    $64 - $118 
Weighted average   $91 
      
Effect on fair value of adverse change of:     
5%  $(484,051)
10%  $(968,101)
20%  $(1,936,203)

 

 

(1)Prepayment speed is measured using CPR.

 

The Company contracts with licensed sub-servicers to perform all servicing functions for these loans. The following table presents the loan servicing fee income, net of direct costs, for the three and nine months ended September 30, 2015:

 

   Three Months Ended
September 30, 2015
   Nine Months Ended
September 30, 2015
 
Income   $2,729,891   $7,613,023 
Late charges    29    64 
Cost of sub-servicer    (989,813)   (2,568,246)
Loan servicing fee income, net of direct costs   $1,740,107   $5,044,841 

 

The Company did not have any MSRs or loan servicing fees, net of direct costs prior to the acquisition of GMFS on October 31, 2014.

 

9. Warehouse Lines of Credit

 

At September 30, 2015 and December 31, 2014, the Company had two warehouse lines of credit and two master repurchase agreements, each with different lenders, which provide financing for the Company's origination of mortgage loans held for sale in its mortgage banking segment.

 

 - 22 - 

 

 

The warehouse lines of credit and repurchase agreements bear interest at a rate that has historically moved in close relationship to LIBOR. The agreements contain covenants that include certain financial requirements, including maintenance of minimum liquidity, minimum tangible net worth, maximum debt to net worth ratio and current ratio and limitations on capital expenditures, indebtedness, distributions, transactions with affiliates and maintenance of positive net income, as defined in the agreements. The Company was in compliance with all significant debt covenants for the three and nine months ended September 30, 2015 and at December 31, 2014.

 

The following tables present certain information regarding the Company's warehouse lines of credit and repurchase agreements in its mortgage banking segment at September 30, 2015 and December 31, 2014:

 

   September 30,  2015   December 31, 2014 
Availability   $185,000,000   $130,000,000 
Maturity dates    November 2015 – September 2016    January 2015 – June 2016 

 

   September 30, 2015   December 31, 2014 
Maturity Dates  Balance   Weighted
Average Rate
   Balance   Weighted
Average Rate
 
30 days or less   $    %  $21,210,431    2.47%
31 – 90 days    25,403,955    2.50         
181 days to 1 year    78,812,639    2.49    57,118,533    2.46 
Greater than 1 year            11,088,600    2.92 
Total balance and weighted average rate   $104,216,594    2.49%  $89,417,564    2.52%

 

At September 30, 2015 and December 31, 2014 the Company pledged $114,303,003 and $97,690,960 of mortgage loans held for sale, respectively, to secure the warehouse lines of credit and repurchase agreements related to the GMFS origination platform. These obligations are also fully guaranteed by the Company.

 

10. Loan Repurchase Facilities

 

At September 30, 2015 and December 31, 2014, the Company had the following outstanding master repurchase agreements with Citibank, N.A. (the "Citi Loan Repurchase Facility") and Credit Suisse First Boston Mortgage Capital LLC (the "Credit Suisse Loan Repurchase Facility") (collectively, the "Loan Repurchase Facilities") used to fund the purchase of mortgage loans held for investment in its residential mortgage investments segment:

 

   September 30, 2015   December 31, 2014 
Lender    Citibank, N.A    Credit Suisse First
Boston Mortgage
Capital LLC
    Citibank, N.A    Credit Suisse First
Boston Mortgage
Capital LLC
 
Collateral type funded by facility    Distressed and Re-
Performing Loans
    Newly Originated
Loans
    Distressed and Re-
Performing Loans
    Newly Originated
Loans
 
Total facility size   $325,000,000   $100,000,000   $325,000,000   $100,000,000 
Amount committed   $150,000,000   $25,000,000   $150,000,000   $100,000,000 
Maturity date    May 20, 2016    June 27, 2016    May 22, 2015    August 13, 2015 
Outstanding balance   $284,931,244   $10,383,786   $299,402,024   $690,269 

 

Each of the Loan Repurchase Facilities is collateralized by the underlying mortgages and related documents and instruments in the residential mortgage investments segment and the obligations are fully guaranteed by the Company.

 

Under the Loan Repurchase Facilities, the Company may sell, and later repurchase trust certificates representing interests in residential mortgage loans (the "Trust Certificates"). The principal amount paid by the lenders under the Loan Repurchase Facilities for the Trust Certificates, which represent interests in residential mortgage loans, is based on (i) in the case of the Citi Loan Repurchase Facility, a percentage of the lesser of the market value or the unpaid principal balance of such mortgage loans backing the Trust Certificates and (ii) in the case of the Credit Suisse Loan Repurchase Facility, a percentage of the lesser of the market value, the unpaid principal balance or the acquisition price of such mortgage loans backing the Trust Certificates. Upon the Company's repurchase of a Trust Certificate sold to the lenders under the Loan Repurchase Facilities, the Company is required to repay the lenders a repurchase amount based on the purchase price plus accrued interest. The Company is also required to pay the lenders a commitment fee for the Loan Repurchase Facilities, as well as certain other administrative costs and expenses in connection with the lenders' structuring, management and ongoing administration of the Loan Repurchase Facilities. The commitment fees are included in interest expense in the consolidated statements of operations.

 

 - 23 - 

 

 

The Company pledges cash and certain of its Trust Certificates as collateral under the Loan Repurchase Facilities. The amounts available to be borrowed are dependent upon the fair value of the Trust Certificates pledged as collateral, which fluctuates with changes in interest rates, type of underlying mortgage loans and liquidity conditions within the banking, mortgage finance and real estate industries. In response to declines in the fair value of pledged Trust Certificates, the lenders may require the Company to post additional collateral or pay down borrowings to re-establish agreed upon collateral requirements, referred to as margin calls. During the three and nine months ended September 30, 2015 and September 30, 2014, and at December 31, 2014, the Company has met all margin call requirements related to any outstanding balances under its Loan Repurchase Facilities.

 

The agreements contain covenants that include certain financial requirements, including maintenance of minimum liquidity, minimum tangible net worth and maximum debt to net worth ratio, as defined in the agreements. The Company was in compliance with all significant debt covenants for the three and nine months ended September 30, 2015 and September 30, 2014, and at December 31, 2014.

 

The following tables present certain information regarding the Company's Loan Repurchase Facilities at September 30, 2015 and December 31, 2014:

 

   September 30, 2015   December 31, 2014 
   Balance   Weighted 
Average Rate
   Balance   Weighted 
Average Rate
 
Loan Repurchase Facilities borrowings maturing within                    
91-180 days   $    %  $299,402,024    2.92%
181 days to 1 year    295,315,030    2.92    690,269    2.46%
Total balance and weighted average rate   $295,315,030    2.92%  $300,092,293    2.92%

 

   September 30,
2015
   December 31,
2014
 
Fair value of Trust Certificates pledged as collateral   $399,301,401   $415,814,067 
Fair value of mortgage loans not pledged as collateral    1,904,949    145,771 
Cash pledged as collateral    9,152     
Unused Amount(1)    129,684,970    124,907,707 

 

 

(1)The amount the Company is able to borrow under the Loan Repurchase Facilities is tied to the fair value of unencumbered Trust Certificates eligible to secure those agreements and the Company's ability to fund the agreements' margin requirements relating to the collateral sold.

 

   Three Months Ended   Nine Months Ended 
   September 30,
2015
   September 30,
2014
   September 30,
2015
   September 30,
2014
 
Weighted average interest rate(1)    3.14%   3.09%   3.15%   3.07%
Average unpaid principal balance of loans sold under agreements to repurchase   $694,916   $   $698,204   $192,380 
Maximum daily amount outstanding    298,047,583    310,575,669   $302,037,635    310,575,669 

 

 

(1)Includes commitment fees.

 

 - 24 - 

 

  

11. Securities Repurchase Agreements

 

Securities repurchase agreements related to real estate securities and Other Investment Securities involve the sale and a simultaneous agreement to repurchase the transferred assets or similar assets at a future date. The amount borrowed generally is equal to the fair value of the assets pledged less an agreed-upon discount, referred to as a "haircut." Repurchase agreements related to real estate securities and Other Investment Securities entered into by the Company are accounted for as financings and require the repurchase of the transferred securities at the end of each arrangement's term, typically 30 to 90 days. The Company maintains the beneficial interest in the specific securities pledged during the term of the repurchase arrangement and receives the related principal and interest payments. Interest rates on these borrowings are fixed based on prevailing rates corresponding to the terms of the borrowings, and interest is paid at the termination of the repurchase arrangement at which time the Company may enter into a new repurchase arrangement at prevailing market rates with the same counterparty or repay that counterparty and negotiate financing with a different counterparty. In response to declines in fair value of pledged securities due to changes in market conditions or the publishing of monthly security paydown factors, the lender requires the Company to post additional securities as collateral, pay down borrowings or establish cash margin accounts with the counterparty in order to re-establish the agreed-upon collateral requirements, referred to as margin calls. Under the terms of the Company's master repurchase agreements related to real estate securities and Other Investment Securities, the counterparty may sell or re-hypothecate the pledged collateral.

 

The Company has master repurchase agreements with four financial institutions at September 30, 2015 and December 31, 2014.

 

The following tables present certain information regarding the Company's securities repurchase agreements at September 30, 2015 and December 31, 2014 by remaining maturity and collateral type:

 

   September 30, 2015 
   Non-Agency RMBS   Other Investment Securities 
   Balance   Weighted
Average Rate
   Balance   Weighted
Average Rate
 
Securities repurchase agreements maturing within                    
30 days or less   $74,520,999    1.69%  $    

%
Total balance/weighted average rate   $74,520,999   1.69%  $  

%

 

   December 31, 2014 
   Non-Agency RMBS   Other Investment Securities 
   Balance   Weighted
Average Rate
   Balance   Weighted
Average Rate
 
Securities repurchase agreements maturing within                     
30 days or less   $101,553,292    1.57%  $1,460,813    1.66%
Total balance/weighted average rate   $101,553,292    1.57%  $1,460,813    1.66%

 

Although securities repurchase agreements are committed borrowings until maturity, the lender retains the right to mark the underlying collateral to fair value. A reduction in the value of pledged assets would require the Company to provide additional collateral or cash to fund margin calls.

 

The Company pledges cash and certain of its non-Agency RMBS and Other Investment Securities as collateral under these securities repurchase agreements. The amounts available to be borrowed are dependent upon the fair value of the RMBS and Other Investment Securities pledged as collateral, which fluctuates with changes in interest rates, type of securities and liquidity conditions within the banking, mortgage finance and real estate industries. In response to declines in the fair value of pledged RMBS and Other Investment Securities, the lenders may require the Company to post additional collateral or pay down borrowings to re-establish agreed upon collateral requirements, referred to as margin calls. During the three and nine months ended September 30, 2015 and September 30, 2014 and at December 31, 2014, the Company has met all margin call requirements under its securities repurchase agreements.

 

 - 25 - 

 

 

The following table presents information with respect to the Company's posting of collateral under its securities repurchase agreements at September 30, 2015 and December 31, 2014:

 

   September 30,
2015
   December 31,
2014
 
Total outstanding under securities repurchase agreements secured by non-Agency RMBS   $74,520,999   $101,553,292 
Total outstanding under securities repurchase agreements secured by Other Investment Securities        1,460,813 
Fair value of non-Agency RMBS pledged as collateral    99,239,271    135,779,193 
Fair value of Other Investment Securities pledged as collateral        2,040,532 
Fair value of non-Agency RMBS not pledged as collateral    13,980,805    12,806,540 
Fair value of Other Investment Securities not pledged as collateral    15,209,050     
Cash pledged as collateral    2,021,389    684,256 

 

12. 8.0% Exchangeable Senior Notes due 2016

 

On November 25, 2013, the Operating Partnership issued the Exchangeable Senior Notes with a stated rate of 8.0% and an aggregate principal amount of $57.5 million (the "Exchangeable Senior Notes"). The Exchangeable Senior Notes were issued pursuant to an Indenture, dated November 25, 2013, between the Company, as guarantor, the Operating Partnership and U.S. Bank National Association, as trustee. The sale of the Exchangeable Senior Notes generated net proceeds of approximately $55.3 million. Aggregate estimated offering expenses in connection with the transaction, including the initial purchasers' discount of approximately $1.7 million, were approximately $2.2 million.

 

The Exchangeable Senior Notes are the Company's senior unsecured obligations and rank senior in right of payment to the Company's existing and future indebtedness that is expressly subordinated in right of payment to the Exchangeable Senior Notes; equal in right of payment to the Company's existing and future unsecured indebtedness that is not so subordinated; effectively junior in right of payment to any of the Company's secured indebtedness (including existing unsecured indebtedness that the Company later secures) to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness (including trade payables) incurred by the Company's subsidiaries, financing vehicles or similar facilities.

 

The Exchangeable Senior Notes are exchangeable for shares of the Company's common stock or, to the extent necessary to satisfy NYSE listing requirements, cash, at the applicable exchange rate at any time prior to the close of business on the scheduled trading day prior to November 15, 2016 (the "Maturity Date"). The Company may not elect to issue shares of common stock upon exchange of the Exchangeable Senior Notes to the extent such election would result in the issuance of 20% or more of the common stock outstanding immediately prior to the issuance of the Exchangeable Senior Notes (or 1,779,560 or more shares).

 

As a result of the NYSE related limitation on the use of share-settlement for the full conversion option, the embedded conversion option does not qualify for equity classification and instead is separately valued and accounted for as a derivative liability. The initial value allocated to the derivative liability was $1.3 million, which represents a discount to the debt to be amortized through interest expense using the effective interest method through the Maturity Date. During each reporting period, the conversion option derivative liability is marked to fair value through earnings.

 

The exchange rate was initially 52.5417 shares of common stock per $1,000 principal amount of Exchangeable Senior Notes (equivalent to an initial exchange price of approximately $19.03 per share of common stock). The exchange rate will be subject to adjustment for certain events, including for regular quarterly dividends in excess of $0.50 per share, but will not be adjusted for any accrued and unpaid interest. In addition, if certain corporate events occur prior to the Maturity Date, the exchange rate will be increased but will in no event exceed 60.4229 shares of common stock per $1,000 principal amount of Exchangeable Senior Notes. The exchange rate was adjusted on December 27, 2013 to 54.3103 shares of common stock per $1,000 principal amount of Exchangeable Senior Notes pursuant to the Company's special dividend of $0.55 per share of common stock and OP unit declared on December 19, 2013.

 

 - 26 - 

 

 

The Company does not have the right to redeem the Exchangeable Senior Notes prior to the Maturity Date, except to the extent necessary to preserve its qualification as a REIT for U.S. federal income tax purposes. No sinking fund is provided for the Exchangeable Senior Notes. In addition, if the Company undergoes certain corporate events that constitute a "fundamental change," the holders of the Exchangeable Senior Notes may require the Company to repurchase for cash all or part of their Exchangeable Senior Notes at a repurchase price equal to 100% of the principal amount of the Exchangeable Senior Notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date.

 

The Exchangeable Senior Notes bear interest at a rate of 8.0% per year, payable semiannually in arrears on May 15 and November 15 of each year, beginning on May 15, 2014. The effective interest rate of the Exchangeable Senior Notes, which is equal to the stated rate of 8.0% plus the amortization of the original issue discount and associated costs, is 10.2%.

 

The following table presents information with respect to the Exchangeable Senior Notes at September 30, 2015 and December 31, 2014:

 

   September 30,
2015
   December 31,
2014
 
Fair value of conversion option derivative liability   $8,646   $1,022,248 
Unamortized discount    1,259,336    2,025,259 

 

The Exchangeable Senior Notes will mature on the Maturity Date, unless previously exchanged or repurchased in accordance with their terms. The Company is currently evaluating alternatives to settle the obligation at maturity including refinancing the obligation or selling assets.

 

13. Derivative Instruments

 

The Company’s derivative instruments, by segment, are as follows:

 

Residential Mortgage Investments Segment

 

Interest Rate Swap and Swaption Agreements

 

To help mitigate exposure to higher short-term interest rates, the Company uses currently-paying and forward-starting, three-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements. Additionally, the Company enters into interest rate swaption agreements which gives the Company the right, but not the obligation, to enter into a previously agreed upon swap contract on a future date. If exercised, the Company will enter into an interest rate swap agreement and will be obligated to pay a fixed rate of interest and receive a floating rate of interest. These swap agreements establish an economic fixed rate on related borrowings because the variable-rate payments received on the interest rate swap agreements largely offset interest accruing on the related borrowings, leaving the fixed-rate payments to be paid on the interest rate swap agreements as the Company's effective borrowing rate, subject to certain adjustments including changes in spreads between variable rates on the interest rate swap agreements and actual borrowing rates.

 

The Company's interest rate swap agreements and interest rate swaption agreement have not been designated as hedging instruments.

 

Loan Purchase Commitments ("LPCs")

 

The Company enters into LPCs as a means to help mitigate interest rate risk. The LPCs are pursuant to Master Loan Purchase Agreements with approved, third party residential loan originators to purchase residential loans, which meet the guidelines established by the Company, at a future date. LPCs provide that loans acceptable to the Company be delivered if and when they close and are subject to "pair off" fees if the loans are not delivered by the seller.

 

 - 27 - 

 

 

TBA Securities

 

The Company may, as it has in the past, enter into TBA contracts for this segment as a means of acquiring exposure to Agency RMBS and may, from time to time, utilize TBA dollar roll transactions to finance Agency RMBS purchases. The Company may also enter into TBA contracts as a means of hedging against short-term changes in interest rates. The Company may choose, prior to settlement, to move the settlement of these securities to a later date by entering into an offsetting position (referred to as a "pair off"), settling the paired off positions against each other for cash, and simultaneously entering into a similar TBA contract for a later settlement date, which is commonly and collectively referred to as a "dollar roll" transaction. The Company accounts for its TBA contracts as derivative instruments due to the fact that it does not intend to take physical delivery of the securities.

 

The Company had no exposure to TBA contracts for this segment at any time during the three and nine months ended September 30, 2015 and September 30, 2014. At September 30, 2015 and December 31, 2014 the Company did not have any TBA contracts outstanding relating to this segment.

 

Residential Mortgage Banking Segment

 

IRLCs

 

The Company enters into IRLCs to originate residential mortgage loans held for sale, at specified interest rates and within a specified period of time (generally between 30 and 90 days), with customers who have applied for a loan and meet certain credit and underwriting criteria.

 

MBS Forward Sales Contracts and TBA Securities

 

The Company manages the interest rate price risk associated with its outstanding IRLCs and mortgage loans held for sale by entering into derivative loan instruments such as MBS forward sales contracts, some of which are TBA securities. The Company expects these derivatives will experience changes in fair value opposite to changes in fair value of the IRLCs and mortgage loans held for sale, thereby reducing earnings volatility. The Company takes into account various factors and strategies in determining the portion of the IRLCs and mortgage loans held for sale it wants to economically hedge.

 

Other

 

Conversion Option – Exchangeable Senior Notes

 

Changes in the fair value of the conversion option derivative related to the Exchangeable Senior Notes are recorded through earnings.

 

Derivative Instruments

 

The following table presents certain information related to derivative instruments held at September 30, 2015 and December 31, 2014:

 

Non-hedge derivatives  September 30, 2015   December 31, 2014 
Notional amount of interest rate swaption   $   $225,000,000 
Notional amount of interest rate swaps    17,200,000    17,200,000 
LPCs (Principal balance of underlying loans)    16,162,370    1,905,700 
IRLCs (Principal balance of underlying loans)    196,941,326    118,486,590 
Notional amount of MBS forward sales contracts    177,500,000    154,000,000 

 

The notional amount is not representative of the maximum exposure to the Company.

 

 - 28 - 

 

  

The following table presents the fair value of the Company's derivative instruments and their balance sheet location at September 30, 2015 and December 31, 2014:

 

Derivative instruments  Designation  Balance Sheet Location  September 30,
2015
   December 31,
2014
 
Interest rate swaps   Non-hedge  Derivative liabilities, at fair value  $(1,251,498)  $(860,553)
                 
Interest rate swaption   Non-hedge  Derivative assets, at fair value        
                 
LPCs   Non-hedge  Derivative assets, at fair value   55,480    4,037 
                 
IRLCs   Non-hedge  Derivative assets, at fair value   3,473,259    2,481,063 
                 
MBS forward sales contracts   Non-hedge  Derivative liabilities, at fair value   (1,333,828)   (702,383)
                 
Conversion Option - Exchangeable Senior Notes  Non-hedge  Derivative liabilities, at fair value   (8,646)   (1,022,248)

 

At September 30, 2015 and December 31, 2014, no credit valuation adjustment was made in determining the fair value of the interest rate swaption or interest rate swaps.

 

The following table presents the gains and losses related to Company's derivative instruments:

 

      Three Months Ended   Nine Months Ended 
Non-hedge derivatives  Income Statement 
Location
  September 30,
2015
   September 30,
2014
   September 30,
2015
   September 30,
2014
 
Interest rate swaps   Gain/(loss) on derivative instruments related to investment portfolio  $(675,562)  $(36,315)  $(748,348)  $(976,394)
                        
Interest rate swaption   Gain/(loss) on derivative instruments related to investment portfolio       (298,478)       (4,734,092)
                        
LPCs   Gain/(loss) on derivative instruments related to investment portfolio   118,277        51,443     
                        
IRLCs   Mortgage banking activities, net   1,227,839        992,196     
                        
MBS forward sales contracts   Mortgage banking activities, net   (1,593,515)       (631,445)    
                        
Conversion Option - Exchangeable Senior Notes  Gain/(loss) on derivative instruments related to investment portfolio   379,615    (182,324)   1,013,602    181,739 

 

The Company did not have any IRLCs or MBS forward sales contracts prior to the acquisition of GMFS on October 31, 2014. Additionally, the Company did not have any LPCs during the three and nine months ended September 30, 2014.

 

Interest Rate Swaption

 

The following table presents information about the Company's interest rate swaption agreement at December 31, 2014:

 

Swaption Expiration  Notional Amount   Strike Rate   Swap Maturity  

Cash Pledged as
Collateral(1)

 
January 15, 2015   $225,000,000    3.64%   2025   $4,886,011 

 

 

(1)At December 31, 2014 all collateral provided under the interest rate swaption agreement consisted of cash collateral which is included in restricted cash in the Company's consolidated balance sheets. The interest rate swaption agreement expired in January 2015.

 

The credit support annex provisions of the Company's interest rate swaption agreement allow the parties to mitigate their credit risk by requiring the party which is out of the money to post collateral.

 

 - 29 - 

 

  

Interest Rate Swaps

 

The following table presents information about the Company's interest rate swap agreements at September 30, 2015 and December 31, 2014:

 

   September 30, 2015   December 31, 2014 
Maturity    2023    2023 
Notional Amount   $17,200,000   $17,200,000 
Weighted Average Pay Rate    2.72%   2.72%
Weighted Average Receive Rate    0.33%   0.23%
Weighted Average Years to Maturity    7.8    8.6 
Cash Pledged as Collateral(1)    1,995,726   $1,572,811 

 

 

(1)At September 30, 2015 and December 31, 2014 all collateral provided under the interest rate swap agreements consisted of cash collateral which is included in restricted cash in the Company's consolidated balance sheets.

 

The Company's interest rate swap agreements contain legally enforceable provisions that allow for netting or setting off of all individual interest rate swap receivables and payables with each respective counterparty and, therefore, the fair value of those interest rate swap agreements are netted. The credit support annex provisions of the Company's interest rate swap agreements allow the parties to mitigate their credit risk by requiring the party which is out of the money to post collateral.

 

14. Mortgage Banking Activities

 

The following table presents the components of mortgage banking activities, net, recorded in the Company's consolidated statements of operations for the three and nine months ended September 30, 2015:

 

   Three Months Ended
September 30, 2015
   Nine Months Ended
September 30, 2015
 
Gain on sale of mortgage loans held for sale, net of direct costs(1)   $12,769,854   $35,530,805 
Loan expenses, including provision for loan indemnification    (208,576)   (602,926)
Loan origination fee income    507,082    1,395,863 
Total   $13,068,360   $36,323,742 

 

 

(1)Includes the change in fair value related to IRLCs and MBS forward sales contracts held during the periods.

 

The Company did not have any mortgage banking activities prior to the acquisition of GMFS on October 31, 2014.

 

15. Loan Indemnification Reserve

 

A liability has been established for potential losses related to representations and warranties made by GMFS for loans sold with a corresponding provision recorded for loan losses. The liability is included in accounts payable and other liabilities in the Company's consolidated balance sheets and the provision is included in mortgage banking activities, net in the Company's consolidated statements of operations. In assessing the adequacy of the liability, management evaluates various factors including actual losses on repurchases and indemnifications during the period, historical loss experience, known delinquent and other problem loans, and economic trends and conditions in the industry. Actual losses incurred are reflected as a reduction of the reserve liability.

 

The activity for the loan indemnification reserve for the nine months ended September 30, 2015 is as follows:

 

Balance at the beginning of year   $2,662,162 
Loan losses incurred    (198,834)
Provision for losses    576,654 
Balance at end of period   $3,039,982 

 

The Company did not have any loan indemnification reserve prior to the acquisition of GMFS on October 31, 2014.

 

 - 30 - 

 

 

Because of the uncertainty in the various estimates underlying the loan indemnification reserve, there is a range of losses in excess of the recorded loan indemnification reserve that is reasonably possible. The estimate of the range of possible losses for representations and warranties does not represent a probable loss, and is based on current available information, significant judgment, and a number of assumptions that are subject to change. At September 30, 2015 and December 31, 2014, the reasonably possible loss above the recorded loan indemnification reserve was not considered material.

 

16. Income Taxes

 

For the three and nine months ended September 30, 2015 and September 30, 2014, and at December 31, 2014, the Company qualified to be taxed as a REIT under the Code for U.S. federal income tax purposes. As long as the Company qualifies as a REIT, the Company generally will not be subject to U.S. federal income taxes on its taxable income to the extent it annually distributes its net taxable income to stockholders and does not engage in prohibited transactions. The majority of states also recognize the Company's REIT status.

 

The Company has separately made joint elections with three of its subsidiaries, ZFC Funding, Inc., ZFC Trust TRS I, LLC and ZFC Honeybee TRS, LLC to treat such subsidiaries as taxable REIT subsidiaries (the "TRS entities"). The Company's TRS entities file separate tax returns and are taxed as standalone C-Corporations for U.S. income tax purposes.

 

The following table summarizes the tax (expense) benefit recorded at the TRS entity level for the three and nine months ended September 30, 2015 and September 30, 2014.

 

Provision for Income Taxes

 

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2015   2014   2015   2014 
Current tax benefit (expense)                     
Federal   $   $  $    
State                 
Total current tax benefit (expense)                
                     
Deferred tax benefit (expense)                    
Federal    200,541   $    (2,001,745)  $ 
State    49,950       (502,151)    
Total deferred tax benefit (expense)   250,491        (2,503,896)    
Total benefit (expense) for income taxes   $250,491   $   $(2,503,896)  $ 

 

The following is a reconciliation of the statutory federal and state rate to the effective rate for the three and nine months ended September 30, 2015 and September 30, 2014.

 

Reconciliation of Statutory Tax Rate to Effective Tax Rate

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2015   2014   2015   2014 
Tax benefit (expense) at statutory rate    35.00%   (35.00%)   (35.00%)   (35.00%)
State Tax (Net of Federal benefit)    0.85       (7.91)    
Permanent differences    (0.19)       (1.98)    
Valuation Allowance    (2.85)       (23.25)    
Impact of REIT election    (29.21)   35.00   (17.63)   35.00
Effective Tax Rate    3.60%   0.00%   (85.77%)   0.00%

 

The Company's effective tax rate differs from its statutory tax rate primarily due to the impact of the REIT election and an increase in the deferred tax asset valuation allowances.

 

 - 31 - 

 

 

Deferred income taxes reflect the net tax effect of temporary differences between the carrying amount of assets and liabilities for financial reporting and tax purposes. The Company assesses whether a valuation allowance should be established against its deferred tax assets based on the consideration of all available evidence using a "more likely than not" approach. The Company's estimate of net deferred tax assets could change in future periods to the extent that actual or revised estimates of future taxable income during the carryforward periods change from current expectations. The deferred tax assets and liabilities reported below relate solely to the TRS entities.

 

The Company had activity in ZFC Honeybee TRS, LLC which resulted in a deferred tax liability of $1,652,900 at September 30, 2015 related to unrealized gains and other temporary differences.

 

The Company also had activity in ZFC Trust TRS I, LLC and ZFC Funding, Inc., which resulted in a deferred tax asset of $1,350,536 at September 30, 2015. At September 30, 2015, the Company has established a full valuation allowance for deferred tax assets related to net operating loss and other future deductible amounts of ZFC Trust TRS I, LLC and ZFC Funding, Inc., as these entities do not have a history of positive taxable income and are currently in a cumulative taxable loss position since inception. At December 31, 2014, the Company had activity in the TRS entities, which resulted in a deferred tax asset of $850,996 after establishing a partial valuation allowance related to net operating losses and other future deductible amounts for tax purposes. The Company is allowed to carryforward its net operating losses for 20 years under U.S. Federal Income Tax law and between 12 and 20 years in the majority of states which it operates in. The Company's net operating losses will expire between the years 2026-2035.

 

Components of the Company's net deferred tax asset and liability at September 30, 2015 and December 31, 2014 are presented in the following table:

 

Deferred Tax Asset (Liability)

 

   September 30, 2015   December 31, 2014 
Deferred tax asset           
Tax effect of unrealized losses and other temporary differences   $2,016,769   $1,207,520 
Net operating loss carryforward    2,588,015    673,052 
Total deferred tax asset    4,604,784    1,880,572 
           
Deferred tax liability         
Tax effect of unrealized gains and other temporary differences    (4,907,148)   (357,663)
Total deferred tax liability    (4,907,148)   (357,663)
           
Valuation allowance    (1,350,536)   (671,913)
Total Deferred Tax (Liability) Asset, net of Valuation Allowance   $(1,652,900)  $850,996 

 

The Company evaluates uncertain income tax positions each period. Based upon its analysis of income tax positions, the Company concluded that there are no significant uncertain tax positions that meet the recognition or measurement criteria at either September 30, 2015 or December 31, 2014. Additionally, there were no amounts accrued for penalties or interest as of or during the periods presented in the Company's consolidated financial statements.

 

17. Other Assets and Liabilities

 

Servicing Advances

 

Servicing advances represent escrows and advances on behalf of borrowers and investors to cover delinquent balances for property taxes, insurance premiums and other out-of-pocket costs. Advances are made in accordance with the Company's servicing agreements and are recoverable upon liquidation. At September 30, 2015 and December 31, 2014, the Company had servicing advances of $1,737,586 and $1,987,073, respectively. Such amounts are included in other assets in the Company's consolidated balance sheets.

 

Loans Eligible for Repurchase from Ginnie Mae

 

The Company has recorded an asset and liability in its consolidated balance sheets representing the unilateral right it has to repurchase Ginnie Mae pool loans it has previously sold (generally loans that are more than 90 days past due).

 

 - 32 - 

 

 

There were no actual repurchases of Ginnie Mae delinquent or defaulted mortgage loans during the three and nine months ended September 30, 2015. The Company did not have any loans eligible for repurchase from Ginnie Mae prior to the acquisition of GMFS on October 31, 2014.

 

Escrow and Fiduciary Funds

 

The Company maintains segregated bank accounts in trust for mortgagor escrow balances. The balances of these accounts are $41,105,931 and $25,619,979 at September 30, 2015 and December 31, 2014, respectively, and are excluded from the Company's consolidated balance sheets.

 

Real Estate Owned

 

At September 30, 2015 and December 31, 2014, the Company held REO (see Note 5) which are included in other assets in the Company's consolidated balance sheets.

 

18. Earnings Per Share

 

The following table presents a reconciliation of the earnings and shares used in calculating basic and diluted earnings per share:

 

   Three Months Ended   Nine Months Ended 
   September 30,
2015
   September 30,
2014
   September 30,
2015
   September 30,
2014
 
Numerator:                    
Net (loss) income attributable to ZAIS Financial Corp. common stockholders (Basic)   $(6,040,746)  $1,149,497   $386,845   $26,547,633 
Effect of dilutive securities:                    
Net (loss) income allocated to non-controlling interests relating to OP Units exchangeable for shares of common stock of the Company    (702,460)   130,301    44,988    3,087,159 
Exchangeable Senior Notes                     
Interest expense                2,425,381 
Gain on conversion option derivative liability                (103,564)
Total – Exchangeable Senior Notes                2,321,817 
Net income available to stockholders, after effect of dilutive securities   $(6,743,206)  $1,279,798   $431,833   $31,956,609 
Denominator:                    
Weighted average number of shares of common stock    7,970,886    7,970,886    7,970,886    7,970,886 
Effect of dilutive securities:                    
Weighted average number of OP units    926,914    926,914    926,914    926,914 
Weighted average number of shares convertible under Exchangeable Senior Notes                1,779,560 
Diluted weighted average shares outstanding    8,897,800    8,897,800    8,897,800    10,677,360 
Net (loss) income per share applicable to ZAIS Financial Corp. common stockholders – Basic   $(.76)  $0.14   $.05   $3.33 
Net (loss) income per share applicable to ZAIS Financial Corp. common stockholders – Diluted   $(.76)  $0.14   $.05   $2.97 

 

For purposes of computing diluted earnings per share, the Company assumes the conversion of OP units and the Exchangeable Senior Notes to shares of common stock unless the effect is anti-dilutive. The dilutive effect of OP units, if any, is computed assuming all units are converted to common stock. The dilutive effect of the Exchangeable Senior Notes, if any, is computed assuming shares converted are limited to 1,779,560 pursuant to New York Stock Exchange ("NYSE") restrictions.

 

19. Related Party Transactions

 

ZAIS REIT Management, LLC

 

The Company is externally managed and advised by the Advisor, a subsidiary of ZAIS. Subject to certain restrictions and limitations, the Advisor is responsible for managing the Company's affairs on a day-to-day basis including, among other responsibilities, (i) the origination, selection, purchase and sale of the Company's portfolio of assets, (ii) arranging the Company's financing activities and (iii) providing the Company with advisory services.

 

 - 33 - 

 

 

The Company pays to its Advisor an advisory fee, calculated and payable quarterly in arrears, equal to 1.5% per annum of the Company's stockholders' equity, as defined in the amended and restated investment advisory agreement between the Company and the Advisor, as amended from time to time (the "Investment Advisory Agreement"). Prior to the Company's IPO, the advisory fee paid to the Advisor was calculated based on the Company's net asset value, as set forth in the Investment Advisory Agreement. The Advisor may be paid or reimbursed for the documented cost of its performing certain services for the Company, which may include legal, accounting, due diligence tasks and other services, that outside professionals or outside consultants otherwise would perform, provided that such costs and reimbursements are in amounts which are no greater than those which would be payable to outside professionals or consultants engaged to perform such services pursuant to agreements negotiated on an arm's-length basis. In addition, the Company may be required to pay its portion of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses of the Advisor and its affiliates required for the Company's operations. To date, the Advisor has not sought reimbursement for the services and expenses described in the two preceding sentences. In the future, however, the Advisor may seek reimbursement for all such services, costs and expenses, as a result of which the total expense ratio of the Company may increase. The Company is also required to pay directly, or reimburse the Advisor for, products and services, including hardware and software, research and market data provided by third parties, other than those operating expenses required to be borne by the Advisor under the Investment Advisory Agreement (the "Expense Reimbursements").

 

After an initial three-year term, the Advisor may be terminated annually upon the affirmative vote of at least two-thirds of the Company's independent directors or by a vote of the holders of at least two-thirds of the outstanding shares of the Company's common stock based upon (i) unsatisfactory performance by the Advisor that is materially detrimental to the Company or (ii) a determination that the advisory fees payable to the Advisor are not fair, subject to the Advisor's right to prevent such termination due to unfair fees by accepting a reduction of advisory fees agreed to by at least two-thirds of the Company's independent directors. Additionally, upon such a termination without cause, the Investment Advisory Agreement provides that the Company will pay the Advisor a termination fee equal to three times the average annual advisory fee earned by the Advisor during the prior 24-month period immediately preceding such termination, calculated as of the end of the most recently completed fiscal year before the date of termination.

 

On August 11, 2014, the Company amended its Investment Advisory Agreement to provide that the Company shall pay its Advisor a loan sourcing fee quarterly in arrears in lieu of any payments or reimbursements that would otherwise be due to the Advisor or its affiliates pursuant to Investment Advisory Agreement for loan sourcing services provided. The loan sourcing fee is equal to 0.50% of the principal balance of newly originated residential mortgage loans sourced by the Advisor or its affiliates through its loan conduit program and acquired by the Company's subsidiaries.

 

The Company incurred the following fees pursuant to the Investment Advisory Agreement:

 

   Three Months Ended   Nine Months Ended 
   September 30,
2015
   September 30,
2014
   September 30,
2015
   September 30,
2014
 
Advisory fees   $718,372   $718,372   $2,131,690   $2,131,690 
Loan sourcing fees    41,694        56,664     
Total – Advisory fees – related party   $760,066   $718,372   $2,188,354   $2,131,690 

 

Such amounts are included in "Advisory fee – related party" in the Company's consolidated statements of operations. At September 30, 2015 and December 31, 2014, $760,066 and $718,372, respectively, of advisory fee expense and loan sourcing fee expense was included in accounts payable and other liabilities in the Company's consolidated balance sheets. The fees were calculated and payable as set forth above.

 

For the three months ended September 30, 2015 and September 30, 2014, the Company incurred Expense Reimbursements of $168,134 and $224,189, respectively, for amounts incurred by the Advisor for research and market data. For the nine months ended September 30, 2015 and September 30, 2014, the Company incurred Expense Reimbursements of $604,959 and $309,855, respectively, for amounts incurred by the Advisor for research and market data (including the amortization expense related to amounts prepaid to the Advisor). Such amounts are included in operating expenses in the Company's consolidated statements of operations. At September 30, 2015 and December 31, 2014, Expense Reimbursements of $99,116 and $266,231, respectively, due to the Advisor were included in accounts payable and other liabilities in the Company's consolidated balance sheets.

 

 - 34 - 

 

 

 

GMFS received total sub-lease income related to a portion of its office space (see Note 22) of $10,800 and $28,160 for the three and nine months ended September 30, 2015, respectively, from a related party. Such amount is included in other income in the Company's consolidated statements of operations.

 

On March 17, 2015, a business combination was completed between HF2 Financial Management Inc. ("HF2 Financial"), a special purpose acquisition company, and ZAIS Group Parent, LLC ("ZGP"), which wholly owns ZAIS, pursuant to a definitive agreement dated September 16, 2014. The current owners of ZGP did not receive any proceeds at the closing of the transaction and retained a significant equity stake in ZGP. Following the close of the transaction, ZAIS's management team has remained in place to continue to lead the combined organization.

 

20. Equity

 

Common Stock

 

The holders of shares of the Company's common stock are entitled to one vote per share on all matters voted on by common stockholders, including election of the Company's directors. The Company's charter does not provide for cumulative voting in the election of directors.

 

Therefore, the holders of a majority of the outstanding shares of the Company's common stock can elect its entire board of directors. Subject to any preferential rights of any outstanding series of preferred stock, the holders of shares of the Company's common stock are entitled to such distributions as may be authorized from time to time by the Company's board of directors out of legally available funds and declared by the Company and, upon liquidation, are entitled to receive all assets available for distribution to stockholders. Holders of shares of the Company's common stock do not have preemptive rights. This means that stockholders do not have an automatic option to purchase any new shares of common stock that the Company issues. In addition, stockholders only have appraisal rights under circumstances specified by the Company's board of directors or where mandated by law.

 

Dividends and Distributions

 

During the nine months ended September 30, 2015 and September 30, 2014 the Company declared the following dividends:

 

Declaration Date  Record Date  Payment Date  Amount per Share 
Nine months ended September 30, 2015:           
March 19, 2015   March 31, 2015  April 15, 2015  $0.40 
June 18, 2015   June 30, 2015  July 15, 2015  $0.40 
September 17, 2015   September 30, 2015  October 15, 2015  $0.40 
            
Nine months ended September 30, 2014:           
March 19, 2014   March 31, 2014  April 14, 2014  $0.40 
June 17, 2014   June 30, 2014  July 15, 2014  $0.40 
September 17, 2014   September 30, 2014  October 15, 2014  $0.40 

 

Preferred Shares

 

The Company's charter authorizes its board of directors to classify and reclassify any unissued shares of its common stock and preferred stock into other classes or series of stock. Prior to issuance of shares of each class or series, the board of directors is required by the Company's charter to set, subject to the charter restrictions on transfer of its stock, the terms, preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends or other distributions, qualifications and terms or conditions of redemption for each class or series. Thus, the board of directors could authorize the issuance of shares of common stock or preferred stock with terms and conditions which could have the effect of delaying, deferring or preventing a transaction or change in control that might involve a premium price for holders of the Company's common stock or otherwise be in their best interest.

 

 - 35 - 

 

 

21. Non-controlling Interests

 

Non-controlling interests included in the Company's consolidated financial statements consist of the OP units in the Operating Partnership held by parties other than the Company.

 

Certain investors own OP units in the Operating Partnership. An OP unit and a share of common stock of the Company have substantially the same economic characteristics in as much as they effectively share equally in the net income or loss of the Operating Partnership. OP unit holders have the right to redeem their OP units, subject to certain restrictions. The redemption is required to be satisfied in shares of common stock or cash at the Company's option, calculated as follows: one share of the Company's common stock, or cash equal to the fair value of a share of the Company's common stock at the time of redemption, for each OP unit. When an OP unit holder redeems an OP unit, non-controlling interest in the Operating Partnership is reduced and the Company's equity is increased. At September 30, 2015 and December 31, 2014, the non-controlling interest OP unit holders owned 926,914 OP units, or 10.4% of the OP units issued by the Operating Partnership.

 

GMFS has a 50% controlling interest in a joint venture which performs mortgage brokerage activities.

 

22. Commitments and Contingencies

 

Advisor Services

 

The Company is dependent on the Advisor for certain services that are essential to the Company, including the identification, evaluation, negotiation, origination, acquisition and disposition of investments; management of the daily operations of the Company's investment portfolio including determination of fair value; and other general and administrative responsibilities. In the event that the Advisor is unable to provide the respective services, the Company will be required to obtain such services from an alternative source.

 

Litigation

 

From time to time, the Company may become involved in various claims and legal actions arising in the ordinary course of business.

 

In late April 2015, the Company received a claim from a counterparty with whom a statute of limitations tolling agreement is in place relating to certain mortgage loans that were sold servicing released by GMFS prior to its acquisition by the Company in 2014. The Company is currently evaluating this matter which is in its early stages and is unable to reasonably estimate the amount of probable losses or the range of losses that could potentially exist.

 

Management is not aware of any other contingencies that would require accrual or disclosure in the consolidated financial statements at September 30, 2015 or December 31, 2014.

 

Commitments to Originate Loans

 

GMFS enters into IRLCs with customers who have applied for residential mortgage loans and meet certain credit and underwriting criteria. These commitments expose GMFS to market risk if interest rates change, and the loan is not economically hedged or committed to an investor. GMFS is also exposed to credit loss if the loan is originated and not sold to an investor and the mortgagor does not perform. The collateral upon extension of credit typically consists of a first deed of trust in the mortgagor's residential property.

 

Commitments to originate loans do not necessarily reflect future cash requirements as some commitments are expected to expire without being drawn upon. Total commitments to originate loans approximated $249.1 million and $117.7 million at September 30, 2015 and December 31, 2014, respectively.

 

Leases

 

GMFS leases office space for use in its mortgage banking operations under a non-cancelable operating lease. The lease provides that GMFS pays taxes, maintenance, insurance, and other occupancy expenses applicable to the leased premises. The lease contains three five-year renewal options at pre-determined amounts specified by the original lease agreement. GMFS also leases equipment under various short-term rental agreements. GMFS incurred rent expense of $188,811 and $557,331 for the three and nine months ended September 30, 2015, respectively. Such amounts are included in operating expenses in the Company's consolidated statements of operations.

 

 - 36 - 

 

 

GMFS sub-leases a portion of its office space and furniture and fixtures contained therein to a related party (see Note 19).

 

At September 30, 2015, the future minimum rental payments for the period from October 1, 2015 to December 31, 2015 and the next five years and thereafter are as follows:

 

October 1, 2015 – December 31, 2015   $264,115 
2016  $909,686 
2017  $731,725 
2018  $628,901 
2019  $129,938 
2020  $ 
Thereafter   $ 

 

23. Counterparty Risk and Concentration

 

Counterparty risk is the risk that counterparties may fail to fulfill their obligations, including their inability to post additional collateral in circumstances where their pledged collateral value becomes inadequate. The Company attempts to manage its exposure to counterparty risk through diversification, use of financial instruments and monitoring the creditworthiness of counterparties.

 

The Company finances the acquisition of a significant portion of its mortgage loans held for investment, RMBS and Other Investment Securities with repurchase agreements. Additionally, the Company finances a significant portion of its mortgages held for sale with its warehouse lines of credit and repurchase agreements. In connection with these financing arrangements, the Company pledges its residential mortgage loans, securities and cash as collateral to secure the borrowings. The amount of collateral pledged will typically exceed the amount of the borrowings (i.e., the haircut) such that the borrowings will be over-collateralized. As a result, the Company is exposed to the counterparty if, during the term of the repurchase agreement financing, a lender should default on its obligation and the Company is not able to recover its pledged assets. The amount of this exposure is the difference between the amount loaned to the Company plus interest due to the counterparty and the fair value of the collateral pledged by the Company to the lender including accrued interest receivable on such collateral.

 

The Company's deposits with financial institutions may exceed federally insurable limits of $250,000 per institution. The Company mitigates this risk by depositing funds with major financial institutions. At September 30, 2015 and December 31, 2014, a portion of the Company's operating cash was held with two custodians and three other financial institutions. The Company also maintains separate cash accounts with each of its warehouse lenders at September 30, 2015 and December 31, 2014. There is no guarantee that these custodians or other financial institutions will not become insolvent. While there are certain regulations that seek to protect customer property in the event of a failure, insolvency or liquidation of a custodian, there is no certainty that the Company would not incur losses due to its assets being unavailable for a period of time in the event of a failure of a custodian that has custody of the Company's assets. Although management monitors the credit worthiness of its custodians, such losses could be significant and could materially impair the ability of the Company to achieve its investment objective.

 

In the normal course of business, companies in the mortgage banking industry encounter certain economic and regulatory risks. Economic risks include interest rate risk and credit risk. The Company is subject to interest rate risk to the extent that in a rising interest rate environment, the Company may experience a decrease in loan production, as well as decreases in the value of mortgage loans held for sale and in commitments to originate loans, which may negatively impact the Company's operations. Credit risk is the risk of default that may result from the borrowers' inability or unwillingness to make contractually required payments during the period in which loans are being held for sale.

 

 - 37 - 

 

 

GMFS sells loans to investors without recourse. As such, the investors have assumed the risk of loss or default by the borrower. However, GMFS is usually required by these investors to make certain standard representations and warranties relating to credit information, loan documentation and collateral. To the extent that GMFS does not comply with such representations, or there are early payment defaults, GMFS may be required to repurchase the loans or indemnify these investors for any losses from borrower defaults. In addition, if loans pay-off within a specified time frame, GMFS may be required to refund a portion of the sales proceeds to the investors.

 

The Company's business requires substantial cash to support its operating and investing activities. As a result, the Company is dependent on its warehouse lines of credit, repurchase facilities and other financing facilities in order to finance its continued operations and investments. If the Company's principal lenders decided to terminate or not to renew any of these credit facilities with the Company, the loss of borrowing capacity could have a material adverse impact on the Company's consolidated financial statements unless the Company found a suitable alternative source.

 

MSRs are subject to substantial interest rate risk and the value of MSRs generally tend to diminish in periods of declining interest rates as borrowers can prepay the mortgage notes underlying the MSRs. MSRs increase in periods of rising interest rates (as prepayments decrease). Although the level of interest rates is a key driver of prepayment activity, there are other factors that influence prepayments, including home prices, underwriting standards and product characteristics.

 

24. Offsetting Assets and Liabilities

 

The following table presents information about certain liabilities that are subject to master netting arrangements (or similar agreements) and can potentially be offset in the Company's consolidated balance sheets at September 30, 2015 and December 31, 2014:

 

Offsetting of Liabilities

 

                Net Amounts of              
                Liabilities              
          Gross Amounts     Presented in     Gross Amounts Not Offset in the        
    Gross Amounts     Offset in the     the      Consolidated Balance Sheets              
    of Recognized     Consolidated     Consolidated     Financial     Cash Collateral        
     Liabilities     Balance Sheets     Balance Sheets     Instruments     Pledged     Net Amount  
September 30, 2015                                                
Warehouse lines of credit   $ 104,216,594     $     $ 104,216,594     $ (104,216,594 )   $     $  
Loan Repurchase Facilities     295,315,030             295,315,030       (295,305,878 )     (9,152 )      
Securities repurchase agreements     74,520,999             74,520,999       (72,499,610 )     (2,021,389 )      
Interest rate swap agreements     1,251,498             1,251,498             (1,251,498 )      
Total   $ 475,304,121     $     $ 475,304,121     $ (472,022,082 )   $ (3,282,039 )   $  
December 31, 2014                                                
Warehouse lines of credit   $ 89,417,564     $     $ 89,417,564     $ (89,417,564 )   $     $  
Loan Repurchase Facilities     300,092,293             300,092,293       (300,092,293 )            
Securities repurchase agreements     103,014,105             103,014,105       (102,329,849 )     (684,256 )      
Interest rate swap agreements     860,553             860,553       (860,553 )            
Total   $ 493,384,515     $     $ 493,384,515     $ (492,700,259 )   $ (684,256 )   $  

 

The Company did not have any assets that are subject to master netting arrangements which can potentially be offset in the Company's consolidated balance sheets at September 30, 2015 or December 31, 2014.

 

25. Employee Benefit Plan

 

GMFS has a 401(k) profit sharing plan covering substantially all GMFS employees. The employees may contribute amounts as allowable by IRS and plan limitations. GMFS may make discretionary matching and non-elective contributions. GMFS made contributions to the plan totaling $92,643 and $298,996 for the three and nine months ended September 30, 2015, respectively. Such amounts are included in salaries, commissions and benefits in the Company's consolidated statements of operations. The Company did not have a 401(k) profit sharing plan prior to the acquisition of GMFS on October 31, 2014.

 

26. Segment Information

 

The Company operated as one operating segment for the three and nine months ended September 30, 2014.

 

 - 38 - 

 

 

Subsequent to the acquisition of GMFS on October 31, 2014, the Company operates in two operating segments: residential mortgage investments and residential mortgage banking. These operating segments have been identified based on the Company's organizational and management structure. These segments are based on an internally-aligned segment structure, which is how the Company's results are monitored and performance is assessed.

 

The residential mortgage investments segment includes a portfolio of mortgage loans which were either distressed, re-performing or newly originated at the time of purchase. The residential mortgage investments segment's profit and loss consist primarily of net interest income from whole loans and RMBS, changes in unrealized gains and losses from the valuation of the portfolio and realized gains and losses recognized upon the paydowns of mortgage loans and sales of RMBS.

 

Since the operations of GMFS are conducted in ZFC Honeybee TRS, LLC, a wholly owned TRS of the Company, the residential mortgage banking segment includes the operations of GMFS, which originates mortgage loans for subsequent sale as either servicing retained or released, and expenses incurred by ZFC Honeybee TRS, LLC.

 

Each segment includes the operating and other expenses associated with the respective activities.

 

Segment contribution represents the measure of profit that management uses to assess the performance of its business segments and make resource allocation and operating decisions. Certain expenses not directly assigned or allocated to one of the two primary segments are included in the Corporate/Other column. These unallocated expenses primarily include interest expense on the Company's Exchangeable Senior Notes and corporate operating expenses such as insurance, public company expenses, advisory fees, transaction costs and general and administrative expenses. All amounts are before amounts allocated to non-controlling interests.

 

The Company's segment profit and loss information is as follows:

 

Three Months Ended September 30, 2015:  Residential
 Mortgage
Investments
   Residential 
Mortgage Banking
   Corporate/Other   Total 
Interest income   $8,664,713   $986,239   $   $9,650,952 
Interest expense    2,687,401    574,977    1,449,476    4,711,854 
Net interest income (expense)    5,977,312    411,262    (1,449,476)   4,939,098 
Non-interest income        8,943,047        8,943,047 
Change in unrealized gain or loss    (8,093,720)           (8,093,720)
Realized gain    284,448            284,448 
Gain or (loss) on derivative instruments    (177,670)           (177,670)
Advisory fee – related party    406,053    138,789    215,224    760,066 
Salaries, commissions and benefits        7,681,983        7,681,983 
Operating expenses    64,958    1,921,180    1,475,017    3,461,155 
Other Expenses                     
Expenses    717,696            717,696 
Depreciation and amortization        236,212        236,212 
Total other expenses    717,696    236,212        953,908 
Net loss before income taxes    (3,198,337)   (623,855)   (3,139,717)   (6,961,909)
Income tax benefit        250,491        250,491 
Segment net loss   $(3,198,337)  $(373,364)  $(3,139,717)  $(6,711,418)

 

 - 39 - 

 

 

Nine months ended September 30, 2015:  Residential
 Mortgage
Investments
   Residential 
Mortgage Banking
   Corporate/Other   Total 
Interest income   $26,512,002   $2,387,695   $   $28,899,697 
Interest expense    8,208,669    1,647,268    4,329,143    14,185,080 
Net interest income (expense)    18,303,333    740,427    (4,329,143)   14,714,617 
Non-interest income        35,750,028        35,750,028 
Change in unrealized gain or loss    (10,036,457)           (10,036,457)
Realized gain    933,686            933,686 
Gain or (loss) on derivative instruments    316,697            316,697 
Advisory fee – related party    1,102,342    404,053    681,959    2,188,354 
Salaries, commissions and benefits        23,171,648        23,171,648 
Operating expenses    282,916    6,087,395    3,963,648    10,333,959 
Other Expenses                     
Expenses    2,306,545    64,652        2,371,197 
Depreciation and amortization        694,173        694,173 
Total other expenses    2,306,545    758,825        3,065,370 
Net income/(loss) before income taxes    5,825,456    6,068,534    (8,974,750)   2,919,240 
Income tax expense        (2,503,896)       (2,503,896)
Segment net income (loss)   $5,825,456   $3,564,638   $(8,974,750)  $415,344 

 

The following table is a reconciliation of the net income of the residential mortgage banking segment to the operations of GMFS for the three and nine months ended September 30, 2015:

 

   Three Months Ended
September 30, 2015
   Nine Months Ended
September 30, 2015
 
Net (loss) income of the residential mortgage banking segment   $(373,364)  $3,564,638 
Add back (deduct) expenses incurred by ZFC           
Honeybee TRS, LLC:          
Advisory fee – related party    138,789    404,053 
Amortization of deferred premiums, production and profitability earn-outs included in salaries, commission and benefits    161,620    592,606 
Operating expenses    439,589    1,543,008 
Other expenses    197,085    655,907 
Income tax (benefit) expense    (250,491)   2,503,896 
Net income of GMFS   $313,228   $9,264,108 

 

 - 40 - 

 

 

 

Supplemental Disclosures

 

The Company's segment balance sheet information is as follows:

 

   Residential
Mortgage
Investments
   Residential
Mortgage
Banking
   Corporate/Other   Total 
September 30, 2015                    
Mortgage loans held for investment, at fair value   $401,206,350   $   $   $401,206,350 
Mortgage loans held for investment, at cost        1,074,313        1,074,313 
Mortgage loans held for sale        114,670,811        114,670,811 
Real estate securities    113,220,076            113,220,076 
Other investment securities    15,209,050            15,209,050 
Mortgage servicing rights        42,044,651        42,044,651 
Goodwill        14,183,538        14,183,538 
Intangible assets        5,077,355        5,077,355 
Total assets    549,677,040    228,193,394    1,229,846    779,100,280 
                     
December 31, 2014                    
Mortgage loans held for investment, at fair value   $415,959,838   $   $   $415,959,838 
Mortgage loans held for investment, at cost        1,338,935        1,338,935 
Mortgage loans held for sale        97,690,960        97,690,960 
Real estate securities    148,585,733            148,585,733 
Other investment securities    2,040,532            2,040,532 
Mortgage servicing rights        33,378,978        33,378,978 
Goodwill        16,512,680        16,512,680 
Intangible assets        5,668,611        5,668,611 
Total assets    596,553,227    194,700,643    1,144,735    792,398,605 

 

27. Subsequent Events

 

The Company has engaged a financial advisor to commence a process to evaluate potential strategic alternatives to enhance shareholder value.

 

Item 1A. Forward-Looking Statements

 

ZAIS Financial Corp. (the "Company") makes forward-looking statements in this quarterly report on Form 10-Q within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). For these statements, the Company claims the protections of the safe harbor for forward-looking statements contained in such Sections. Forward-looking statements are subject to substantial risks and uncertainties, many of which are difficult to predict and are generally beyond the Company's control. These forward-looking statements include information about possible or assumed future results of the Company's business, financial condition, liquidity, results of operations, plans and objectives. When the Company uses the words "believe," "expect," "anticipate," "estimate," "plan," "continue," "intend," "should," "could," "would," "may," "potential" or the negative of these terms or other comparable terminology, the Company intends to identify forward-looking statements. Statements regarding the following subjects, among others, may be forward-looking:

 

·the Company’s evaluation of potential strategic alternatives to enhance shareholder value;

 

·the Company's investment objectives and business strategy;

 

·the Company's ability to obtain future financing arrangements;

 

·the Company's expected leverage;

 

·the Company's expected investments;

 

·the GMFS, LLC ("GMFS") transaction;

 

·The HF2 Financial Management Inc. ("HF2 Financial") transaction;

 

·estimates or statements relating to, and the Company's ability to make, future distributions;

 

 - 41 - 

 

 

·the Company's ability to compete in the marketplace;

 

·the Company's ability to originate or acquire the assets it targets and achieve risk-adjusted returns;

 

·the Company's ability to borrow funds at favorable rates;

 

·market, industry and economic trends;

 

·recent market developments and actions taken and to be taken by the U.S. Government, the U.S. Department of the Treasury and the Board of Governors of the Federal Reserve System, the Federal Depositary Insurance Corporation, the Federal National Mortgage Association ("Fannie Mae"), the Federal Home Loan Mortgage Corporation ("Freddie Mac"), the Government National Mortgage Association ("Ginnie Mae") and the U.S. Securities and Exchange Commission ("SEC");

 

·mortgage loan modification programs and future legislative actions;

 

·the Company's ability to maintain its qualification as a real estate investment trust ("REIT");

 

·the Company's ability to maintain its exemption from qualification under the Investment Company Act of 1940, as amended (the "1940 Act");

 

·projected capital and operating expenditures;

 

·availability of qualified personnel;

 

·prepayment rates; and

 

·projected default rates.

 

The Company's beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to the Company or are within its control, including:

 

·the factors referenced in the Company's annual report on Form 10-K, including those set forth under Item 1, "Business" and Item 1A, "Risk Factors" therein and the factors described herein under this heading, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and under the heading "Quantitative and Qualitative Disclosures about Market Risk";

 

·general volatility of the capital markets;

 

·changes in the Company's investment objectives and business strategy;

 

·the availability, terms and deployment of capital;

 

·the availability of suitable investment opportunities;

 

·changes in future loan production;

 

·the Company's ability to retain certain key managers of GMFS;

 

·the Company's dependence on its external advisor, ZAIS REIT Management, LLC (the "Advisor"), and the Company's ability to find a suitable replacement if the Company or the Advisor were to terminate the investment advisory agreement the Company has entered into with the Advisor;

 

·changes in the Company's assets, interest rates or the general economy;

 

·increased rates of default and/or decreased recovery rates on the Company's investments;

 

 - 42 - 

 

 

·changes in interest rates, interest rate spreads, the yield curve or prepayment rates; changes in prepayments of the Company's assets;

 

·limitations on the Company's business as a result of its qualification as a REIT; and

 

·the degree and nature of the Company's competition, including competition for residential mortgage-backed securities ("RMBS"), loans or its other target assets.

 

Upon the occurrence of these or other factors, the Company's business, financial condition, liquidity and consolidated results of operations may vary materially from those expressed in, or implied by, any such forward-looking statements.

 

Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee future results, levels of activity, performance or achievements. These forward-looking statements apply only as of the date of this quarterly report on Form 10-Q. The Company is not obligated, and does not intend, to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. See Item 1A, "Risk Factors," of the Company's annual report on Form 10-K.

 

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion should be read in conjunction with the Company's consolidated financial statements and accompanying Notes included in Item 1, "Financial Statements," of this quarterly report on Form 10-Q and with Items 6, 7, 8, and 9A of the Company's annual report on Form 10-K. See "Forward-Looking Statements" in this quarterly report on Form 10-Q and in the Company's annual report on Form 10-K and "Critical Accounting Policies and Use of Estimates" in the Company's annual report on Form 10-K for certain other factors that could cause actual results or future events to differ, perhaps materially, from historical performance and from those anticipated in the forward-looking statements included in this quarterly report on Form 10-Q.

 

Overview

 

The Company originates, acquires, finances, sells, services and manages residential mortgage loans. GMFS, a mortgage banking platform the Company acquired in October 2014, originates, sells and services mortgage loans and the Company acquires performing, re-performing and newly originated loans through other channels. The Company also invests in, finances and manages RMBS that are not issued or guaranteed by a federally chartered corporation, such as Fannie Mae, Freddie Mac or an agency of the U.S. Government, such as Ginnie Mae, ("non-Agency RMBS") with an emphasis on securities that, when originally issued, were rated in the highest rating category by one or more of the nationally recognized statistical rating organizations and mortgage servicing rights ("MSRs"). The Company also has the discretion to invest in RMBS that are issued or guaranteed by a federally chartered corporation or a U.S. Government agency ("Agency RMBS"), including through To-Be-Announced ("TBA") contracts, and in other real estate-related and financial assets, such as interest only strips created from RMBS ("IOs"), commercial mortgage-backed securities ("CMBS") and asset-backed securities ("ABS"). The Company refers collectively to the assets it targets as its target assets.

 

The Company's income is generated primari