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EX-31.1 - EXHIBIT 31.1 - Ready Capital Corpv437817_ex31-1.htm
EX-31.2 - EXHIBIT 31.2 - Ready Capital Corpv437817_ex31-2.htm
EX-32.2 - EXHIBIT 32.2 - Ready Capital Corpv437817_ex32-2.htm
EX-32.1 - EXHIBIT 32.1 - Ready Capital Corpv437817_ex32-1.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 March 31, 2016
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 May 9, 2016.

 

   

 

 

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION  
     
Item 1. Financial Statements 3
     
Item 1A. Forward-Looking Statements 35
     
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 37
     
Item 3. Quantitative and Qualitative Disclosures about Market Risk 56
     
Item 4. Controls and Procedures 59
     
PART II. OTHER INFORMATION  
     
Item 1. Legal Proceedings 60
     
Item 1A. Risk Factors 60
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 60
     
Item 3. Defaults Upon Senior Securities 60
     
Item 4. Mine Safety Disclosures 60
     
Item 5. Other Information 60
     
Item 6. Exhibits 60
     
SIGNATURES 62

 

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

 

 2 

 

 

PART I. FINANCIAL INFORMATION

  

Item 1. Financial Statements

 

ZAIS Financial Corp. and Subsidiaries
Condensed Consolidated Balance Sheets (Unaudited)

 

   March 31,
2016
   December 31,
2015
 
   (Expressed in United States Dollars,
except share data)
 
Assets          
Cash and cash equivalents  $66,604,813   $20,793,716 
Restricted cash   4,160,074    4,371,725 
Mortgage loans held for investment, at fair value – $32,114,039 and $394,942,512 pledged as collateral, respectively   32,114,043    397,678,140 
Mortgage loans held for sale previously held for investment, at fair value – $368,071,942 pledged as collateral   368,956,195     
Mortgage loans held for investment, at cost   1,879,254    1,886,642 
Mortgage loans held for sale, at fair value – $110,859,815 and $115,942,230 pledged as collateral, respectively   110,859,815    115,942,230 
Real estate securities, at fair value – $78,795,777 and $95,627,850 pledged as collateral, respectively   87,120,006    109,339,281 
Other Investment Securities, at fair value – $2,033,403 and $1,989,174 pledged as collateral, respectively   12,878,022    12,804,196 
Loans eligible for repurchase from Ginnie Mae   37,480,440    34,745,103 
Mortgage servicing rights, at fair value   44,852,686    48,209,016 
Derivative assets, at fair value   4,040,132    2,376,187 
Other assets   12,858,366    7,928,878 
Goodwill   14,183,537    14,183,537 
Intangible assets   4,683,185    4,880,270 
Total assets  $802,670,568   $775,138,921 
Liabilities          
Warehouse lines of credit  $101,478,055   $100,768,428 
Treasury security repurchase agreement   39,574,000     
Loan repurchase facilities   297,392,137    296,789,330 
Securities repurchase agreements   60,800,779    73,300,159 
Exchangeable Senior Notes   56,784,242    56,509,046 
Contingent consideration   11,483,100    11,285,100 
Derivative liabilities, at fair value   3,735,023    1,831,967 
Dividends and distributions payable   3,559,120    3,559,120 
Accounts payable and other liabilities   19,540,931    18,572,613 
Liability for loans eligible for repurchase from Ginnie Mae   37,480,440    34,745,103 
Total liabilities   631,827,827    597,360,866 
           
Commitments and contingencies (Note 21)          
           
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   (11,211,280)   (4,984,178)
Total ZAIS Financial Corp. stockholders’ equity   152,997,135    159,224,237 
Non-controlling interests   17,845,606    18,553,818 
Total equity   170,842,741    177,778,055 
Total liabilities and equity  $802,670,568   $775,138,921 

 

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

 

 3 

 

 

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

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
   (Expressed in United States Dollars,
except share data)
 
Interest income          
Mortgage loans held for investment  $294,519   $6,625,989 
Mortgage loans held for sale previously held for investment   6,081,850     
Mortgage loans held for sale   773,963    608,232 
Real estate securities   1,343,237    2,420,633 
Other investment securities   211,347    32,543 
Total interest income   8,704,916    9,687,397 
Interest expense          
Warehouse lines of credit   551,820    553,359 
Treasury securities repurchase agreement   1,275     
Loan repurchase facilities   2,459,274    2,352,936 
Securities repurchase agreements   321,972    402,509 
Exchangeable Senior Notes   1,462,936    1,436,673 
Total interest expense   4,797,277    4,745,477 
Net interest income   3,907,639    4,941,920 
           
Non-interest income          
Mortgage banking activities, net   11,652,914    11,152,389 
Loan servicing fee income, net of direct costs   2,053,796    1,637,099 
Change in fair value of mortgage servicing rights   (8,054,306)   (3,424,914)
Other income   12,460    11,856 
    Total non-interest income   5,664,864    9,376,430 
           
Other (losses)/gains          
Change in unrealized gain or loss on mortgage loans held for investment and sale   2,517,993    (1,199,755)
Change in unrealized gain or loss on real estate securities   (1,793,101)   (177,771)
Change in unrealized gain or loss on Other Investment Securities   24,622    136,320 
Change in unrealized gain or loss on real estate owned   (66,766)   101,780 
Change in unrealized gain or loss on treasury securities   5,941     
Realized gain on mortgage loans held for investment and sale   536,344    144,111 
Realized loss on real estate securities   (724,607)    
Realized gain on real estate owned   2,229    20,677 
Loss on derivative instruments related to investment portfolio   (676,268)   (907,090)
Total other (losses)/gains   (173,613)   (1,881,728)
           
Expenses          
Advisory fee - related party   767,478    710,800 
Salaries, commissions and benefits   7,966,092    7,399,258 
Operating expenses   3,040,884    2,919,648 
Other expenses   2,603,865    1,135,199 
Total expenses   14,378,319    12,164,905 
           
Net (loss)/income before income taxes   (4,979,429)   271,717 
           
Income tax benefit   (1,603,235)   (145,529)
Net (loss)/income   (3,376,194)   417,246 
           
Net (loss)/income allocated to non-controlling interests   (337,446)   43,466 
Net (loss)/income attributable to ZAIS Financial Corp. common stockholders  $(3,038,748)  $373,780 
           
Net (loss)/income per share applicable to ZAIS Financial Corp. common stockholders:          
Basic  $(0.38)  $0.05 
Diluted  $(0.38)  $0.05 
Weighted average number of shares of common stock:          
Basic   7,970,886    7,970,886 
Diluted   8,897,800    8,897,800 

 

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

 

 4 

 

 

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

(Expressed in United States Dollars, except share data)

 

   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
   ZAIS Financial
Corp. Stockholders'
Equity
   Non-Controlling
Interests
   Total Equity 
Three months ended March 31, 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                               (370,766)   (370,766)
Dividends on common stock                       (3,188,354)   (3,188,354)       (3,188,354)
Net income                       373,780    373,780    43,466    417,246 
Balance at March 31, 2015      $    7,970,886   $798   $164,207,617   $6,215,373   $170,423,788   $19,818,150   $190,241,938 
                                              
Three months ended March 31, 2016                                             
Balance at December 31, 2015      $    7,970,886   $798   $164,207,617   $(4,984,178)  $159,224,237   $18,553,818   $177,778,055 
Distributions on OP units                               (370,766)   (370,766)
Dividends on common stock                       (3,188,354)   (3,188,354)       (3,188,354)
Net loss                       (3,038,748)   (3,038,748)   (337,446)   (3,376,194)
Balance at March 31, 2016      $    7,970,886   $798   $164,207,617   $(11,211,280)  $152,997,135   $17,845,606   $170,842,741 

 

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

 

 5 

 

 

ZAIS Financial Corp. and Subsidiaries

Condensed Consolidated Statements of Cash Flows (unaudited)

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
   (Expressed in United States Dollars) 
Cash flows from operating activities          
Net (loss)/ income  $(3,376,194)  $417,246 
Adjustments to reconcile net (loss)/income to net cash provided by/(used in) operating activities          
Net accretion of discounts related to mortgage loans held for investment   (1,769,937)   (2,012,281)
Net accretion of discounts related to real estate securities   (571,063)   (1,248,910)
Net accretion of discounts related to Other Investment Securities   (49,204)   (10,740)
Change in unrealized gain or loss on mortgage loans   (2,517,993)   1,199,755 
Change in unrealized gain or loss on real estate securities   1,793,101    177,771 
Change in unrealized gain or loss on Other Investment Securities   (24,622)   (136,320)
Change in unrealized gain or loss on real estate owned   66,766    (101,780)
Change in fair value of mortgage servicing rights   8,054,306    3,424,914 
Realized gain on mortgage loans held for investment   (536,344)   (144,111)
Realized loss on real estate securities   724,607     
Realized gain on real estate owned   (2,229)   (20,677)
Change in unrealized gain or loss on derivative instruments   239,111    (538,062)
Amortization of Exchangeable Senior Notes discount   275,196    248,934 
Depreciation and amortization expense   232,430    227,424 
Proceeds from sale and principal payments on mortgage loans held for sale   456,891,268    431,251,708 
Originations and purchases of mortgage loans held for sale   (435,225,414)   (451,669,250)
Gain on sale of mortgage loans held for sale   (16,583,439)   (7,920,341)
Capitalization of originated mortgage servicing rights   (4,697,976)   (3,409,899)
Changes in operating assets and liabilities          
Increase in other assets   (3,516,147)   (810,733)
Increase in accounts payable and other liabilities   968,318    467,431 
Increase in contingent consideration   198,000    523,425 
Net cash provided by (used in) operating activities   572,541    (30,084,496)
           
Cash flows from investing activities          
Origination of mortgage loans held for investment   (1,405,191)   (1,476,838)
Acquisition of mortgage loans held for investment   (10,123,602)    
Proceeds from principal repayments on mortgage loans held for investment and sale   11,455,134    7,460,149 
Proceeds from principal repayments on real estate securities   4,178,332    3,942,700 
Proceeds from sales of real estate securities   16,094,298     
Restricted cash provided by investment activities   211,651    4,112,699 
Net cash provided by investing activities   20,410,622    14,038,710 
           
Cash flows from financing activities          
Net borrowings under warehouse lines of credit   709,627    27,468,994 
Borrowings from Treasury security repurchase agreement   39,574,000     
Net borrowings under loan repurchase facilities   602,807    (244,515)
Borrowings from securities repurchase agreements   83,722    1,016,063 
Repayments of securities repurchase agreements   (12,583,102)   (4,404,331)
Dividends on common stock and distributions on OP units (net of change in dividends and distributions payable)   (3,559,120)   (3,559,120)
Net cash provided by financing activities   24,827,934    20,277,091 
Net increase in cash and cash equivalents   45,811,097    4,231,305 
           
Cash and cash equivalents          
Beginning of period   20,793,716    33,791,013 
End of period  $66,604,813   $38,022,318 
           
Noncash 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  $1,513,223   $189,648 

 

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

 

 6 

 

 

ZAIS FINANCIAL CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1. Formation and Organization

 

ZAIS Financial Corp. and subsidiaries (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.

 

The Company invests in residential mortgage loans. GMFS, LLC (“GMFS”), a mortgage banking platform the Company acquired in October 2014, originates, sells and services residential 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 and residential 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.

 

 On April 6, 2016, the Company, ZAIS Financial Partners, L.P. (“Company Operating Partnership” or the “Operating Partnership”), the operating partnership of the Company, ZAIS Merger Sub, LLC (“Merger Sub”), a wholly owned subsidiary of the Company, Sutherland Asset Management Corporation ( “Sutherland”) and Sutherland Partners, L.P. (“Sutherland Operating Partnership”) entered into an agreement and plan of merger, as amended as of May 9, 2016 (the “Sutherland Merger Agreement”). Subject to the terms and conditions of the Sutherland Merger Agreement, (i) Sutherland will merge with and into Merger Sub (the “Sutherland Merger”), with Merger Sub surviving the Sutherland Merger and continuing as a wholly owned subsidiary of the Company and (ii) Sutherland Operating Partnership will merge with and into Company Operating Partnership (the “Partnership Merger” and together with the Sutherland Merger, the “Mergers”), with Company Operating Partnership surviving the Partnership Merger (the “Surviving Partnership”). The transaction will be accounted for as a reverse merger.

 

In order to reduce market risk in its investment portfolio, prior to entering into the Sutherland Merger Agreement, the Company had begun the process of selling its seasoned, re-performing mortgage loans from its residential mortgage investments segment. The Sutherland Merger Agreement requires the Company to complete the sale of its seasoned, re-performing mortgage loans as a condition to closing of the Mergers. A sale of these mortgage loans is expected to be completed in the second quarter of 2016. If completed, these mortgage loan sales are likely to result in a reduction of the Company’s investment income and, if the Mergers are not completed, may therefore result in a decision to curtail dividends in the future. Additionally, as part of the strategic review, the Company had made the decision to cease the purchase of newly originated residential mortgage loans as part of its mortgage conduit purchase program and began the process of terminating contracts and surrendering governmental licenses relating to the Company’s mortgage conduit business. The Sutherland Merger Agreement requires the Company to complete the process of terminating contracts and surrendering governmental licenses relating to its mortgage conduit business.

 

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'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, 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. GMFS had 243 employees at March 31, 2016.

 

2. Summary of Significant Accounting Policies

 

Basis of Presentation

 

The accompanying condensed 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, 2015.  

 

 7 

 

 

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 period. 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 Entities”), and a joint venture in which GMFS 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, held approximately 89.6% of the operating partnership units ("OP Units") in the Operating Partnership at March 31, 2016 and December 31, 2015. 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

 

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 Company adopted ASU 2015-02 on January 1, 2016. The adoption of this standard did not have a material effect on the Company’s consolidated financial statements.

 

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.

 

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 March 31, 2016 or December 31, 2015. 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.

 

 8 

 

 

Cash and Cash Equivalents

 

The Company considers highly liquid short-term interest bearing instruments with original maturities of three months or less and other instruments readily convertible into cash to be cash equivalents.

 

Mortgage Loans Held for Sale Previously Held for Investment, at Fair Value

 

Mortgage loans which the Company has decided it no longer intends to hold for the foreseeable future are reclassified from mortgage loans held for investment to mortgage loans held for sale previously held for investment in the consolidated balance sheets.  These mortgage loans were reported at fair value when held for investment and held for sale.

 

The Company decided during the three months ended March 31, 2016 that it no longer intended to hold its seasoned, re-performing mortgage loan portfolio for the foreseeable future and, as such, reclassified mortgage loans with a fair value of $368,956,195 from held for investment to held for sale previously held for investment. 

 

Other Investment Securities

 

The Company held Freddie Mac Structured Agency Credit Risk Notes (“FMRT Notes”) at and during the three months ended March 31, 2016, during the three months ended March 31, 2015 and at December 31, 2015. Additionally, the Company held Fannie Mae's Risk Transfer Notes (“FNRT Notes”) at December 31, 2015 (the FMRT Notes and the FNRT Notes are collectively referred to as 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 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 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.

 

Recently Issued 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.

 

 9 

 

 

In January 2016, the FASB issued ASU 2016-01, “Financial Instruments─Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities” (“ASU 2016-01”). 'The amendments in ASU 2016-01, among other things: (i) requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; (ii) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (iii) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables) and (iii) eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. ASU 2016-01 is effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The new guidance permits early adoption of the own credit provision. The Company is currently evaluating the impact of adopting this new standard.

 

3. GMFS Transaction

 

The following relates to the acquisition of GMFS in October 2014 pursuant to the terms of the agreement and plan of merger dated August 5, 2014 (the “GMFS Merger Agreement”):

 

Contingent Consideration

 

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 “Production and Profitability Earn-Out”). The $2 million of deferred premium payments is contingent on GMFS remaining profitable and retaining certain key employees. The Production and Profitability Earn-Out are dependent on GMFS achieving certain profitability and loan production goals and is capped at $20 million. Up to 50% of the Production and Profitability Earn-Out may be paid in common stock of the Company, at the Company's option.

 

Contingent consideration represents the estimated present value of the deferred premiums and Production and Profitability Earn-Out. Contingent consideration was estimated at closing based on future production and 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 months ended March 31, 2016 and March 31, 2015, the Company recorded the following changes in the consideration liability:

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
Beginning balance  $11,285,100   $11,430,413 
Change in fair value   198,000    523,425 
Ending balance  $11,483,100   $11,953,838 

 

The increase in the estimated liability for the three month period ended March 31, 2016 and March 31, 2015 resulted from the impact of the passage of time. The change in the contingent consideration liability is included in operating expenses in the consolidated statements of operations.

 

The Company has delayed the first year installment payment of the contingent consideration (see Note 21).

 

Goodwill

 

Goodwill, with a carrying amount of $14,183,537 at March 31, 2016 and December 31, 2015, represents the excess of the purchase price over the fair value of the net assets acquired and has been allocated to the Company’s residential mortgage banking segment.

 

The changes in the carrying amount of the goodwill during the three months ended March 31, 2016 and March 31, 2015.

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
Beginning balance  $14,183,537   $16,512,680 
Reversal of a liability existing as of the date of acquisition       (385,610)
Ending balance  $14,183,537   $16,127,070 

 

 10 

 

 

Goodwill is not amortized but is tested for impairment on the anniversary date of the acquisition or more frequently if events or changes in circumstances indicate that a potential impairment may have occurred. No impairment losses relating to goodwill were recorded for the three months ended March 31, 2016 or March 31, 2015.

 

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 months ended March 31, 2016 and March 31, 2015 was as follows:

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
Amortization expense  $197,085   $197,085 

 

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

 

At March 31, 2016 and December 31, 2015, accumulated amortization is as follows:

 

  

March 31,

2016

   December 31
2015
 
Trade name  $283,339   $233,338 
Customer relationships   184,161    151,662 
Licenses   472,226    388,892 
Favorable lease   177,089    145,838 
Total accumulated amortization  $1,116,815   $919,730 

 

Amortization expense related to the intangible assets for the period April 1, 2016 to December 31, 2016 and for the five years subsequent to December 31, 2016 will be as follows:

 

April 1, 2016 – December 31, 2016  $591,255 
2017  $732,776 
2018  $455,004 
2019  $455,004 
2020  $455,004 
2021  $455,004 

 

No impairment losses relating to intangible assets were recorded for the three months ended March 31, 2016 or March 31, 2015.

 

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.

  

The following tables present the Company’s financial instruments that were accounted for at fair value on a recurring basis at March 31, 2016 and December 31, 2015 by level within the fair value hierarchy:

 

 11 

 

 

March 31, 2016

   Assets and Liabilities at Fair Value 
   Level 1   Level 2   Level 3   Total 
Assets                    
Mortgage loans held for investment  $   $   $32,114,043   $32,114,043 
Mortgage loans held for sale previously held for investment           368,956,195    368,956,195 
Mortgage loans held for sale        110,859,815        110,859,815 
Non-Agency RMBS           87,120,006    87,120,006 
Other Investment Securities           12,878,022    12,878,022 
MSRs           44,852,686    44,852,686 
Derivative assets           4,040,132    4,040,132 
Total  $   $110,859,815   $549,961,084   $660,820,899 
Liabilities                    
Contingent consideration  $   $   $11,483,100   $11,483,100 
Derivative liabilities       3,735,023        3,735,023 
Total  $   $3,735,023   $11,483,100   $15,218,123 

 

December 31, 2015

   Assets and Liabilities at Fair Value 
   Level 1   Level 2   Level 3   Total 
Assets                    
Mortgage loans held for investment  $   $   $397,678,140   $397,678,140 
Mortgage loans held for sale       115,942,230        115,942,230 
Non-Agency RMBS           109,339,281    109,339,281 
Other Investment Securities           12,804,196    12,804,196 
MSRs           48,209,016    48,209,016 
Derivative assets           2,376,187    2,376,187 
Total  $   $115,942,230   $570,406,820   $686,349,050 
Liabilities                    
Contingent consideration  $   $   $11,285,100   $11,285,100 
Derivative liabilities       1,822,096    9,871    1,831,967 
Total  $   $1,822,096   $11,294,971   $13,117,067 

 

The following table presents 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 and Held for Sale Previously Held for Investment, RMBS and Other Investment Securities

  

   Three Months Ended   Three Months Ended 
   March 31, 2016   March 31, 2015 
   Mortgage
Loans Held
for
Investment and
Held for Sale
Previously Held
for Investment
   Real Estate
Securities
   Other
Investment
Securities
   Mortgage
Loans Held
for
Investment
   Real Estate
Securities
   Other
Investment
Securities
 
Balance, beginning of period  $397,678,140   $109,339,281   $12,804,196   $415,959,838   $148,585,733   $2,040,532 
Originations/acquisitions   11,528,793            1,476,838         
Proceeds from sales       (16,094,298)                
Amortization of premiums   (12,568)           (384)        
Net accretion of discounts   1,782,505    571,063    49,204    2,012,665    1,248,910    10,740 
Proceeds from principal repayments   (11,447,746)   (4,178,332)       (7,112,305)   (3,942,700)    
Conversion of mortgage loans to REO   (1,513,223)           (189,648)        
Total losses (realized/unrealized) included in earnings   (4,646,504)   (3,290,046)   (45,733)   (8,823,926)   (1,028,489)    
Total gains (realized/unrealized) included in earnings   7,700,841    772,338    70,355    7,768,282    850,718    136,320 
Balance, end of period  $401,070,238   $87,120,006   $12,878,022   $411,091,360   $145,714,172   $2,187,592 
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  $2,531,471   $(2,423,297)  $24,622   $(1,204,068)  $(177,772)  $136,320 

 

 12 

 

 

Derivative Instruments

  

   Three Months Ended 
March 31, 2016
   Three Months Ended 
March 31, 2015
 
   Loan Purchase
Commitments
   Interest Rate
Lock
Commitments
   Loan Purchase
Commitments
   Interest Rate
Lock
Commitments
 
Beginning balance  $(9,871)  $2,376,187   $4,037   $2,481,063 
Change in unrealized gain or loss   32,463    1,641,353    23,822    1,936,514 
Ending balance  $22,592   $4,017,540   $27,859   $4,417,577 
The amount of total gains or (losses) for the year included in earnings attributable to the change in unrealized gains or losses relating to assets or liabilities still held at the reporting date  $32,463   $1,641,353   $23,822   $1,936,514 

 

MSRs

 

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

 

Contingent Consideration

 

 See Note 3 – "GMFS Transaction" for additional information about the Company's contingent consideration.

 

 There were no financial assets or liabilities that were accounted for at fair value on a nonrecurring basis at March 31, 2016 or December 31, 2015. During the three months ended March 31, 2016 and March 31, 2015, 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 months ended March 31, 2016 or March 31, 2015.

 

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
March 31,
2016
   Valuation
Technique(s)
  Unobservable
Input
  Min   Max   Weighted
Average
 
Mortgage loans Held for Investment and Sale  $401,070,238   Discounted cash flow model  Constant voluntary prepayment   2.1%   5.2%   3.4%
           Constant default rate   1.6%   4.0%   3.0%
           Loss severity   6.5%   37.3%   21.9%
           Delinquency   6.5%   13.7%   11.2%
Non-Agency RMBS                          
Alternative – A  $26,102,680   Broker quotes/comparable trades  Constant voluntary prepayment   2.6%   16.2%   11.3%
           Constant default rate   0.3%   7.1%   2.8%
           Loss severity   0.3%   85.0%   20.8%
           Delinquency   1.7%   22.4%   8.8%
Pay option adjustable rate   25,541,425   Broker quotes/comparable trades  Constant voluntary prepayment   2.2%   7.1%   4.1%
           Constant default rate   1.1%   15.3%   3.7%
           Loss severity   0.1%   74.0%   34.7%
           Delinquency   5.4%   20.1%   13.1%
Prime   28,928,776   Broker quotes/comparable trades  Constant voluntary prepayment   4.2%   23.6%   7.9%
           Constant default rate   0.8%   8.9%   3.5%
           Loss severity   0.0%   87.8%   27.5%
           Delinquency   3.7%   25.4%   11.9%
Subprime   6,547,125   Broker quotes/comparable trades  Constant voluntary prepayment   1.3%   4.4%   3.1%
           Constant default rate   4.3%   6.0%   5.3%
           Loss severity   10.9%   85.0%   49.1%
           Delinquency   19.6%   27.8%   23.1%
Total Non-Agency RMBS  $87,120,006                      
                           
Other Investment Securities  $12,878,022   Broker quotes/comparable trades  Constant voluntary prepayment   4.1%   23.6%   7.6%
                           
MSRs  $44,852,686   Discounted cash flow model  Constant voluntary prepayment   10.3%   12.2%   11.3%
           Cost of servicing  $77   $109   $91 
           Discount rate   9.0%   10.0%   9.4%
                           
Contingent consideration  $11,483,100   Option pricing model  Discount rate   10.2%   10.8%   10.5%
           Production volatility           20.0%
           Profitability volatility           50.0%

 

 13 

 

  

   Fair Value at
December 31,
2015
   Valuation
Technique(s)
  Unobservable
Input
  Min   Max   Weighted
Average
 
Mortgage loans held for Investment  $397,678,140   Discounted cash flow model  Constant voluntary prepayment   1.9%   5.0%   3.2%
           Constant default rate   1.4%   5.0%   3.1%
           Loss severity   5.9%   37.2%   22.1%
           Delinquency   6.3%   13.2%   10.9%
Non-Agency RMBS                          
Alternative – A  $35,998,175   Broker quotes/comparable trades  Constant voluntary prepayment   2.7%   18.9%   12.9%
           Constant default rate   0.2%   7.8%   2.8%
           Loss severity   0.0%   85.0%   21.0%
           Delinquency   1.4%   22.2%   8.9%
Pay option adjustable rate   32,209,538   Broker quotes/comparable trades  Constant voluntary prepayment   2.2%   13.5%   7.5%
           Constant default rate   0.5%   13.0%   3.5%
           Loss severity   0.0%   95.6%   40.0%
           Delinquency   5.3%   21.9%   12.3%
Prime   32,482,521   Broker quotes/comparable trades  Constant voluntary prepayment   3.6%   21.0%   8.0%
           Constant default rate   0.5%   9.4%   3.7%
           Loss severity   0.0%   85.1%   28.9%
           Delinquency   4.4%   25.5%   12.0%
Subprime   8,649,047   Broker quotes/comparable trades  Constant voluntary prepayment   1.2%   7.7%   3.9%
           Constant default rate   3.0%   8.0%   6.2%
           Loss severity   11.1%   128.5%   54.0%
           Delinquency   18.3%   28.0%   22.2%
Total Non-Agency RMBS  $109,339,281                      
                           
Other Investment Securities  $12,804,196   Broker quotes/comparable trades  Constant voluntary prepayment   4.0%   18.4%   6.9%
                           
MSRs  $48,209,016   Discounted cash flow model  Constant voluntary prepayment   8.5%   10.5%   9.3%
           Cost of servicing  $77   $110   $92 
           Discount rate   9.0%   10.0%   9.4%
                           
Contingent consideration  $11,285,100   Option pricing model  Discount rate   10.2%   10.8%   10.5%
           Production volatility           20.0%
           Profitability volatility           50.0%

 

 14 

 

 

Derivative Financial Instruments

 

The Company estimates the fair value of interest rate lock commitments ("IRLC") based on quoted Agency MBS prices, the expected net future cash flows related to servicing the mortgage loan, adjusted for: (i) estimated costs to complete and originate the loan and (ii) an adjustment to reflect the estimated percentage of IRLCs that will result in a closed mortgage loan under the original terms of the agreement (or “pullthrough 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 expected net future cash flows related to servicing the MSRs 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 expected net future cash flows related to servicing 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. 

   

The following is a quantitative summary of key unobservable inputs used in the valuation of IRLCs at March 31, 2016 and December 31, 2015:

 

   

 March 31,

2016

     

December 31,

2015

 
Pull-through rate                
Range     56.4% - 100.0 %     62.4% – 100.0 %
Weighted average     87.6 %     87.6 %
MSR value expressed as:                
Servicing fee multiple                
Range     0.1% - 6.1 %     0.8% - 5.9 %
Weighted average     4.2 %     4.3 %
Percentage of unpaid principal balance                
Range     0.1% - 1.5 %     0.3% - 1.7 %
Weighted average     1.1 %     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.

 

 15 

 

 

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 March 31, 2016 and December 31, 2015:

 

   March 31, 2016   December 31, 2015 
   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)  $32,114,043   $31,304,573   $809,470   $397,678,140   $444,500,063   $(46,821,923)
Mortgage loans held for sale previously held for investment   368,956,195    411,002,700    (42,046,505)            
Mortgage loans held for sale   110,859,815    105,739,051    5,120,764    115,942,230    111,393,424    4,548,806 
Non-Agency RMBS (2)   87,120,006    143,682,422    (56,562,416)   109,339,281    168,925,162    (59,585,881)
Other Investment Securities   12,878,022    13,395,816    (517,794)   12,804,196    13,398,851    (594,655)
MSRs   44,852,686    4,429,521,268    N/A(3)   48,209,016    4,173,927,393    N/A(3)

 

 

 

  (1) At December 31, 2015, the balance is 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 $33.7 million and $35.0 million at March 31, 2016 and December 31, 2015, respectively.
  (3) Amounts not presented. Unpaid principal balance of MSRs is generally significantly greater than their fair value.

 

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.

 

The following table summarizes the estimated fair value and carrying value for all other financial instruments at March 31, 2016 and December 31, 2015: 

 

   March 31, 2016   December 31, 2015 
   Fair Value   Carrying Value   Fair Value   Carrying Value 
Other financial instruments                    
Assets                    
Cash and cash equivalents  $66,604,813   $66,604,813   $20,793,716   $20,793,716 
Restricted cash   4,160,074    4,160,074    4,371,725    4,371,725 
Mortgage loans held for investment, at cost   1,879,254    1,879,254    1,886,642    1,886,642 
                     
Liabilities                    
Warehouse lines of credit  $101,478,055   $101,478,055   $100,768,428   $100,768,428 
Treasury security repurchase facility   39,574,000    39,574,000         
Loan repurchase facilities   297,392,137    297,392,137    296,789,330    296,789,330 
Securities repurchase agreements   60,800,779    60,800,779    73,300,159    73,300,159 
Exchangeable Senior Notes   57,098,650    56,784,242    56,775,500    56,509,046 

 

Cash and cash equivalents includes cash on hand and treasury securities 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, at cost 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 mortgage banking platform, treasury security repurchase agreement, 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 13) is based on observable market prices (a Level 2 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 and Held for Sale Previously Held for Investment, at Fair Value

 

Distressed and re-performing loans at the time of purchase

 

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 months ended March 31, 2016 or March 31, 2015.

 

 16 

 

 

During the three months ended March 31, 2016, the Company decided it no longer intended to hold its seasoned and re-performing loan portfolio which were held as loans held for investment, at fair value at December 31, 2015 for the foreseeable future and reclassified this portfolio to Mortgage loans held for sale previously held for investment, at fair value.  

 

The following tables present certain information regarding the Company's mortgage loans at March 31, 2016 and December 31, 2015 which showed evidence of credit deterioration at the time of purchase:

 

March 31, 2016

 

Mortgage Loans Held for Sale Previously Held for Investment

 

   Unpaid           Gross Unrealized (1)   Difference
Between Fair
Value and
Aggregate
Unpaid
   Weighted Average 
   Principal
Balance
   Premium
(Discount)
   Amortized
Cost
   Gains   Losses   Fair 
Value
   Principal
Balance
   Coupon   Unleveraged
Yield
 
                                     
Performing                                             
Fixed  $236,675,463   $(43,298,017)  $193,377,446   $27,002,346   $(2,374,288)  $218,005,504   $(18,669,959)   4.74%   7.65%
ARM   135,940,617    (14,520,006)   121,420,611    5,098,008    (3,656,027)   122,862,592    (13,078,025)   3.69    7.17 
Total performing   372,616,080    (57,818,023)   314,798,057    32,100,354    (6,030,315)   340,868,096    (31,747,984)   4.36    7.47 
Non-performing (2)   38,386,620    (7,017,147)   31,369,473    948,312    (4,229,686)   28,088,099    (10,298,521)   4.72    7.84 
Total  $411,002,700   $(64,835,170)  $346,167,530   $33,048,666   $(10,260,001)  $368,956,195   $(42,046,505)   4.39%   7.50%

 

December 31, 2015

 

Mortgage Loans Held for Investment

 

   Unpaid           Gross Unrealized (1)   Difference
Between Fair
Value and
Aggregate
Unpaid
   Weighted Average 
   Principal
Balance
   Premium
(Discount)
   Amortized
Cost
   Gains   Losses   Fair 
Value
   Principal
Balance
   Coupon   Unleveraged
Yield
 
                                     
Performing                                             
Fixed  $240,031,119   $(44,650,666)  $195,380,453   $23,626,555   $(2,521,921)  $216,485,087   $(23,546,032)   4.70%   7.59%
ARM   143,625,653    (15,597,990)   128,027,663    5,918,004    (3,126,826)   130,818,841    (12,806,812)   3.63    7.15 
Total performing   383,656,772    (60,248,656)   323,408,116    29,544,559    (5,648,747)   347,303,928    (36,352,844)   4.30    7.41 
Non-performing (2)   40,100,775    (7,515,130)   32,585,645    990,974    (4,245,960)   29,330,659    (10,770,116)   4.65    7.78 
Total  $423,757,547   $(67,763,786)  $355,993,761   $30,535,533   $(9,894,707)  $376,634,587   $(47,122,960)   4.34%   7.45%

 

 

 

(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
March 31, 2016
   Three Months Ended
March 31, 2015
 
$2,147,861   $(1,086,535)

 

(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 three month period ended March 31, 2016 and March 31, 2015:

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
Accretable yield, beginning of period  $247,751,944   $267,509,905 
Acquisitions        
Accretion   (6,207,756)   (6,605,967)
Reclassifications from nonaccretable difference   (4,282,052)   (1,686,736)
Accretable yield, end of period  $237,262,136   $259,217,202 

 

 17 

 

 

Newly originated loans at the time of purchase

 

During the three months ended March 31, 2016 and March 31, 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 
   March 31, 2016   March 31, 2015 
Aggregate Unpaid Principal Balance  $11,382,962   $1,447,319 
Loan Repurchase Facilities Used   10,169,242    1,302,587 

 

The following tables present certain information regarding the Company's mortgage loans held for investment, at fair value, at March 31, 2016 and December 31, 2015 which were newly originated at the time of purchase and sourced through the Company’s loan purchase program:

 

March 31, 2016

 

   Unpaid           Gross Unrealized (1)       Weighted Average 
   Principal
Balance
   Premium   Amortized
Cost
   Gains   Losses   Fair Value   Coupon   Unleveraged
Yield
 
Performing                                        
Fixed  $25,079,640   $412,382   $25,492,022   $292,794   $(10,823)  $25,773,993    4.93%   4.78%
ARM   6,224,933    86,651    6,311,584    28,463        6,340,047    4.46    4.33 
Total Mortgage Loans Held for Investment  $31,304,573   $499,033   $31,803,606   $321,257   $(10,823)  $32,114,040    4.84%   4.69%

 

December 31, 2015

 

   Unpaid           Gross Unrealized (1)       Weighted Average 
   Principal
Balance
   Premium   Amortized
Cost
   Gains   Losses   Fair Value   Coupon   Unleveraged
Yield
 
Performing                                        
Fixed  $17,674,257   $315,860   $17,990,117   $58,069   $(99,486)  $17,948,700    5.05%   4.89%
ARM   3,068,259    44,875    3,113,134        (18,280)   3,094,854    4.37    4.25 
Total Mortgage Loans Held for Investment  $20,742,516   $360,735   $21,103,251   $58,069   $(117,766)  $21,043,554    4.95%   4.79%

  

(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
March 31,
2016
   Three Months
Ended
March 31,
2015
 
$370,132   $(5,885)

 

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 March 31, 2016 and December 31, 2015:

 

   March 31,
2016
   December 31,
2015
 
         
Percentage of fair value of mortgage loans with unpaid principal balance to current property value in excess of 100%   37.8%   44.1%
Percentage of fair value of mortgage loans secured by properties in the following states:          
           
Each representing 10% or more of fair value:          
California   26.1%   26.2%
Florida   15.6%   16.1%
Additional state representing more than 5% of fair value:          
Georgia   6.1%   6.1%
Percentage of unpaid principal balance of mortgage loans carrying mortgage insurance   8.0%   8.2%

 

 18 

 

 

The range of interest rates and contractual maturities of the Company's mortgage loans held for investment at March 31, 2016 and December 31, 2015 were as follows:

 

    March 31,
2016
    December 31,
 2015
 
Interest rates   2.0% - 12.2 %   1.75% - 12.20 %
Contractual maturities   1 – 45 years     1 - 45 years  

 

REO

 

Additional information about the Company’s REO assets at March 31, 2016 and December 31, 2015, are as follows:

 

   March 31,
2016
   December 31,
 2015
 
Net realizable value (included in other assets in the Company's consolidated balance sheets)  $2,356,589   $1,784,670 
Carrying amount of mortgage loans held for investment, at fair value secured by residential real estate properties for which formal foreclosure proceedings are in process according to local requirements of the applicable jurisdiction   11,254,632    5,597,611 

 

6. Mortgage Loans Held for Sale, at Fair Value

  

During the three months ended March 31, 2016 and March 31, 2015, the Company's mortgage loans held for sale activity was as follows:

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
Balance at beginning of period  $115,942,230   $97,690,960 
Originations and repurchases   435,225,414    451,669,250 
Proceeds from sales and principal payments   (456,891,268)   (431,251,708)
Gain on sale   16,583,439    7,920,341 
Balance at end of period  $110,859,815   $126,028,843 

 

Mortgage loans held for sale, at fair value at March 31, 2016 and December 31, 2015 is as follows:

 

   March 31, 2016   December 31, 2015 
   Unpaid
Principal
Balance
   Fair Value   Unpaid
Principal
Balance
   Fair Value 
Conventional  $67,791,764   $70,195,369   $54,962,904   $56,586,717 
Governmental   20,203,875    21,776,355    30,531,301    32,131,354 
United States Department of Agriculture loans   10,445,984    11,054,233    16,222,152    17,059,982 
United States Department of Veteran Affairs loans   6,809,762    7,284,408    8,922,978    9,314,255 
Reverse mortgage   487,666    549,450    754,089    849,922 
Total  $105,739,051   $110,859,815   $111,393,424   $115,942,230 

 

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 March 31, 2016 and December 31, 2015:

 

March 31, 2016

 

   Principal or           Gross Unrealized (2)       Weighted Average 
   Notional
Balance
   Premium
(Discount)
   Amortized 
Cost
   Gains   Losses   Fair Value   Coupon   Unleveraged
Yield
 
Real estate securities                                        
Non-Agency RMBS:                                        
Alternative – A  $64,387,620   $(37,379,264)  $27,008,356   $618,969   $(1,524,645)  $26,102,680    1.82%   5.19%
Pay option adjustable rate   35,131,326    (6,102,461)   29,028,865        (3,487,440)   25,541,425    1.16    4.19 
Prime   33,604,620    (4,257,529)   29,347,091    448,354    (866,669)   28,928,776    3.68    5.29 
Subprime   10,558,856    (3,847,482)   6,711,374    20,269    (184,518)   6,547,125    0.59    6.81 
Total non-Agency RMBS  $143,682,422   $(51,586,736)  $92,095,686   $1,087,592   $(6,063,272)  $87,120,006    2.01%   5.03%
Other Investment Securities (1)  $13,395,816   $17,975   $13,413,791   $77,463   $(613,232)  $12,878,022    4.96%   6.03%

 

 19 

 

 

December 31, 2015

 

   Principal or           Gross Unrealized (2)       Weighted Average 
   Notional
Balance
   Premium
(Discount)
   Amortized 
Cost
   Gains   Losses   Fair Value   Coupon   Unleveraged
Yield
 
Real estate securities                                        
Non-Agency RMBS:                                        
Alternative – A  $76,328,172   $(40,150,416)  $36,177,756   $846,318   $(1,025,899)  $35,998,175    2.01%   6.18%
Pay option adjustable rate   42,562,819    (7,480,996)   35,081,823    6,863    (2,879,148)   32,209,538    1.10    5.31 
Prime   37,366,079    (4,732,637)   32,633,442    563,311    (714,232)   32,482,521    3.62    5.95 
Subprime   12,668,092    (4,039,253)   8,628,839    111,651    (91,443)   8,649,047    0.93    6.63 
Total non-Agency RMBS  $168,925,162   $(56,403,302)  $112,521,860   $1,528,143   $(4,710,722)  $109,339,281    2.05%   5.87%
Other Investment Securities (1)  $13,398,851   $(34,264)  $13,364,587   $897   $(561,288)  $12,804,196    4.94%   6.65%

  

(1)See Note 2 – Summary of Significant Accounting Policies, “Other Investment Securities".

 

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

   

   March 31, 2016   December 31, 2015 
   Non-Agency RMBS   Other Investment
Securities
   Non-Agency RMBS   Other Investment
Securities
 
Notional balance of IO included in Alternative A  $33,668,901       $35,042,860     
Contractual maturities (range)   19.1 to 31.0 years    

8.2 to

12.1 years

    19.3 to 31.3 years    

8.4 to

12.3 years

 
Weighted average maturity   24.7 years    9.8 years    21.3 years    10.1 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 March 31, 2016 and December 31, 2015 were issued by issuers based in the United States.

 

The Company did not have any realized losses on real estate securities relating to other than temporary impairments for the three months ended March 31, 2016 or March 31, 2015.

 

 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 securitized 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 three months ended March 31, 2016 and March 31, 2015 is as follows:

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
Balance at beginning of period  $48,209,016   $33,378,978 
Additions due to loans sold, servicing retained   4,697,976    3,409,899 
Change in fair value of MSRs (1)          
Changes in values of market related inputs or assumptions used in a valuation model (2)   (6,609,585)   (2,710,478)
Other changes (3)   (1,444,721)   (714,436)
Total - change in fair value of MSRs   (8,054,306)   (3,424,914)
Balance at end of period  $44,852,686   $33,363,963 

 

 20 

 

 

(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 change in value primarily 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's MSR portfolio at March 31, 2016 and December 31, 2015 is as follows:

 

   March 31, 2016   December 31, 2015 
   Unpaid Principal
Balance
   Fair Value   Unpaid Principal
Balance
   Fair Value 
Fannie Mae  $1,943,871,922   $18,994,424   $1,880,177,827   $20,751,648 
Ginnie Mae   1,561,234,153    16,871,814    1,488,159,758    18,231,527 
Freddie Mac   924,415,193    8,986,448    805,589,808    9,225,841 
Total  $4,429,521,268   $44,852,686   $4,173,927,393   $48,209,016 

 

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) at March 31, 2016 and December 31, 2015:

 

  

March 31,

2016

  

December 31,

2015

 
Discount rate:          
Range   6.6% - 12.2%   6.6%-12.2%
Weighted average   9.4%   9.4%
           
Effect on fair value of adverse change of:          
5%  $(816,293)  $(958,786)
10%  $(1,604,489)  $(1,881,870)
20%  $(3,101,957)  $(3,628,281)
           
Prepayment speed (1) :          
Range   8.2% - 14.6%   7.0%-12.0%
Weighted average   11.3%   9.3%
           
Effect on fair value of adverse change of:          
5%  $(1,014,616)  $(938,584)
10%  $(1,944,772)  $(1,756,195)
20%  $(3,758,628)  $(3,428,890)
           
Per-loan annual cost of servicing:          
Range  $63 - $118   $64-$119 
Weighted average  $91   $92 
           
Effect on fair value of adverse change of:          
5%  $(520,707)  $(547,228)
10%  $(1,041,414)  $(1,094,455)
20%  $(2,082,827)  $(2,188,910)

 

 

 

(1)Prepayment speed is measured using CPR.

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
The amount of total losses for the three months ended included in earnings attributable to the change in unrealized gains or losses relating to assets still held at the reporting date  $(6,609,585)  $(2,710,478)

 

 21 

 

 

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 months ended March 31, 2016 and March 31, 2015:

  

   Three Months Ended 
   March 31, 2016   March 31, 2015 
Loan servicing fee income  $3,166,264   $2,384,402 
Late fee income   86    35 
Sub-servicing costs   (1,112,554)   (747,338)
Loan servicing fee income, net of direct costs  $2,053,796   $1,637,099 

   

9. Warehouse Lines of Credit

 

At March 31, 2016 and December 31, 2015, 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 residential mortgage banking segment.

 

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 at March 31, 2016 and December 31, 2015 and for the three months ended March 31, 2016 and March 31, 2015.

 

The following tables present certain information regarding the Company's warehouse lines of credit and repurchase agreements in its residential mortgage banking segment at March 31, 2016 and December 31, 2015:

 

   March 31, 2016   December 31, 2015 
Availability  $185,000,000   $185,000,000 
Maturity dates   June 2016 – November 2016    June 2016 – November 2016 

 

These obligations are secured by mortgage loans held for sale, at fair value and also fully guaranteed by the Company. The Company expects to renew the warehouse lines of credit at similar terms in the ordinary course of business as the facilities mature.

 

10. Treasury Securities Repurchase Agreement

 

On March 29, 2016, the Company purchased Treasury securities with a principal balance of $40,000,000 for a purchase price of $39,973,422. The Treasury securities are non-interest bearing and mature on June 30, 2016. In connection with the purchase, the Company executed a repurchase agreement with a counterparty (the “Treasury Security Repo”). The repurchase agreement bears interest at a fixed annual rate of 0.58% and matured on April 29, 2016. At maturity, the Company renewed the repurchase agreement (see Note 25). The Treasury securities are reported as cash equivalents in accordance with the Company’s accounting policies.

 

11. Loan Repurchase Facilities

 

At March 31, 2016 and December 31, 2015, 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:

 

 

   March 31, 2016   December 31, 2015 
   Citibank, N.A
Distressed and
   Credit Suisse
First
Boston
Mortgage
Capital LLC
   Citibank, N.A
Distressed and
   Credit Suisse
First
Boston
Mortgage
Capital LLC
 
Lender
Collateral type funded by facility
  Re-
Performing
Loans
   Newly
Originated
Loans
   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   $25,000,000 
Maturity date   May 20, 2016    June 27, 2016    May 20, 2016    June 27, 2016 
Outstanding balance  $272,199,827   $25,192,310   $279,467,573   $17,321,757 

 

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.

 

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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.

 

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. At March 31, 2016 and December 31, 2015 and for the three months ended March 31, 2016 and March 31, 2015, the Company has met all margin call requirements related to any outstanding balances under its Loan Repurchase Facilities.

 

The following table presents information with respect to the Company's posting of collateral under its Loan Repurchase Facilities at March 31, 2016 and December 31, 2015:

 

  

March 31, 

2016

   December 31,
2015
 
Fair value of Trust Certificates pledged as collateral  $400,185,981   $394,942,512 
Cash pledged as collateral   20,886    375,579 

 

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 as of March 31, 2016 and December 31, 2015 and for the three months ended March 31, 2016 and March 31, 2015. 

 

The maturity dates of the Loan Repurchase Facilities were extended subsequent to March 31, 2016 (see Note 25).

 

12. 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 the 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 March 31, 2016 and December 31, 2015.

 

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 fair 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. As of March 31, 2016 and December 31, 2015 and for the three months ended March 31, 2016 and March 31, 2015, the Company has met all margin call requirements under its securities repurchase agreements.

 

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The following table presents information with respect to the Company's posting of collateral under its securities repurchase agreements at March 31, 2016 and December 31, 2015:

 

  

March 31,

2016

   December 31,
2015
 
Fair value of non-Agency RMBS pledged as collateral  $78,795,777   $95,627,850 
Fair value of Other Investment Securities pledged as collateral   2,033,403    1,989,174 
Cash pledged as collateral   1,989,775    2,029,581 

 

13. 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 New York Stock Exchange (“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.

 

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. If the Mergers do not close, the Company intends to sell assets and use the proceeds to settle the obligation.

 

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 March 31, 2016 and December 31, 2015:

 

  

March 31,

2016

   December 31,
2015
 
Fair value of conversion option derivative liability  $547,457   $612,878 
Unamortized discount   715,758    990,954 

 

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14. Derivative Instruments

 

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

 

Residential Mortgage Investments Segment

 

Interest Rate Swap 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. 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.

 

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 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 the 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 March 31, 2016 and December 31, 2015:

 

Non-hedge derivatives  March 31, 2016   December 31, 2015 
Notional amount of interest rate swaps  $17,200,000   $17,200,000 
LPCs (Principal balance of underlying loans)   19,955,150    18,494,332 
IRLCs (Principal balance of underlying loans)   243,381,890    190,933,017 
Notional amount of MBS forward sales contracts   242,701,243    179,417,280 

 

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

 

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The following table presents the fair value of the Company's derivative instruments and their balance sheet location at March 31, 2016 and December 31, 2015: 

 

Derivative instruments  Designation  Balance Sheet Location 

March 31,

2016

   December 31,
2015
 
Interest rate swaps  Non-hedge  Derivative liabilities, at fair value  $(1,641,200)  $(1,009,014)
                 
LPCs  Non-hedge  Derivative assets (liabilities), at fair value   22,592    (9,871)
                 
IRLCs  Non-hedge  Derivative assets, at fair value   4,017,540    2,376,187 
                 
MBS forward sales contracts  Non-hedge  Derivative liabilities, at fair value   (1,546,366)   (200,204)
                 
Conversion Option - Exchangeable Senior Notes  Non-hedge  Derivative liabilities, at fair value   (547,457)   (612,878)

 

At March 31, 2016 and December 31, 2015, 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:

 

   Income Statement  Three Months Ended 
Non-hedge derivatives  Location  March 31, 2016   March 31, 2015 
Interest rate swaps  Loss on derivative instruments related to investment portfolio  $(774,152)  $(451,439)
              
LPCs  Loss on derivative instruments related to investment portfolio   32,463    23,822 
              
IRLCs  Mortgage banking activities, net   1,641,353    1,936,514 
              
MBS forward sales contracts  Mortgage banking activities, net   (1,346,162)   (638,711)
              
Conversion Option - Exchangeable Senior Notes  Loss on derivative instruments related to investment portfolio   65,421    (479,473)

 

Interest Rate Swaps

 

 The following table presents information about the Company's interest rate swap agreements at March 31, 2016 and December 31, 2015:

 

  

March 31,

2016

   December 31,
2015
 
Maturity   2023    2023 
Notional Amount  $17,200,000   $17,200,000 
Weighted Average Pay Rate   2.72%   2.72%
Weighted Average Receive Rate   0.39%   0.33%
Weighted Average Years to Maturity   7.3    7.6 
Cash Pledged as Collateral (1)  $2,149,413   $1,966,565 

 

 

 

(1)At March 31, 2016 and December 31, 2015 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.

 

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15. 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 months ended March 31, 2016 and March 31, 2015:

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
Gain on sale of mortgage loans held for sale, net of direct costs (1)  $11,533,909   $10,956,258 
Loan expenses, including provision for loan indemnification   (197,220)   (192,866)
Loan origination fee income   316,225    388,997 
Total  $11,652,914   $11,152,389 

 

 

 

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

 

16. 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 indemnification losses. The liability is included in accounts payable and other liabilities in the Company's consolidated balance sheets and the provision for loan indemnification losses 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 historical repurchases and indemnifications, historical loss experience, known delinquent and other problem loans, outstanding repurchase demand, historical rescission rates 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 three months ended March 31, 2016 and March 31, 2015 is as follows:

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
Balance at the beginning of period  $3,201,000   $2,662,162 
Loan indemnification losses incurred       (42,356)
Provision for loan indemnification losses   173,373    180,163 
Balance at end of period  $3,374,373   $2,799,969 

 

 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 March 31, 2016 and December 31, 2015, the reasonably possible loss above the recorded loan indemnification reserve was not considered material.

 

17. Income Taxes

 

For the three months ended March 31, 2016 and the years ended December 31, 2011 through December 31, 2015, 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 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 Company recorded income tax benefit of $1,603,235 and $145,529 for the three month period ended March 31, 2016 and March 31, 2015 respectively solely related to U.S. federal, state and local income taxes on activity in its ZFC Honeybee TRS, LLC subsidiary.

 

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The following is a reconciliation of the statutory federal and state rates to the effective rates for the three months ended March 31, 2016 and March 31, 2015:

 

 Reconciliation of Statutory Tax Rate to Effective Tax Rate

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
Tax expense/(benefit) at statutory rate   (34.00)%   35.00%
State and local taxes, net of Federal Benefit   (4.09)%   (10.97)%
Impact of REIT election (1)   6.26%   (109.68)%
Change in valuation allowance (2)   (0.74)%   31.82%
Other non-deductible/non-taxable items (3)   0.37%   0.27%
Effective Tax Rate   (32.20)%   (53.56)%

 

(1)For all tax years, the Company’s effective tax rate differs from its statutory tax rate due to the deduction for dividend distributions required to be paid under Code section 857(a).

 

(2)For the three months ended March 31, 2016 and March 31, 2015, the change in valuation allowance relates to the change in reserve related to net operating losses and other future deductible items for ZFC Trust TRS I, LLC and ZFC Funding, Inc.

 

(3)For the three months ended March 31, 2016 and March 31, 2015, the amount primarily relates to non-deductible meals and entertainment expenses.

 

At March 31, 2016, the Company had a net deferred tax liability of $1,961,243 related to unrealized gains and other temporary differences related to activity in ZFC Honeybee TRS, LLC subsidiary.

 

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 
  

March 31,

2016

  

March 31,

2015

 
Numerator:          
Net (loss)/ income attributable to ZAIS Financial Corp. common stockholders (Basic)  $(3,038,748)  $373,780 
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   (337,446)   43,466 
Exchangeable Senior Notes:          
Interest expense        
Gain on conversion option derivative liability        
Total – Exchangeable Senior Notes        
Net (loss)/ income available to stockholders, after effect of dilutive securities  $(3,376,194)  $417,246 
           
Denominator:          
Weighted average number of shares of common stock   7,970,886    7,970,886 
Effect of dilutive securities:          
Weighted average number of OP Units   926,914    926,914 
Weighted average number of shares convertible under Exchangeable Senior Notes        
Diluted weighted average shares outstanding   8,897,800    8,897,800 
Net (loss) income per share applicable to ZAIS Financial Corp. common stockholders – Basic  $(0.38)  $0.05 
Net (loss) income per share applicable to ZAIS Financial Corp. common stockholders – Diluted  $(0.38)  $0.05 

 

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 NYSE restrictions.

 

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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.

 

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.

 

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.

 

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

 

   Three Months Ended 
  

March 31,

2016

  

March 31,

2015

 
Advisory fees  $710,563   $702,755 
Loan sourcing fees   56,915    8,045 
Total – Advisory fees – related party  $767,478   $710,800 

 

Such amounts are included in "Advisory fee – related party" in the Company's consolidated statements of operations.

 

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The Company incurred the following Expense Reimbursements for amounts incurred by the Advisor for research and market data (including the amortization expense related to amounts prepaid to the Advisor):

 

   Three Months Ended 
  

March 31,

2016

  

March 31,

2015

 
Expense Reimbursements  $283,688   $101,439 

 

Such amounts are included in operating expenses in the Company's consolidated statements of operations.

 

Amounts payable to the Advisor for advisory fees, loan sourcing fees and Expense Reimbursements at March 31, 2016 and December 31, 2015 are as follows:

 

March 31,

2016

  

December 31,

2015

 
$875,720   $867,415 

 

Such amounts were included in accounts payable and other liabilities in the Company's consolidated balance sheets.

 

Other

 

GMFS received the following sub-lease income related to a portion of its office space (see Note 21) from a related party:

 

 

Three Months Ended 

March 31,

2016

  

March 31,

2015

 
$5,400   $4,800 

 

Such amounts are included in other income in the Company's consolidated statements of operations. 

 

20. Dividends and Distributions

 

During the three months ended March 31, 2016 and March 31, 2015 the Company declared the following dividends and distributions:

 

Declaration Date  Record Date  Payment Date 

Amount per Share

and OP Unit

 
Three months ended March 31, 2016:           
March 17, 2016  March 31, 2016  April 15, 2016  $0.40 
            
Three months ended March 31, 2015:           
March 19, 2015  March 31, 2015  April 15, 2015  $0.40 

 

21. 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 April 2015, GMFS received a claim from a counterparty of GMFS with respect to residential mortgage loans that were sold servicing released by GMFS to this counterparty’s predecessor prior to its acquisition by the Company on October 31, 2014. GMFS has since executed statute of limitations tolling agreements with this counterparty which have been extended to expire on June 2, 2016 but can be further extended by agreement of the parties (the initial tolling agreement was executed by GMFS on December 12, 2013).

 

 30 

 

 

Although the Company has established a loan indemnification reserve for potential losses related to loan sale representations and warranties with a corresponding provision recorded for loan losses (see Note 16), due to the limited information available at this stage of the matter, the Company is not able to determine the likelihood of the outcome or estimate an amount of loss or range of losses.

 

The Company believes that any losses in excess of the loan indemnification reserve will be recovered by the Company as either a reduction of total contingent consideration owed under the GMFS Merger Agreement given the indemnification provisions in the GMFS Merger Agreement or by withdrawing funds from an escrow account established by the sellers at the time of the acquisition (as of March 31, 2016, the balance in the escrow account was $4,005,732). The Company has delayed the first year installment payment of the contingent consideration (see Note 3).

 

Losses in excess of the loan indemnification reserve, total contingent consideration and the escrow account could have a material adverse impact on the Company's results of operations, financial position or cash flows. In the event of litigation or settlement with the counterparty, the Company intends to pursue claims against the sellers of GMFS seeking indemnification for any losses or any amounts paid in settlement, although there can be no assurance that such claims would be successful or that any amounts available for indemnification would be adequate.

 

Management is not aware of any other contingencies that would require accrual or disclosure in the consolidated financial statements at March 31, 2016 and December 31, 2015.

 

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. 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 are as follows at March 31, 2016 and December 31, 2015:

 

March 31, 2016   December 31, 2015 
$265,054,976   $216,072,457 

 

Leases

 

GMFS leases office space in Baton Rouge, LA for its corporate headquarters under a non-cancelable operating lease. The lease provides that GMFS pays taxes, maintenance, insurance, and other occupancy expenses applicable to the leased premises and contains three five-year renewal options at pre-determined amounts specified by the original lease agreement. GMFS also leases space in various states for its branch offices and equipment under various short-term rental agreements. GMFS incurred rent expense as follows:

 

Three Months Ended 
March 31, 2016   March 31, 2015 
$237,391   $182,987 

 

Such amounts are included in operating expenses in the Company's consolidated statements of operations.

 

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

 

At March 31, 2016, the future minimum rental payments for the period April 1, 2016 to December 31, 2016 and the five years subsequent to December 31, 2016 and thereafter are as follows:

 

April 1, 2016 – December 31, 2016  $720,626 
2017  $812,919 
2018  $680,366 
2019  $128,358 
2020  $ 
Thereafter  $ 

 

 31 

 

 

22. 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 March 31, 2016 and December 31, 2015, 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 March 31, 2016 and December 31, 2015. 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.

 

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 and repurchase 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.

 

23. 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 March 31, 2016 and December 31, 2015:

 

 

           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 
March 31, 2016                              
Warehouse lines of credit  $101,478,055   $   $101,478,055   $(101,478,055)  $   $ 
Treasury repurchase agreement   39,574,000        39,574,000    (39,574,000)         
Loan Repurchase Facilities   297,392,137        297,392,137    (297,371,251)   (20,886)    
Securities repurchase agreements   60,800,779        60,800,779    (58,811,004)   (1,989,775)    
Interest rate swap agreements   1,641,200        1,641,200        (1,641,200)    
Total  $500,886,171   $   $500,886,171   $(497,234,310)  $(3,651,861)  $ 
                               
December 31, 2015                              
Warehouse lines of credit  $100,768,428   $   $100,768,428   $(100,768,428)  $   $ 
Loan Repurchase Facilities   296,789,330        296,789,330    (296,413,751)   (375,579     
Securities repurchase agreements   73,300,159        73,300,159    (71,270,578)   (2,029,581)    
Interest rate swap agreements   1,009,014        1,009,014        (1,009,014)    
Total  $471,866,931   $   $471,866,931   $(468,452,757)  $(3,414,174)  $ 

 

 32 

 

 

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 March 31, 2016 or December 31, 2015.

 

24. Segment Information

 

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, an indirect subsidiary 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 March 31, 2016:  Residential
 Mortgage
Investments
   Residential 
Mortgage
Banking
   Corporate/Other   Total 
Interest income  $7,930,953   $773,963   $   $8,704,916 
Interest expense   2,781,246    551,820    1,464,211    4,797,277 
Net interest income (expense)   5,149,707    222,143    (1,464,211)   3,907,639 
Non-interest income       5,664,864        5,664,864 
Change in unrealized gain or loss   682,748        5,941    688,689 
Realized loss   (186,034)           (186,034)
Loss on derivative instruments   (676,268)           (676,268)
Advisory fee – related party   324,939    113,122    329,417    767,478 
Salaries, commissions and benefits       7,966,092        7,966,092 
Operating expenses   358,332    1,715,793    966,759    3,040,884 
Other Expenses:                    
Expenses   380,161        1,991,274    2,371,435 
Depreciation and amortization       232,430        232,430 
Total other expenses   380,161    232,430    1,991,274    2,603,865 
Net income (loss) before income taxes   3,906,721    (4,140,430)   (4,745,720)   (4,979,429)
Income tax benefit       (1,603,235)       (1,603,235)
Segment net income (loss)  $3,906,721   $(2,537,195)  $(4,745,720)  $(3,376,194)

 

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Three Months Ended March 31, 2015:  Residential
 Mortgage
Investments
   Residential 
Mortgage
Banking
   Corporate/Other   Total 
Interest income  $9,079,165   $608,232   $   $9,687,397 
Interest expense   2,755,445    553,359    1,436,673    4,745,477 
Net interest income (expense)   6,323,720    54,873    (1,436,673)   4,941,920 
Non-interest income       9,376,430        9,376,430 
Change in unrealized gain or loss   (1,139,426)           (1,139,426)
Realized gain   164,788            164,788 
Loss on derivative instruments   (907,090)           (907,090)
Advisory fee – related party   328,966    128,836    252,998    710,800 
Salaries, commissions and benefits       7,399,258        7,399,258 
Operating expenses   47,395    1,990,288    881,965    2,919,648 
Other Expenses:                    
Expenses   858,452    49,324        907,776 
Depreciation and amortization       227,423        227,423 
Total other expenses   858,452    276,747        1,135,199 
Net income (loss) before income taxes   3,207,179    (363,826)   (2,571,636)   271,717 
Income tax benefit       (145,529)       (145,529)
Segment net income (loss)  $3,207,179   $(218,297)  $(2,571,636)  $417,246 

 

The following table is a reconciliation of the net income of the residential mortgage banking segment to the operations of GMFS:

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
Net loss of the residential mortgage banking segment  $(2,537,195)  $(218,297)
Add back (deduct) expenses incurred by ZFC          
Honeybee TRS, LLC:          
Advisory fee – related party   113,122    128,836 
Amortization of deferred premiums, production and profitability earn-outs included in salaries, commission and benefits   189,000    269,367 
Operating expenses (including change in contingent consideration)   170,900    732,024 
Other expenses   197,085    246,409 
Income tax benefit   (1,603,235)   (145,529)
Net (loss) income of GMFS  $(3,470,323)  $1,012,810 

 

Supplemental Disclosures

 

 Selected segment balance sheet information is as follows:

 

   Residential
Mortgage
Investments
   Residential
Mortgage
Banking
   Corporate/Other   Total 
March 31, 2016                    
Cash and cash equivalents  $56,160,193   $10,440,033   $4,587   $66,604,813 
Mortgage loans held for investment, at fair value   32,114,043            32,114,043 
Mortgage loans held for sale previously held for investment, at fair value   368,956,195            368,956,195 
Mortgage loans held for investment, at cost       1,879,254        1,879,254 
Mortgage loans held for sale, at fair value       110,859,815        110,859,815 
Real estate securities, at fair value   87,120,006            87,120,006 
Other investment securities, at fair value   12,878,022            12,878,022 
Mortgage servicing rights, at fair value       44,852,686        44,852,686 
Goodwill       14,183,537        14,183,537 
Intangible assets       4,683,185        4,683,185 
Total assets   568,284,662    232,988,961    1,396,945    802,670,568 
                     
December 31, 2015                    
Cash and cash equivalents  $15,082,286   $5,702,608   $9,362   $20,793,716 
Mortgage loans held for investment, at fair value   397,678,140            397,678,140 
Mortgage loans held for investment, at cost       1,886,642        1,886,642 
Mortgage loans held for sale, at fair value       115,942,230        115,942,230 
Real estate securities, at fair value   109,339,281            109,339,281 
Other investment securities, at fair value   12,804,196            12,804,196 
Mortgage servicing rights, at fair value       48,209,016        48,209,016 
Goodwill       14,183,537        14,183,537 
Intangible assets       4,880,270        4,880,270 
Total assets   542,396,756    232,450,793    291,372    775,138,921 

 

 34 

 

 

25. Subsequent Events

 

See Note 1 - Formation and Organization for disclosures relating to the Sutherland Merger Agreement.

 

On April 6, 2016, the Company, Company Operating Partnership, the Advisor, Sutherland and certain subsidiaries of the Company entered into a termination agreement (the “Termination Agreement”). Pursuant to the Termination Agreement, effective upon the closing of the Mergers, the existing advisory agreement between the Company, the Advisor, Company Operating Partnership and the Company’s subsidiaries would be terminated and the Company would pay the Advisor a termination fee in the amount of $8,000,000. In the event that the Sutherland Merger Agreement is terminated prior to the consummation of the Mergers, the Termination Agreement will automatically terminate and be of no further effect.

 

Additionally, on April 6, 2016, the Company, the Operating Partnership, certain subsidiaries of the Company, Sutherland, and Waterfall Asset Management, LLC (“Waterfall”) entered into a management agreement , as amended as of May 9, 2016 (the “Sutherland Management Agreement”), and the Company and Waterfall entered into a related Side-Letter Agreement (the “Side Letter”). Pursuant to the Sutherland Management Agreement and the Side Letter, effective upon the closing of the Mergers, the Company will retain Waterfall to provide investment advisory services to the Company on the terms and conditions set forth in the Sutherland Management Agreement. In exchange for services provided, the Company will pay Waterfall a management fee and the Operating Partnership will issue Waterfall a newly authorized special limited partnership unit entitling Waterfall to an incentive fee under the terms of the Sutherland Management Agreement. The Sutherland Management Agreement has an initial term of three years, after which it will renew automatically for additional one year terms. In the event that the Merger Agreement is terminated prior to the consummation of the Mergers, the Sutherland Management Agreement and the Side Letter will automatically terminate and be of no further effect.

 

On April 28, 2016 the Company renewed the Treasury Security Repo. The new agreement bears interest at an annual rate of 0.54% and matures on June 30, 2016.

 

On May 6, 2016, the maturity date of the Citi Loan Repurchase Facility was extended to June 3, 2016. This facility is secured by the Company's mortgage loans held for sale previously held for investment and will be settled upon the sale of these loans. The sales are expected to close in the second quarter of 2016.

 

Additionally, on May 6, 2016, the maturity date of the Credit Suisse Loan Repurchase Facility was extended to September 30, 2016 and the facility size was reduced to $36,000,000.

 

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 investment objectives and business strategy;

 

  · the consummation of the strategic combination with Sutherland Asset Management Corporation (“Sutherland”);

 

  · the Company's ability to obtain future financing arrangements, and to extend existing arrangements in light of the planned combination with Sutherland Asset Management Corporation;

 

  · the Company's expected leverage;

 

 35 

 

 

  · 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;

 

  · 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";

 

  · the risk that the Mergers (as defined below) will not be consummated within the expected time period or at all;

 

  · the occurrence of any event, change or other circumstances that could give rise to the termination of the Sutherland Merger Agreement (as defined below);

 

  · the inability to obtain stockholder approvals relating to the Mergers or the failure to satisfy the other conditions to completion of the Mergers;

 

  · fluctuations in the adjusted book value per share of the shares of both the Company and Sutherland;

 

  · risks related to disruption of management's attention from the ongoing business operations due to the proposed Mergers;

 

  · the effect of the announcement of the proposed Mergers on the Company's operating results and business generally;

 

  · the outcome of any legal proceedings relating to the Mergers;

  

  · 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;

 

  · 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;

 

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

 

 36 

 

 

  · 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 invests in residential mortgage loans. GMFS, a mortgage banking platform the Company acquired in October 2014, originates, sells and services residential 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"). 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 distributions and secondarily through capital appreciation.

 

The Company was incorporated in Maryland on May 24, 2011 and has elected to be taxed as a REIT for U.S. federal income tax purposes commencing with its taxable year ended December 31, 2011. The Company is organized in a format pursuant to which it serves as the general partner of, and conducts substantially all of its business through ZAIS Financial Partners, L.P. (the “Company Operating Partnership” or the “Operating Partnership”). The Company is externally managed by the Advisor, a subsidiary of ZAIS Group LLC (“ZAIS”), and has no employees other than those employed by GMFS, its wholly-owned subsidiary. GMFS had 243 employees at March 31, 2016. The Company also expects to operate its business so that it is not required to register as an investment company under the 1940 Act.

 

The Company is externally managed by the Advisor, a subsidiary of ZAIS. On March 17, 2015, a business combination was completed between 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.

 

 37 

 

 

Definitive Merger Agreement

 

As described in greater detail in the Company’s current reports on Form 8-K filed on April 7, 2016 and on May 9, 2016, the Company entered into a definitive merger agreement on April 6, 2016 , as amended on May 9, 2016 (the “Sutherland Merger Agreement”) pursuant to which the Company will combine with Sutherland, a privately held commercial mortgage REIT. In the transactions described in the Sutherland Merger Agreement (the “Mergers”), the Company’s stockholders will continue to be stockholders of the surviving corporation and will be eligible to receive cash of up to $64.3 million in a tender offer to be made by the Company following stockholder approval of the transaction. Pursuant to the terms of the Sutherland Merger Agreement, Sutherland stockholders will receive newly issued shares of the Company’s common stock, and holders of Sutherland operating partnership units will receive operating partnership units in the Company Operating Partnership, which will be the surviving operating partnership. Following the Mergers, the combined entity will be renamed Sutherland Asset Management Corporation, and its shares will continue to be listed on the New York Stock Exchange (“NYSE”) under the symbol SLD. Following the Mergers, the Company will be externally managed by Waterfall Asset Management, LLC (“Waterfall”), Sutherland’s current external manager. Upon the effective time of Mergers, expected in the third quarter of 2016, the Company’s board of directors will increase the number of directors to six members, which will consist of the current directors of Sutherland and may include one of the Company’s current directors, and the resignations of the Company’s other directors will become effective. For additional details related to the Mergers, including the closing conditions, please refer to the Company’s Forms 8-K filed with the Securities and Exchange Commission on April 7, 2016 and on May 9, 2016 and "Item 13. Certain Relationships and Related Party Transactions and Director Independence—Conflicts of Interest and Related Party Transactions—Sutherland Management Agreement" in the Company’s report on Form 10-K/A filed on April 29, 2016. The Company does not intend to disclose further developments until the merger transaction is complete.

 

The Sutherland Merger Agreement has been approved by both companies' boards of directors and is subject to the approval of both companies' stockholders. The completion of the Mergers is subject to the satisfaction of certain other customary conditions, including the commencement and completion or withdrawal of the tender offer described above, the consummation of the sale of the Company’s whole mortgage loan portfolio, receipt of regulatory approvals relating to the issuance of the Company’s common stock, the delivery of certain documents and consents, the representations and warranties of the parties being true and correct, subject to the materiality standards contained in the Sutherland Merger Agreement, and the absence of a material adverse effect with respect to either Sutherland or the Company. The Company expects the transaction to close in the third quarter of 2016.

 

On April 6, 2016, the Company, Company Operating Partnership, the Advisor, Sutherland and certain subsidiaries of the Company entered into a termination agreement (the “Termination Agreement”). Pursuant to the Termination Agreement, effective upon the closing of the Mergers, the existing advisory agreement between the Company, the Advisor, Company Operating Partnership and the Company’s subsidiaries would be terminated and the Company would pay the Advisor a termination fee in the amount of $8,000,000. In the event that the Sutherland Merger Agreement is terminated prior to the consummation of the Mergers, the Termination Agreement will automatically terminate and be of no further effect.

 

Additionally, on April 6, 2016, the Company, the Operating Partnership, certain subsidiaries of the Company, Sutherland, and Waterfall entered into a management agreement, as amended on May 9, 2016 (the “Sutherland Management Agreement”), and the Company and Waterfall entered into a related Side-Letter Agreement (the “Side Letter”). Pursuant to the Sutherland Management Agreement and the Side Letter, effective upon the closing of the Mergers, the Company will retain Waterfall to provide investment advisory services to the Company on the terms and conditions set forth in the Sutherland Management Agreement. In exchange for services provided, the Company will pay Waterfall a management fee and the Operating Partnership will issue Waterfall a newly authorized special limited partnership unit entitling Waterfall to an incentive fee under the terms of the Sutherland Management Agreement. The Sutherland Management Agreement has an initial term of three years, after which it will renew automatically for additional one year terms. In the event that the Merger Agreement is terminated prior to the consummation of the Mergers, the Sutherland Management Agreement and the Side Letter will automatically terminate and be of no further effect.

 

In order to reduce market risk in its investment portfolio, prior to entering into the Sutherland Merger Agreement, the Company had begun the process of selling its seasoned, re-performing mortgage loans from its residential mortgage investments segment. The Sutherland Merger Agreement requires the Company to complete the sale of its seasoned, re-performing mortgage loans as a condition to closing of the Mergers. A sale of these mortgage loans is expected to be completed in the second quarter of 2016. If completed, these mortgage loan sales are likely to result in a reduction of the Company’s investment income and, if the Mergers are not completed, may therefore result in a decision to curtail dividends in the future. Additionally, as part of the strategic review, the Company had made the decision to cease the purchase of newly originated residential mortgage loans as part of its mortgage conduit purchase program and began the process of terminating contracts and surrendering governmental licenses relating to the Company’s mortgage conduit business. Consistent with these changes to the Company’s strategy, on March 9, 2016, Brian Hargrave resigned as the Company’s Chief Investment Officer and was succeeded by Christian Zugel, the current Chairman of the Company’s Board of Directors. The Sutherland Merger Agreement requires the Company to complete the process of terminating contracts and surrendering governmental licenses relating to its mortgage conduit business.

 

In connection with the proposed Mergers, the Company filed a registration statement on Form S-4 with the SEC, that included a preliminary joint proxy statement/prospectus, and will file other relevant documents concerning the proposed Mergers. The registration statement on Form S-4 has not yet been declared effective by the SEC and is subject to revision, some of which may be significant. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities or a solicitation of any vote or approval. BEFORE MAKING ANY VOTING OR INVESTMENT DECISION, INVESTORS ARE URGED TO READ THE DEFINITIVE JOINT PROXY STATEMENT/PROSPECTUS AND ANY OTHER DOCUMENTS TO BE FILED WITH THE SEC IN CONNECTION WITH THE PROPOSED MERGERS OR INCORPORATED BY REFERENCE IN THE DEFINITIVE JOINT PROXY STATEMENT/PROSPECTUS BECAUSE THEY WILL CONTAIN IMPORTANT INFORMATION ABOUT THE COMPANY, SUTHERLAND AND THE PROPOSED MERGER.

 

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GMFS Transaction

 

Pursuant to the terms of the August 5, 2014 agreement and plan of merger (the “GMFS Merger Agreement”) among ZFC Honeybee TRS, LLC (“Honeybee TRS”), an indirect subsidiary of the Company, ZFC Honeybee Acquisitions, LLC (“Honeybee Acquisitions”), a wholly owned subsidiary of Honeybee TRS, GMFS, and Honeyrep, LLC, solely in its capacity as the security holder representative, Honeybee Acquisitions merged with and into GMFS on October 31, 2014, with GMFS continuing as the surviving entity and an indirect subsidiary of the Company. GMFS is an approved Fannie Mae Seller-Servicer, Freddie Mac Seller-Servicer, Ginnie Mae issuer, Department of Housing and Urban Development / Federal Housing Administration (“FHA”) Mortgagee, U.S. Department of Agriculture (“USDA”) approved originator and U.S. Department of Veterans Affairs (“VA”) Lender. GMFS currently originates loans that are eligible to be purchased, guaranteed or insured by Fannie Mae, Freddie Mac, FHA, VA and USDA through retail, correspondent and broker channels. GMFS also originates and sells reverse mortgage loans as part of its existing operations. 

 

The final purchase price was approximately $61.2 million, net of approximately $1.7 million received from an escrow account pursuant to the GMFS Merger Agreement, based on the final reconciliation of GMFS's net tangible assets. The net tangible assets at closing were comprised of the estimated fair value of GMFS's MSR portfolio, the estimated value of GMFS's net tangible assets and 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 “Production and Profitability Earn-Out”). The $2 million of deferred premium payments is contingent on GMFS remaining profitable and retaining certain key employees. The Production and Profitability Earn-Out is dependent on GMFS achieving certain profitability and loan production goals and is capped at $20 million. Up to 50% of the Production and Profitability Earn-Out may be paid in common stock of the Company, at the Company's option. The estimated present value of the total contingent consideration at October 31, 2014 was $11.4 million based on the future production and earnings projections of GMFS over the four-year earn-out period (at March 31, 2016 the contingent consideration liability was $11.5 million; the Company has delayed the first year installment payment of the contingent consideration). The Company funded the closing cash payment through a combination of available cash and the sale of a portion of its non-Agency RMBS portfolio. As discussed above, pursuant to the GMFS Merger Agreement, based on the final reconciliation of the October 31, 2014 values, the Company received approximately $1.7 million in June 2015 from an escrow account established at the time of the closing. The Company recorded a reduction to goodwill in the consolidated balance sheets that included this amount, along with other final closing adjustments. Additionally, in 2016 and 2015, the goodwill and other intangible assets were measured for impairment. The Company determined that it is more likely than not that the carrying amount of these assets are recoverable and therefore, the Company did not recognize any impairment of these assets under accounting principles generally accepted in the United States (“U.S. GAAP”).

 

Segments

 

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 banking segment includes the operations of GMFS, which originates mortgage loans for subsequent sale as either servicing retained or released, and expenses incurred by Honeybee TRS.

 

At March 31, 2016, the Company held a diversified portfolio of residential mortgage loans, RMBS and MSRs with an aggregate fair value of $643.9 million, comprised of the following:

 

Residential Mortgage Investments

 

  · Newly originated loans with a fair value of $32.1 million;

 

  · Seasoned and re-performing loans held for sale with a fair value of $369.0 million;

 

  · RMBS assets with a fair value of $87.1 million, consisting primarily of senior tranches of non-Agency RMBS that were originally highly rated but subsequently downgraded and,

 

Residential Mortgage Banking

 

  · Mortgage loans originated by the GMFS mortgage banking platform and held for sale with a fair value of $110.9 million; and

 

  · MSRs with a fair value of $44.9 million.

 

The borrowings the Company used to fund the purchase of its portfolio held for investment totaled $415.0 million at March 31, 2016, under: (i) a master repurchase agreement with Citibank, N.A. (the "Citi Loan Repurchase Facility") to fund its distressed and re-performing loan portfolio, (ii) a master repurchase facility with Credit Suisse First Boston Mortgage Capital LLC (the "Credit Suisse Loan Repurchase Facility", and together with the Citi Loan Repurchase Facility, the "Loan Repurchase Facilities") to fund its newly originated loan portfolio, (iii) master securities repurchase agreements with four counterparties and (iv) the 8.0% Exchangeable Senior Notes due 2016 (the "Exchangeable Senior Notes"). Additionally, the borrowings the Company used to fund the origination of its mortgage loans held for sale portfolio totaled $101.5 million at March 31, 2016 under warehouse lines of credit and repurchase agreements with four lenders with an aggregate borrowing capacity of $185.0 million. The Company is also in discussions with other financial institutions to provide it with additional borrowing capacity under various agreements, including repurchase agreements and other types of financing arrangements.

 

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Factors Impacting Operating Results

 

The Company’s results of operations for the three months ended March 31, 2016 were impacted by a number of factors. Home prices, which are a significant correlating factor to the Company’s performance, rose 2.23% for the three months ended March 31, 2016 according to Case Shiller (20 City index, seasonally adjusted). The underlying fundamentals of the housing market, such as home prices, roll rates and credit losses, remained stable. Credit markets experienced a broad sell-off in most credit sectors through mid-February which pushed many credit asset classes lower. The non-Agency RMBS sector also moved lower during the period. While risk assets performed better from mid-February through quarter end, RMBS assets generally closed with negative returns at the end of the quarter. Performance in the non-Agency sector has continued to improve in the early part of the second quarter. Additionally, the 10-year Treasury rose in price and declined in yield during the quarter while credit spreads over Treasuries widened. Nevertheless, the Company recognized a modest net mark-to-market loss on its non-Agency RMBS during the quarter and also experienced a modest gain on its residential mortgage loans held for investment during the same period.

 

 The Company expects that the results of its operations will also be affected by a number of other factors, including the level of its net interest income, the fair value of its assets and the supply of, and demand for, the target assets in which it may invest. The Company's net interest income, which includes the amortization of purchase premiums and accretion of purchase discounts, varies, primarily as a result of changes in market interest rates and prepayment speeds, as measured by CPR on the Company's target assets. Interest rates and prepayment speeds vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty. The Company's operating results may also be impacted by credit losses in excess of initial anticipations or unanticipated credit events experienced by borrowers whose mortgage loans are held directly by the Company or included in its non-Agency RMBS or Other Investment Securities or in other assets it may originate or acquire.

 

Changes in Fair Value of the Company's Assets

 

The Company's mortgage loans held for investment, mortgage loans held for sale, RMBS and Other Investment Securities are carried at fair value and future mortgage-related assets may also be carried at fair value. Accordingly, changes in the fair value of the Company's assets may impact the results of its operations for the period in which such change in value occurs. The expectation of changes in real estate prices is a major determinant of the value of mortgage loans and, therefore, of RMBS and Other Investment Securities. This factor is beyond the Company's control.

 

Changes in Market Interest Rates

 

With respect to the Company's business operations, increases in interest rates, in general, may, over time, cause: (i) the interest expense associated with the Company's borrowings to increase; (ii) the value of its fixed-rate portfolio to decline; (iii) coupons on its ARMs and hybrid ARMs (including RMBS secured by such collateral) and on its residential mortgage loans and other floating rate securities to reset, although on a delayed basis, to higher interest rates; (iv) prepayments on its residential mortgage investments and RMBS to slow, thereby slowing the amortization of the Company's purchase premiums and the accretion of its purchase discounts; (v) a decrease in the Company's mortgage banking origination volume and operating activities; (vi) the value of its interest rate swap agreements to increase; and (vii) the value of its MSRs to increase.

 

Conversely, decreases in interest rates, in general, may, over time, cause: (i) prepayments on the Company's residential mortgage investments and RMBS to increase, thereby accelerating the amortization of its purchase premiums and the accretion of its purchase discounts; (ii) the interest expense associated with its borrowings to decrease; (iii) the value of its fixed-rate portfolio to increase; (iv) the value of its interest rate swap agreements to decrease; (v) coupons on its ARMs and hybrid ARMs held for investment (including RMBS secured by such collateral) and other floating rate securities to reset, although on a delayed basis, to lower interest rates; (vi) an increase in the Company's mortgage banking origination volume and operating activities; and (vii) the value of its MSRs to decrease. At March 31, 2016, 34.6% of the Company's performing mortgage loans held for investment, as measured by fair value, consisted of mortgage loans with a variable interest rate component, including ARMs and hybrid ARMs. At March 31, 2016, 35.8% of the Company's RMBS assets, as measured by fair value, consisted of RMBS assets with a variable interest rate component, including ARMs and hybrid ARMs. Additionally, at March 31, 2016, 100% of the Company's Other Investment Securities, as measured by fair value, consisted of the Fannie Mae Risk Transfer Notes (“FMSA Notes”) and Freddie Mac Structured Agency Credit Risk Notes (“FMRT Notes”) with a variable interest rate component.

 

Prepayment Speeds

 

Prepayment speeds on residential mortgage loans, and therefore, RMBS and MSRs vary according to interest rates, the type of investment, conditions in the financial markets, competition, defaults, foreclosures and other factors that cannot be predicted with any certainty. In general, when interest rates rise, it is relatively less attractive for borrowers to refinance their mortgage loans and, as a result, prepayment speeds tend to decrease. This can extend the period over which the Company earns interest income. When interest rates fall, prepayment speeds on residential mortgage loans, and therefore, RMBS and MSRs tend to increase, thereby decreasing the period over which the Company earns interest income. Additionally, other factors such as the credit rating of the borrower, the rate of home price appreciation or depreciation, financial market conditions, foreclosures and lender competition, none of which can be predicted with any certainty, may affect prepayment speeds on residential mortgage loans, RMBS and MSRs.

 

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Spreads on Non-Guaranteed Mortgage Loans Held for Investment and Sale and Securities

 

Since the financial crisis that began in 2007, the spreads between swap rates and residential mortgage loans and non-Agency RMBS have been volatile. Spreads on these assets initially moved wider due to the difficult credit conditions and have only recovered a portion of that widening. As the prices of securitized assets declined, a number of investors and a number of structured investment vehicles faced margin calls from dealers and were forced to sell assets in order to reduce leverage. The price volatility of these assets also impacted lending terms in the repurchase market, as counterparties raised margin requirements to reflect the more difficult environment. The spread between the yield on the Company's assets and its funding costs is an important factor in the performance of this aspect of the Company's business. Wider spreads imply greater income on new asset purchases but may have a negative impact on the Company's stated book value. Wider spreads generally negatively impact asset prices. In an environment where spreads are widening, counterparties may require additional collateral to secure borrowings, which may require the Company to reduce leverage by selling assets. Conversely, tighter spreads imply lower income on new asset purchases, but may have a positive impact on the Company's stated book value. Tighter spreads generally have a positive impact on asset prices. In this case, the Company may be able to reduce the amount of collateral required to secure borrowings.

 

Mortgage Extension Risk

 

The Advisor computes the projected weighted-average life of the Company's investments based on assumptions regarding the rate at which the borrowers will prepay the underlying mortgages and the rate at which defaults, foreclosures and recoveries will occur. In general, when the Company originates or acquires a fixed-rate mortgage or hybrid ARM asset, the Company may, but is not required to, enter into an interest rate swap agreement, MBS forward sales contract or other hedging instrument that effectively fixes the Company's borrowing costs for a period close to the anticipated average life of the fixed-rate portion of the related assets. This strategy is designed to protect the Company from rising interest rates, because the borrowing costs are effectively fixed for the duration of the fixed-rate portion of the related RMBS.

 

However, if prepayment rates decrease in a rising interest rate environment, the life of the fixed-rate portion of the related assets could extend beyond the term of the swap agreement or other hedging instrument. This could have a negative impact on the Company's consolidated results of operations, as borrowing costs would no longer be fixed after the maturity or termination of hedging instruments while the income earned on the assets would remain fixed. This situation may also cause the fair value of the Company's assets to decline, with little or no offsetting gain from the related hedging transactions. In extreme situations, the Company may be forced to sell assets to maintain adequate liquidity, which could cause the Company to incur losses.

 

In addition, the use of this swap hedging strategy effectively limits increases in the Company's book value in a declining rate environment, due to the effectively fixed nature of the Company's hedged borrowing costs. In an extreme rate decline, prepayment rates on the Company's assets might actually result in certain of its assets being fully paid off while the corresponding swap or other hedge instrument remains outstanding. In such a situation, the Company may be forced to liquidate the swap or other hedge instrument at a level that causes it to incur a loss.

 

Credit Risk

 

The Company is subject to credit risk in connection with its investments. Although the Company does not expect to encounter credit risk in its Agency RMBS, if any, it does expect to encounter credit risk related to its non-Agency RMBS, mortgage loans and other target assets, including assets it may originate or acquire. Increases in defaults and delinquencies will adversely impact the Company's operating results, while declines in rates of default and delinquencies may improve the Company's operating results from this aspect of its business. The Company is subject to counterparty risk under the FMSA Notes and FMRT Notes if Freddie Mac or Fannie Mae, respectively, is unable to perform its obligations under the respective notes.

 

A large portion of the mortgage loans held for investment that the Company acquired was current in their payment status at the time of acquisition. The Company calculates delinquency roll rates for its mortgage loan portfolio which represent the percentage of loans, as measured by unpaid principal balance that were in current payment status in the prior month but became delinquent in the measured month. The Company's delinquency roll rates have generally outperformed its model projections from late 2013, when the whole loan portfolio achieved scale, through March 31, 2016.

 

Size of Investment Portfolio

 

The size of the Company's investment portfolio, as measured by the aggregate principal balance of its mortgage-related securities and the other assets the Company owns, is a key driver of revenues and expenses. The amount of interest income the Company receives and the amount of interest expense to finance these assets is generally dependent on the size of the investment portfolio.

 

Critical Accounting Policies and Use of Estimates

 

See "Notes to Consolidated Financial Statements, Note 2 - Basis of Presentation" included in Part I, Item 1 - "Financial Statements" included in this quarterly report on Form 10-Q and "Notes to Consolidated Financial Statements, Note 2 – Summary of Significant Accounting Polices" included in Part II, Item 8 – "Financial Statements and Supplementary Data" in the Company's report on Form 10-K for the year ended December 31, 2015 for the Company's Critical Accounting Policies.

 

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Selected Financial Highlights

 

A summary of the Company's results for the three months ended March 31, 2016 and March 31, 2015 is below, followed by an overview of the market conditions that impacted the Company's results during the period:

 

    Three Months Ended  
    March 31, 2016     March 31, 2015  
U.S. GAAP net (loss)/income   $ (3.4) million     $ 0.4 million  
U.S. GAAP net (loss)/income per diluted weighted average share outstanding   $ (0.38 )   $ 0.05  
Core Earnings   $ 1.2 million     $ 4.5 million  
Core Earnings per diluted weighted average share outstanding   $ 0.14     $ 0.51  

 

      March 31, 2016       December 31, 2015  
Book value per share of common stock and OP Unit, at end of period/year   $ 19.19     $ 19.98  
Leverage ratio, at end of period/year     3.26 x     2.97 x

 

Non-U.S. GAAP Financial Measures

 

The Company believes that providing investors with Core Earnings, a non-U.S. GAAP financial measure, in addition to the related U.S. GAAP measures, gives investors greater transparency to the information used by management in its financial and operational decision-making. The Company defines Core Earnings as net interest income, plus non-interest income from its mortgage banking platform (excluding the after tax change in fair value of MSRs resulting from changes in values of market related inputs or assumptions used in a valuation model) less total operating expenses (excluding the after tax effect of depreciation and amortization, changes in contingent consideration, amortization of deferred premiums, production and profitability earn-outs and certain non-recurring adjustments) plus/(less) the income tax benefit/(expense) related to the Company's taxable REIT subsidiaries using the applicable effective tax rate for the period. The Company's mortgage banking platform is primarily comprised of income related to originating, selling, and servicing mortgage loans.

 

Core Earnings is an incomplete measure of the Company's financial performance and involves differences from net income computed in accordance with U.S. GAAP, therefore it should be considered along with, but not as an alternative to, the Company's net income computed in accordance with U.S. GAAP as a measure of the Company's financial performance. In addition, because not all companies use identical calculations, the Company's presentation of Core Earnings may not be comparable to other similarly-titled measures of other companies.

 

The following table reconciles net (loss)/income computed in accordance with U.S. GAAP to Core Earnings:

 

   Three Months Ended 
   March 31, 2016   March 31, 2015 
   (dollars in thousands, except per share data) 
Net (loss)/income – U.S. GAAP  $(3,376)  $417 
Recurring adjustments for non-core earnings:          
Change in unrealized gain or loss on mortgage loans held for investment and sale   (2,518)   1,200 
Change in unrealized gain or loss on real estate securities   1,793    178 
Change in unrealized gain or loss on Other Investment Securities   (25)   (136)
Change in unrealized gain or loss on real estate owned   67    (102)
Change in unrealized gain or loss on Treasury securities   (6)    
Realized gain on mortgage loans held for investment and sale   (536)   (144)
Realized loss on real estate securities   725     
Realized gain on real estate owned   (2)   (21)
Loss on derivative instruments related to investment portfolio   676    907 
Change in fair value of MSRs resulting from changes in valuation inputs or assumptions used in a valuation model, net of tax   4,060    1,626 
Change in contingent consideration, net of tax   122    314 
Amortization of deferred premiums, production and profitability earn-outs, net of tax   116    162 
Depreciation and amortization, net of tax   143    136 
Non-controlling interests   (16)    
Core Earnings – non-U.S. GAAP  $1,223   $4,537 
Core Earnings – per diluted weighted average share outstanding – non-U.S. GAAP  $0.14   $0.51 

 

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Core Earnings was $1.2 million for the three months ended March 31, 2016 compared to $4.5 million for the three months ended March 31, 2015. The decrease in Core Earnings was primarily due to $2.0 million of transaction costs related to the strategic alternatives evaluated by the Company and pending Mergers, a decrease of $1.2 million in net interest margin related to the Company’s residential mortgage investment portfolio and an increase in MSR payoffs of $0.7 million. Core earnings for the Company’s residential mortgage banking segment declined by $0.1 million.

 

Financial Overview

 

The Company reported GAAP net loss for the three months ended March 31, 2016 of ($3.4) million or ($0.38) per diluted weighted average share outstanding, compared with net income of $0.4 million or $0.05 per diluted weighted average share outstanding for the same period in 2015.  The change was primarily due to a decrease of $3.7 million in non-interest income from the Company’s residential mortgage banking segment which was primarily driven by a decrease in the value of the MSRs from changes in the prepayment assumptions and payoffs, a decrease in net interest income relating to the Company’s residential mortgage loan investment segment of $1.2 million due to sales of non-Agency RMBS and scheduled principal payments related to non-Agency RMBS and an increase in other expenses of $1.5 million due to transaction costs incurred relating to the strategic alternatives evaluated by the Company and the pending Mergers; offset by a reduction in other losses of $1.7 million.

 

GMFS

 

Highlights of the GMFS operating activity (which is included in the Company’s residential mortgage banking segment) for the three months ended March 31, 2016 are as follows:

 

         

Increase
from the

Prior Quarter

 
Mortgage originations (1)            
Unpaid principal balance   $ 432.1 million   8.1 %
Percentage of originations