Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K


 

x

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

For the fiscal year ended December 31, 2015

 

For the fiscal year ended December 31, 2017

OR

 

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

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

 

For the transition period from            to

 

Commission File Number:  001-35808


 

SUTHERLAND ASSET MANAGEMENT CORPORATION

 

ZAIS FINANCIAL CORP.

(Exact name of registrant as specified in its charter)


 

 

Maryland

90-0729143

(State or other jurisdiction of incorporation or organization)

90-0729143

(I.R.S. Employer Identification No.)

1140 Avenue of the Americas, 7th Floor

 

Two Bridge Avenue, Suite 322
Red Bank,

New Jersey
York, NY

10036

(Address of principal executive offices)

07701-1106

(Zip Code)

(212) 257-4600

(Registrant's telephone number, including area code)

 

(732) 978-7518

(Registrant’s telephone number, including area code)


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

 

Title of Each Class

Name of Each Exchange on Which Registered

Common Stock, $0.0001 par value

New York Stock Exchange

 

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

None


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yeso     Nox

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. 

Yeso     Nox

 

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.  Yesx     Noo

 

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).  Yesx      Noo

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.x Yes ☐      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 or emerging growth company.  See the definitions of “large accelerated filer,” “accelerated filer”filer,” “smaller reporting company”, and “smaller reporting“emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filero

Accelerated filerx

Non-accelerated filero

(Do not check if a smaller reporting company)

Smaller reporting company☐

Emerging growth companyo

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☒

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     Nox

 

As of June 30, 2015,2017, the aggregate market value of the registrant’sregistrant's common stock held by non-affiliates of the registrant was $125,460,507$245,625,504 based on the closing sales price of the registrant’s common stock on Tuesday, June 30, 20152017 as reported on the New York Stock Exchange.

 

On March 8, 2016,1, 2018, the registrant had a total of 7,970,88631,996,440 shares of common stock, $0.0001 par value, outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s proxy statement for the 20162018 annual meeting of stockholders are incorporated by reference into Part III of this annual report on Form 10-K.

 

 

TABLE OF CONTENTS

 


TABLE OF CONTENTS

 

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FORWARD-LOOKING STATEMENTS

 

ZAIS Financial Corp.(

Except where the “Company”) makescontext suggests otherwise, the terms “Company,” “we,” “us” and “our” refer to Sutherland Asset Management Corporation and its subsidiaries. We make forward-looking statements in this annual report on Form 10-K 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 claimswe claim 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’sour control. These forward-looking statements include information about possible or assumed future results of the Company’s business,our operations, financial condition, liquidity, results of operations, plans and objectives. When the Company useswe use 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 intendswe intend to identify forward-looking statements. Statements regarding the following subjects, among others, may be forward-looking:

 

·

the Company’s

our investment objectives and business strategy;

·

the outcome of the Company’s strategic alternatives;  
the Company’s

our ability to obtain future financing arrangements;

the Company’s expected leverage;

the Company’s expected investments;

the GMFS, LLC (“GMFS”) transaction;

the HF2 Financial Management Inc. (“HF2 Financial”) transaction;

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

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.

 

3

·

our expected leverage;

 

·

our expected investments;

·

estimates or statements relating to, and our ability to make, future distributions;

·

our ability to compete in the marketplace;

·

the availability of attractive risk-adjusted investment opportunities in small balance commercial loans (“SBC loans”), loans guaranteed by the U.S. Small Business Administration (the “SBA”) under its Section 7(a) loan program (the “SBA Section 7(a) Program”), mortgage backed securities (“MBS”), residential mortgage loans and other real estate-related investments that satisfy our investment objectives and strategies; 

·

our 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 (“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” and together with Fannie Mae, the “GSEs”), the Government National Mortgage Association (“Ginnie Mae”), Federal Housing Administration (“FHA”) Mortgagee, U.S. Department of Agriculture (“USDA”), U.S. Department of Veterans Affairs (“VA”) and the U.S. Securities and Exchange Commission (“SEC”);

·

mortgage loan modification programs and future legislative actions;

·

our ability to maintain our qualification as a real estate investment trust (“REIT”);

·

our ability to maintain our exemption from qualification under the Investment Company Act of 1940, as amended (the “1940 Act” or “Investment Company Act”);

·

projected capital and operating expenditures;

·

availability of qualified personnel;

 

The Company’s

3


·

prepayment rates; and

·

projected default rates.

Our beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to the Companyus or are within itsour control, including:

 

the factors referenced in this annual report on Form 10-K, including those set forth under Item 1, “Business” and Item 1A,

·

factors described in this annual report on Form 10‑K, including those set forth under the captions “Risk Factors” and “Business”;

 

general volatility of the capital markets;

·

applicable regulatory changes;

 

changes in the Company’s investment objectives and business strategy;

·

risks associated with acquisitions;

 

the availability, terms and deployment of capital;

·

risks associated with achieving expected revenue synergies, cost savings and other benefits from the merger with ZAIS Financial Corp. (“ZAIS Financial”) and the increased scale of our Company;

 

the availability of suitable investment opportunities;

·

general volatility of the capital markets;

 

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 our investment objectives and business strategy;

 

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

·

the availability, terms and deployment of capital;

 

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

·

the availability of suitable investment opportunities;

 

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

·

our dependence on our external advisor, Waterfall Asset Management, LLC (“Waterfall” or the “Manager”), and our ability to find a suitable replacement if we or our Manager were to terminate the management agreement we have entered into with our Manager;

 

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

·

changes in our assets, interest rates or the general economy;

 

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

·

increased rates of default and/or decreased recovery rates on our investments;

·

changes in interest rates, interest rate spreads, the yield curve or prepayment rates; changes in prepayments of our assets;

·

limitations on our business as a result of our qualification as a REIT; and

·

the degree and nature of our competition, including competition for SBC loans, MBS, residential mortgage loans and other real estate-related investments that satisfy our investment objectives and strategies.

 

Upon the occurrence of these or other factors, the Company’sour 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 believeswe believe that the expectations reflected in the forward-looking statements are reasonable, itwe cannot guarantee future results, levels of activity, performance or achievements. These forward-looking statements apply only as of the date of this annual report on Form 10-K. The Company isWe are not obligated, and doesdo 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 this annual report on Form 10-K.

 

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In this annual report on Form 10-K, references to the “Company” refer to ZAIS Financial Corp., a Maryland corporation, together with its consolidated subsidiaries; references to the Advisor refer to ZAIS REIT Management, LLC, a Delaware limited liability company; references to the “Operating Partnership” refer to ZAIS Financial Partners, L.P., a Delaware limited partnership; in each case unless specifically stated otherwise or the context otherwise indicates, and references to “risk-adjusted returns” refer to the profile of expected asset returns across a range of potential macroeconomic scenarios.PART I

 

Item 1. Business.

 

GENERAL

Overview

The Company is

We are a Maryland corporationreal estate finance company that investsacquires, originates, manages, services and finances primarily small balance commercial loans. SBC loans range in residential mortgage loans. GMFS, a mortgage banking platform the Company acquiredoriginal principal amount of between $500,000 and $10 million and are used by small businesses to purchase real estate used in October 2014, originates, sellstheir operations or by investors seeking to acquire small multi-family, office, retail, mixed use or warehouse properties. Our acquisition 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 agencyorigination platforms consist 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 its assets as its “target assets”.following four operating segments:

 

·

Loan Acquisitions. We acquire performing and non-performing SBC loans and intend to continue to acquire these loans as part of our business strategy. We hold performing SBC loans to term, and we seek to maximize the value of the non-performing SBC loans acquired by us through proprietary loan modification programs. We typically acquire non-performing loans at a discount to their unpaid principal balance (“UPB”) when we believe that resolution of the loans will provide attractive risk-adjusted returns.

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

·

SBC Originations. We originate SBC loans secured by stabilized or transitional investor properties using multiple loan origination channels through our wholly-owned subsidiary, ReadyCap Commercial, LLC (“ReadyCap Commercial”).  Additionally, as part of this segment, we originate and service multi-family loan products under Freddie Mac’s small balance loan program (the “Freddie Mac program”).

·

SBA Originations, Acquisitions and Servicing. We acquire, originate and service owner-occupied loans guaranteed by the SBA under the SBA Section 7(a) loan program through our wholly-owned subsidiary, ReadyCap Lending, LLC (“ReadyCap Lending”). We hold an SBA license as one of only 14 non-bank Small Business Lending Companies (“SBLCs”) and have been granted preferred lender status by the SBA. In the future, we may originate SBC loans for real estate under the SBA 504 loan program, under which the SBA guarantees subordinated, long-term financing.

·

Residential Mortgage Banking. In connection with our merger on October 31, 2016, as described in greater detail below, we added a residential mortgage loan origination segment through our wholly-owned subsidiary, GMFS, LLC ("GMFS").  GMFS originates residential mortgage loans eligible to be purchased, guaranteed or insured by Fannie Mae, Freddie Mac, FHA, USDA and VA through retail, correspondent and broker channels.

Our objective is to provide attractive risk-adjusted returns to itsour stockholders, primarily through quarterly dividend distributionsdividends and secondarily through capital appreciation. In order to achieve this objective, we intend to continue to grow our investment portfolio and we believe that the breadth of our full service real estate finance platform will allow us to adapt to market conditions and deploy capital in our asset classes and segments with the most attractive risk-adjusted returns.

 

 The Company was incorporated in Maryland on May 24, 2011,We are organized and has elected to be taxed andconduct our operations to qualify as a real estate investment trust ("REIT"REIT under the Internal Revenue Code (“IRC”) forof 1986, as amended (the “Code”). So long as we qualify as a REIT, we are generally not subject to U.S. federal income tax purposes commencing with itson our net taxable year ended December 31, 2011. The Company isincome to the extent that we annually distribute all of our net taxable income to stockholders. We are organized in a traditional umbrella partnership REIT (“UpREIT”) format pursuant to which it serveswe serve as the sole general partner of, and conductsconduct substantially all of itsour business through its Operating Partnership subsidiary, ZAIS FinancialSutherland Partners, L.P., a Delaware limited partnership. The CompanyLP, or our operating partnership, which serves as our operating partnership subsidiary. We also expectsintend to operate itsour business soin a manner that it is not requiredwill permit us to registerbe excluded from registration as an investment company under the 1940 Act.

Our Path to Becoming a Public Company

Our history of acquiring SBC loans traces back to August 2007 when the Victoria series of funds (“Victoria Funds”) made their initial acquisition of an equity tranche of an SBC loan securitization. The Company is externallyVictoria Funds were formed and managed by our Manager to invest in a range of loan products requiring active management to generate returns. Our business was operated as part of the Advisor,Victoria Funds until November of 2011 at which time the Victoria Funds contributed

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substantially all of their SBC loans to our operating partnership in exchange for substantially all of the operating partnership’s units, representing $371.5 million in assets and $262.2 million of equity capital. In November of 2013, we completed the private placement of shares of common stock and operating partnership units (“OP units”), pursuant to which we raised approximately $226 million of equity capital. Concurrently with the closing of the 2013 private placement, we engaged in a series of transactions, referred to as the REIT formation transactions, in order to allow us to conduct our business as a REIT for U.S. federal income tax purposes. As part of these transactions, we became a Maryland corporation.

On October 31, 2016, we completed our path to becoming a publicly traded company through our merger with and into a subsidiary of ZAIS Group, LLC ("ZAIS"),Financial, with ZAIS Financial surviving the merger and has no employees other than those employed by GMFS,changing its wholly-owned subsidiary. GMFS had 246 employees at December 31, 2015.

As announced on November 4, 2015, the Company has engagedname to Sutherland Asset Management Corporation. Prior to and as a financial advisor to assist it in evaluating potential strategic alternatives to enhance stockholder value. The continuing strategic review includes the exploration of merger or sale transactions involving the Company or a liquidation of the Company's assets. The Company and its financial advisor have engaged in preliminary discussions with several potential counterparties. While the Company is currently engaged in discussions with a potential counterparty about a potential merger or sale transaction, there is no assurance that the discussions will lead to a definitive merger or sale transaction, which would be subject to approval by the Company’s Board of Directors and its stockholders. In the event that the Company does not reach a definitive agreement with respect to a merger or sale transaction, management of the Company intends to presentcondition to the Company’s Boardmerger, ZAIS Financial disposed of Directors for its consideration a plan of liquidation. There is no assurance that the Company’s board of directors will approve any plan of liquidation and recommend its acceptance by the Company’s stockholders. In light of the strategic review and in order to reduce current market risk in its investment portfolio,the Company has recently begun the process of selling its seasoned re-performing mortgage loan portfolio, such that upon the completion of the merger, ZAIS Financial’s assets largely consisted of its GMFS origination subsidiary, cash, conduit loans, from itsand residential mortgage investments segment. A sale of these assets is expected to be completed early 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 may therefore result in a decision to curtail dividends in the future. Additionally, as part of the strategic review, the Company has made the decision to cease the purchase of newly originated residential mortgage loans as part of its mortgage conduit purchase program and will begin the unwinding of 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 will be succeeded by Christian Zugel, the current Chairman of the Company’s board of directors. The Company does not intend to disclose further developments until the review is complete and the Company’s board of directors has taken action with respect to the strategic review.

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Acquisition of GMFS

On August 5, 2014, the Company entered into a merger agreement with GMFS (the “GMFS Merger Agreement”backed securities (“RMBS”).  PursuantAdditionally, prior to the terms of 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 ("HUD") / 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, USDA and VA 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 December 31, 2015 the contingent consideration liability was $11.3 million). 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.

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 transactionmerger, ZAIS Financial completed a tender offer, purchasing 4,185,478 shares of common stock from existing ZAIS Financial stockholders at a purchase price of $15.37 per share. In connection with the merger, 25,870,420 shares of common stock were issued to our pre-merger common stockholders and retained2,288,663 units in the operating partnership subsidiary (“OP units”) were issued to our pre-merger OP unit holders. Our pre-merger stockholders held approximately 86% of our stockholders’ equity as a significant equity stake in ZGP. Following the closeresult of the transaction, ZAIS'smerger, with continuing ZAIS Financial stockholders holding approximately 14% of our stockholders’ equity, on a fully diluted basis. We were designated as the accounting acquirer because of our larger pre-merger size relative to ZAIS Financial, the relative voting interests of our stockholders after consummation of the merger, and our senior management team has remained in place to continue to leadand board of directors continuing on after the combined organization.

At December 31, 2015,consummation of the Company held a diversified portfoliomerger.  Because we were designated as the accounting acquirer, our historical financial statements (and not those of mortgage loans, RMBS assetsZAIS Financial) are the historical financial statements following the consummation of the merger and MSRs with an aggregate fair value of $671.2 million, comprised of:

Residential Mortgage Investments

Performing, re-performing and newly originated loans held for investment with a fair value of $397.7 million,

RMBS assets with a fair value of $109.3 million, consisting primarily of senior tranches of non-Agency RMBS that were originally highly rated but subsequently downgraded,

ResidentialMortgage Banking

Mortgage loans originated by the GMFS mortgage banking platform and held for sale with a fair value of $116.0 million, and

MSRs with a fair value of $48.2 million.

The borrowings the Company used to fund its portfolio held for investment totaled $426.6 million at December 31, 2015, 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 $100.8 million at December 31, 2015 under warehouse lines of credit and repurchase agreements with four lenders with an aggregate borrowing capacity of $185.0 million.

 The Company’s principal place of business is Two Bridge Avenue, Suite 322, Red Bank, New Jersey 07701-1106. The Company’s telephone number is (732) 978-7518. The Company’s website address is www.zaisfinancial.com. The information found on, or otherwise accessible through, the Company’s website is not incorporated into, and does not form a part of, this report.

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INVESTMENT STRATEGY

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 uses the experience and relationships developed in managing the whole loan investment platform of funds managed by ZAIS. The Company’s whole loan strategy has included secondary market purchases of seasoned mortgage loans, a newly originated non-agency loan purchase program and an origination platform. The Company believes that its target assets have presented attractive risk-adjusted return profiles. As market conditions have changed over time, the Company has adjusted its strategy by shifting its asset allocations across its target asset classes to take advantage of changes in interest rates and credit spreads as well as economic and credit conditions. See “Item 1. Business-General”are included in this annual report on Form 10-K for a discussion10-K.  On November 1, 2016, we began trading on the Company’s recent strategic review.New York Stock Exchange (“NYSE”) under ticker symbol “SLD”.

 

The Company reliesOur Manager

We are externally managed and advised by our Manager, an SEC registered investment adviser. Formed in 2005, Waterfall specializes in acquiring, managing, servicing and financing SBC and residential mortgage loans, as well as asset backed securities (“ABS”) and MBS. Waterfall has extensive experience in performing and non-performing loan acquisition, resolution and financing strategies. Waterfall’s investment committee is chaired by Thomas Capasse and Jack Ross, who serve as our Chief Executive Officer and President, respectively. Messrs. Capasse and Ross, who are co-founders of Waterfall, each have over 25 years of experience in managing and financing a range of financial assets, including having executed the first public securitization of SBC loans in 1993, through a variety of credit and interest rate environments. Messrs. Capasse and Ross have worked together in the same organization for more than 20 years. They are supported by a team of approximately 100 investment and other professionals with extensive experience in commercial mortgage credit underwriting, distressed asset acquisition and financing, SBC loan originations, commercial property valuation, capital deployment, financing strategies and legal and financial matters impacting our business.

We rely on the Advisor’s investmentWaterfall’s expertise in identifying loan acquisitions and efficiently financingorigination opportunities. Waterfall uses the data and analytics developed through its assets. The Advisorexperience as an owner of SBC loans and in implementing loss mitigation actions to support its origination activities and to develop its loan underwriting standards. Waterfall makes investment decisions based on a variety of factors, including expected risk-adjusted returns, credit fundamentals, liquidity, availability of adequate financing, borrowing costs and macroeconomic conditions, as well as maintaining the Company’sour REIT qualification and its exemptionour exclusion from registration as an investment company under the 1940 Act.

Our Investment Strategy and Market Opportunities Across Our Operating Segments

Our investment strategy is to opportunistically expand our market presence in our acquisition and origination segments and further grow our SBC securitization capabilities which serve as a source of attractively priced, match-term financing.  Following our 2013 private placement transaction, we capitalized on the dislocation of the credit markets and depressed levels of available capital by acquiring SBC loans from distressed sellers at historically high risk-adjusted returns.  Alongside the growth in our acquired loan portfolio and using our experience in underwriting and managing such loans, we built out our SBC and SBA origination capabilities and most recently added a residential agency mortgage origination component.  As such, we have become a full-service real estate finance platform and we believe that the breadth of our business allows us to adapt to market conditions and deploy capital in our asset classes with the most attractive risk-adjusted returns.

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Our acquisition strategy complements our origination strategy by increasing our market intelligence in potential origination geographies, providing additional data to support our underwriting criteria and offering securitization market insight for various product offerings. The Companyproprietary database on the causes of borrower default, loss severity, and market information that we developed from our SBC loan acquisition experience has followed a predominantly long-term buyserved as the basis for the development ofour SBC and holdSBA loan origination programs. Additionally, our origination strategy complements our acquisition strategy by providing additional captive refinancing options for our borrowers and further data to support our investment analysis while increasing our market presence with potential sellers of SBC assets.

The following table illustrates certain information with respect to manyour four business segments as of December 31, 2017. 

 

 

 

 

 

 

Loan

SBC 

SBA Originations,

Residential Mortgage

 

Acquisitions

Originations

Acquisitions and

Banking

 

 

 

Servicing

 

Coordinating Affiliate / Manager

Waterfall Asset Management, LLC

ReadyCap Commercial

ReadyCap Lending

GMFS

Strategy

SBC loan acquisition

SBC loan origination

SBA loan origination, acquisition and servicing

Residential mortgage origination and servicing

Gross Assets

$511.4 million

$1,154.5 million

$510.0 million

$324.4 million

% Equity Allocation

13.9%

44.1%

26.2%

15.8%

Personnel

108

68

88

248

According to the assets that it has acquired outside itsFederal Reserve, the U.S. commercial mortgage banking operations.market including multi-family residences, and nonfarm, nonresidential mortgages totaled approximately $4.0 trillion as of December 2017.  The Company’s target assetscommercial mortgage market is largely bifurcated by loan size between “large balance” loans and “small balance” loans.  Large balance commercial loans typically include those loans with original principal balances of at least $20 million and are as follows:primarily financed by insurance companies and commercial mortgage backed securities (“CMBS”) conduits.  SBC loans typically include those loans with original principal amounts of between $500,000 and $10 million and are primarily financed by community and regional banks, specialty finance companies and loans guaranteed under the SBA loan programs.

 

Residential Mortgage Loans. Prime,SBC loans are used by small businesses to purchase real estate used in their operations or by investors seeking to acquire small multi-family, office, retail, mixed use or warehouse properties. SBC loans represent a special category of commercial mortgage loans, sharing both commercial and residential mortgage loan characteristics. SBC loans are typically secured by first mortgages on commercial properties or other business assets, but because SBC loans are also often accompanied by personal guarantees, aspects of residential mortgage credit analysis are utilized in the underwriting process. Most SBC loans are fully amortizing on a schedule of up to 30 years.

The table presented below illustrates a summary of how our Manager categorizes SBC loans compared to other real estate loan asset classes.

Asset Class

Average Initial
Principal Balance

Loan-to-value

Yield

Residential housing

~ $225,000

~ 80%

~ 4.0%

Large balance commercial loans

>= $20.0 million

~ 65%

~ 4.0%

Small balance commercial loans

~ $2.0 million

~ 60%

~ 7.0%

We rely on our Manager’s expertise in identifying SBC loans for us to acquire. Our Manager will make decisions based on a variety of factors, including expected risk-adjusted returns, credit fundamentals, liquidity, availability of financing, borrowing costs and macroeconomic conditions, as well as maintaining our REIT qualification and our exclusion from registration as an investment company under the 1940 Act. Our investment decisions will depend on prevailing market conditions and may change over time in response to opportunities available in different economic and capital market environments. As a result, we cannot predict the percentage of its equity that will be invested in any particular asset or strategy at any given time.

7


Our Loan Portfolio

The table below presents a summary of the sourcing of our loan assets as of December 31, 2017 (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan Type (1)

Segment

 

UPB

 

% of Total
UPB

 

Carrying

Amount (2)

 

% of Total Carrying Amount

 

Fair Value

 

% of Total
Fair Value

Acquired loans

Loan Acquisitions (3)

 

$

416,853

 

19.4

%

 

$

383,416

 

18.4

%

 

$

392,505

 

18.3

%

Originated SBC loans

SBC Originations

 

 

583,390

 

27.2

 

 

 

598,633

 

28.8

 

 

 

600,038

 

28.0

 

Originated Freddie Mac loans

SBC Originations (4)

 

 

66,642

 

3.1

 

 

 

67,591

 

3.2

 

 

 

67,589

 

3.2

 

Originated Transitional loans

SBC Originations

 

 

444,260

 

20.7

 

 

 

442,514

 

21.3

 

 

 

456,202

 

21.3

 

Acquired SBA 7(a) loans

SBA Originations, Acquisitions and Servicing

 

 

449,161

 

20.9

 

 

 

400,606

 

19.2

 

 

 

438,015

 

20.5

 

Originated SBA 7(a) loans

SBA Originations, Acquisitions and Servicing (4)

 

 

58,911

 

2.8

 

 

 

57,999

 

2.8

 

 

 

56,071

 

2.6

 

Originated Residential Agency loans

Residential Mortgage

Banking (4)

 

 

126,772

 

5.9

 

 

 

131,109

 

6.3

 

 

 

131,112

 

6.1

 

Total Loan portfolio

 

 

$

2,145,989

 

100.0

%

 

$

2,081,868

 

100.0

%

 

$

2,141,532

 

100.0

%

(1) Includes Loan assets of consolidated variable interest entities ("VIEs").

(2) Excludes specific and general allowance for loan losses.

(3) Excludes real estate acquired in settlement of loans.

(4) Excludes MSR assets.

The charts presented below illustrates additional information related to the geographic concentration, collateral concentration, and lien type of our loan portfolio:

Our SBC Loan Acquisition Platform

Our SBC loan acquisition segment represents our investments in acquired SBC loans. We hold performing SBC loans to term, and we seek to maximize the value of the non-performing SBC loans acquired by us through proprietary loan modification programs. Where this is not possible, such as in the case of many non-performing loans, we seek to effect property resolution through the use of resolution alternatives to foreclosure.

8


Our Manager specializes in acquiring SBC loans that are sold by banks, including as part of bank recapitalizations or mergers, and from other financial institutions such as thrifts and non-bank lenders. Other sources of SBC loans include special servicers of large balance SBC ABS and CMBS trusts, the Federal Deposit Insurance Corporation, as receiver for failed banks, servicers of non-performing SBA Section 7(a) Program loans, and Community Development Companies originating loans under the SBA 504 program, GSEs, and state economic development authorities. Over the last several years, our Manager has developed relationships with many of these entities, primarily banks and their advisors. In many cases, we are able to acquire SBC loans through negotiated transactions, at times partnering with acquiring banks or private equity firms in bank acquisitions and recapitalizations. We believe that our Manager’s experience, reputation and ability to underwrite SBC loans make it an attractive buyer for this asset class, and that its network of relationships will continue to produce opportunities for it to acquire SBC loans on attractive terms.

Competition for SBC loan asset acquisitions has been limited due to the special servicing expertise required to manage SBC loan assets due to the small size of each loan, the uniqueness of the real properties that collateralize the loans, licensing requirements, the high volume of loans needed to build portfolios, and the need to utilize residential mortgage credit analysis in the underwriting process. These factors have limited institutional investor participation in SBC loan acquisitions, which has allowed us to acquire SBC loans with attractive risk-adjusted return profiles.

The following table summarizes our loan acquisitions since 2008, including acquisitions prior to the formation of our operating partnership in November 2011 when our business was operated as part of the Victoria Funds, as of December 31, 2017:

 

 

 

 

 

 

 

 

 

 

 

 

 

Acquisition Year(1)

Purchased UPB
(in thousands)

Cost
(in thousands)

Liquidated UPB
(in thousands)

Liquidated Cost
(in thousands)

Current UPB
(in thousands)

Amortized Cost of Remaining Loans
(in thousands)

2008

$

21,887

$

16,197

$

20,108

$

14,784

$

1,524

$

1,085

2009

 

18,604

 

9,351

 

16,754

 

8,326

 

1,647

 

1,589

2010

 

158,448

 

61,459

 

154,904

 

59,717

 

2,648

 

1,698

2011

 

356,378

 

233,444

 

310,759

 

198,296

 

36,402

 

31,573

2012

 

203,956

 

134,136

 

200,595

 

132,931

 

2,879

 

1,123

2013

 

221,549

 

152,603

 

163,561

 

106,747

 

47,349

 

38,399

2014

 

347,809

 

224,607

 

266,485

 

162,773

 

65,768

 

47,370

2015

 

208,504

 

199,597

 

64,614

 

61,201

 

113,308

 

109,444

2016

 

139,723

 

136,771

 

58,338

 

58,131

 

68,521

 

66,395

2017

 

97,951

 

95,830

 

11,312

 

11,443

 

84,885

 

82,669

Total

$

1,774,809

$

1,263,995

$

1,267,430

$

814,349

$

424,931

$

381,345

(1)

Table includes real estate owned balances with current UPB of $8.0 million and a carrying value of approximately $4.4 million. Excludes general allowance for loan losses of $0.8 million.

The following chart sets forth certain information as of December 31, 2017 related to the unlevered yields on our acquired loan portfolio:

9


The following table sets forth certain information as of December 31, 2017 related to our acquired loan portfolio (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Contractual Status (1)

Original UPB

Current UPB

Average UPB

Carrying Value (2)

Average Cost

Weighted Average Interest Rate

Weighted Average Maturity

Current

$

627,653

$

376,498

$

516

$

352,766

$

481

6.4

%

May 2027

30 - 59 days delinquent

 

7,326

 

5,171

 

575

 

4,954

 

542

6.3

 

February 2029

60 - 89 days delinquent

 

3,694

 

2,529

 

230

 

2,239

 

183

5.7

 

January 2030

90 - 179 days delinquent

 

6,917

 

2,755

 

306

 

2,474

 

195

5.8

 

September 2022

180 + days delinquent

 

37,847

 

25,352

 

357

 

17,576

 

281

5.9

 

October 2025

Bankruptcy

 

5,012

 

3,673

 

184

 

2,928

 

109

6.0

 

January 2031

Foreclosure

 

842

 

877

 

292

 

500

 

138

5.9

 

March 2035

REO

 

10,467

 

8,077

 

1,010

 

4,374

 

547

 —

 

 —

Total

$

699,756

$

424,931

$

492

$

387,811

$

441

6.4

%

May 2027

(1) Includes Loan assets of consolidated VIEs.
(2) Excludes specific and general allowance for loan losses.

Waterfall’s extensive experience in securitization strategies for SBC loans dates to the first SBC ABS for performing loans and liquidating trusts for non-performing loans purchased from the Resolution Trust Corporation in 1993. We believe that in 2011, we were the first post-financial crisis issuer of SBC ABS and have since completed several SBC bond issuances backed by newly originated and acquired SBC and SBA 7(a) loan assets. The following table summarizes our acquired loan securitization activities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Deal Name

Asset Class

 

Issuance

 

Ratings

 

Collateral Securitized

Advance Rate

Weighted Average Debt Cost

WVMT 2011-SBC1

SBC Acquired Loans - NPL

 

February 2011

 

NR(1)

 

$

40.5 million

70.6

%

7.0

%

WVMT 2011-SBC2

SBC Acquired Loans

 

March 2011

 

DBRS(2)

 

 

  97.7 million

84.1

 

5.3

 

WVMT 2011-SBC3

SBC Acquired Loans - NPL

 

October 2011

 

NR(1)

 

 

143.4 million

45.6

 

6.4

 

SCML 2015-SBC4

SBC Acquired Loans - NPL

 

August 2015

 

NR(1)

 

 

125.4 million

83.3

 

4.0

 

SCMT 2017-SBC6

SBC Acquired Loans

 

August 2017

 

NR(1)

 

 

154.9 million

90.0

 

3.3

 

 Total

 

 

 

 

 

 

$

561.9 million

74.8

%

5.4

%

(1)

Not rated.

(2)

DBRS is an SEC-registered nationally recognized statistical rating organization.

Our Loan Origination Platforms

We originate SBC loans generally ranging in initial principal amount of between $500,000 and $10 million, and typically with a duration of six years at origination. Our origination platform, which focuses on first mortgage loans, provides conventional SBC mortgage financing for SBC properties nationwide through the following programs:

·

First mortgage loans. Loans for the acquisition or refinancing of stabilized properties secured by traditional commercial properties such as multi-family, office, retail, mixed use or warehouse properties, which are often guaranteed by the property owners. The loans are typically amortizing and have maturities of five to twenty years.

·

Transitional loans. Loans for the acquisition of properties requiring more substantial expenditures for stabilization, secured by traditional commercial properties such as multi-family, office, retail, mixed use or warehouse properties which may be guaranteed by the property owners. The loans are typically interest-only and have maturities of two to four years.

·

Freddie Mac loans. Origination of loans ranging from $1 million to $5 million secured by multi-family properties through the recently launched Freddie Mac program. Loans are 90% guaranteed through the program. We sell qualifying loans to Freddie Mac, which, in turn, sells such loans to securitization structures. We are obligated to purchase the B-pieces secured by its underlying loans.

10


·

SBA loans. Loans secured by real estate, machinery, equipment and inventory that are guaranteed, typically 75% under the SBA Section 7(a) Programs. SBA loans include personal guarantees of the borrower and are typically amortizing and have maturities of seven to twenty-five years.

Additionally, as a large regional mortgage lender, we are approved to originate and service Fannie Mae, Freddie Mac and Ginnie Mae eligible loans through the residential mortgage loan programs. These include prime, subprime and alternative-A and alternative-B mortgage loans, which may be adjustable-rate, hybrid and/or fixed-rate residential mortgage loans and pay option adjustable rate mortgage loans (“ARMs”).

Our origination platforms include the following segments: (i) SBC Originations (ii) SBA Originations and (iii) Residential Mortgage Originations.

SBC Originations

We operate our SBC loan originations segment through ReadyCap Commercial. ReadyCap Commercial is a specialty-finance nationwide originator focused on originating commercial real estate mortgage loans through its conventional, agency multi-family and transitional loan programs. The Company acquires seasonedfollowing table summarizes the loan features of ReadyCap Commercial’s three product types:

Stabilized Conventional/Agency
Commercial Real Estate Lending

Transitional, Value-Add and Event Driven Commercial Real Estate Lending

First Mortgage Product

Freddie Mac Product

Transitional Product

Loan Purpose

Purchase, Cash-Out Refinance, Rate & Term Refinance

Purchase, Cash-Out Refinance, Rate & Term Refinance

Purchase, Cash-Out Refinance, Rate & Term Refinance, Transitional

Product Highlights

Stabilized Properties, Single-Tenants, Earn-Outs

> 90% Occupancy

Unstabilized Properties, Earn-outs, Rehab/Renovation, Construction, Lease Roll Issues, Vacancy Issues

Core Property Types

Multi-family, Mixed Use, Retail, Office, Industrial

Multi-family

Multi-family, Mixed Use, Retail, Office, Industrial

Rates

From 4.75% (Fixed)

From 3.0% (Fixed)

From 4.75% (Primarily Floating)

Loan Size

$750,000 - $10,000,000

$1,000,000 - $5,000,000

$5,000,000 - $20,000,000

Terms

2 - 10 Years

5 - 20 Years

< 5 Years

Amortization

20 - 30 Years

20 - 30 Years

Full Term Interest Only

Leverage

Up to 75% LTV

Up to 80% LTV

Up to 80% LTV

Take Out

Term Securitization

GSE Wrap Securitization(1)

CLO Securitization

Origination Fees

Up to 1%

Up to 1%

Up to 1% & Up to 2% Exit Fee

                                      (1) Bonds guaranteed by the GSEs.

Through December 31, 2017, we have originated more than $2.2 billion in SBC loans in 36 states since ReadyCap Commercial’s inception in September 2012.    The following chart summarizes our SBC conventional loan originations since ReadyCap Commercial’s formation:

11


As of December 31, 2017, our originated SBC loans held in our portfolio had a UPB of $1,094.3 million and a carrying value of approximately $1,109.2 million. Our originated SBC loans, substantially all of which are currently classified as performing loans, represented approximately 51.0% of the UPB and 53.3% of the carrying value of our total loan portfolio as of December 31, 2017.

The following table summarizes our originated SBC loan securitization activities:

 

 

 

 

 

 

 

 

Deal Name

     Asset Class

  Issuance

    Ratings

Collateral Securitized

Advance Rate

Weighted Average Debt Cost

RCMT 2014-1

SBC Originated Conventional

September 2014

MDY(1) / DBRS

$

181.7 million

79.6%
3.6%

RCMT 2015-2

SBC Originated Conventional

November 2015

MDY(1) / Kroll(2)

 

218.8 million

  75.5

         4.1

FRESB 2016-SB11

Originated Agency Multi-family

January 2016

GSE Wrap(3)

 

110.0 million

  90.0

         2.8

FRESB 2016-SB18

Originated Agency Multi-family

July 2016

GSE Wrap(3)

 

118.0 million

  90.0

            2.2

RCMT 2016-3

SBC Originated Conventional

November 2016

MDY(1) / Kroll(2)

 

162.1 million

  82.6

            3.5

FRESB 2017-SB33

Originated Agency Multi-family

June 2017

GSE Wrap(3)

 

197.9 million

  90.0

        2.6

RCMF 2017-FL1

SBC Originated Transitional

August 2017

MDY(1) / Kroll(2)

 

198.8 million

  82.0

LIBOR +
139 bps

Total

 

 

 

$

1,187.3 billion

  83.4

5.1%

(1)

Moody’s is a rating agency and an SEC-registered nationally recognized statistical rating organization.

(2)

Kroll Bond Rating Agency is a rating agency and an SEC-registered nationally recognized statistical rating organization.

(3)

GSE wrap guarantee.

Additionally, ReadyCap has been approved by Freddie Mac as one of 11 originators and servicers for multi-family loan products under the Freddie Mac program. As of December 31, 2017, ReadyCap employs 68 people focused on originating and supporting the SBC loan origination business.

The SBC loan origination market is highly fragmented, with few dedicated lenders. Furthermore, we believe that as economic conditions continue to stabilize or strengthen, the volume of short-term loan extensions and restructurings of existing SBC loans will be reduced, resulting in increased opportunities for us to originate new SBC loans.

We believe that we have significant opportunity to originate SBC loans at attractive risk-adjusted returns. We believe that many banks have restrictive credit guidelines for our target assets. In addition, large banks are not focused on the SBC market and smaller banks only lend in specific geographies. We see an opportunity to earn an attractive risk spread premium by lending to borrowers that do not fit the credit guidelines of many banks. We believe that increased demand, coupled with the fragmentation of the SBC lending market, provides us with attractive opportunities to originate loans to borrowers with strong credit profiles and real estate collateral that supports ultimate repayment of the loans.

We expect to continue to source SBC loan originations through the following loan origination channels:

·

Direct and indirect lending relationships.  We will generate origination loan leads directly through our extensive relationships with commercial real estate brokers, bank loan officers and mortgage brokers that refer leads to our loan officers. To a lesser extent, we will also source loan leads through commercial real estate realtors, trusted

12


advisors such as financial planners, lawyers, and certified public accountants (“CPAs”) and through direct-to-the-borrower transactions.

·

Other direct origination sources for SBC loans.  From time to time, we may enter into strategic alliances and other referral programs with servicers, sub-servicers, strategic partners and vendors targeted at the refinancing of SBC loans.

SBA Origination, Acquisition and Servicing Platform

We operate our SBA loan origination, acquisition, and servicing segment through ReadyCap Lending. We acquire, originate and service owner-occupied loans guaranteed by the SBA under the SBA Section 7(a) Program through  ReadyCap Lending’s license, one of only 14 licensed non-bank SBLCs. In the future, we may also originate SBC loans for real estate under the SBA 504 loan program, pursuant to which the SBA guarantees subordinated, long-term financing. We believe investor demand for pass-through securities backed by the guaranteed portions of SBA Section 7(a) Program loans has been strong because the principal and interest payments are guaranteed by the full faith and credit of the U.S. Government. For this reason, we believe that SBA participating lenders that have sold the guaranteed portions of SBA Section 7(a) Program loans in recent years have been able to recognize attractive gains.

The SBA was created out of the Small Business Act in 1953. The SBA’s function is to protect the interests of small businesses. The SBA classifies a small business as a business that is organized for profit and is independently owned and operating primarily within the United States with less than $15 million in tangible net worth and not more than $5 million in average after-tax net income. The SBA supports small businesses by administering several programs that provide loan guarantees against default on qualified loans made to eligible small businesses.

The SBA Section 7(a) Program is the SBA’s primary program for providing financing for start-up and existing small businesses. The SBA typically guarantees 75% of qualified loans over $150,000. While the eligibility requirements of the SBA Section 7(a) Program vary depending on the industry of the borrower and other factors, the general eligibility requirements include the following: (i) gross sales of the borrower cannot exceed size standards set by the SBA (e.g., $30.0 million for limited service hospitality properties) or, alternatively, average net income cannot exceed $5.0 million for the most recent two fiscal years, (ii) liquid assets of the borrower and affiliates cannot exceed specified limits, (iii) tangible net worth of the borrower must be less than $15.0 million, (iv) the borrower must be a U.S. citizen or legal permanent resident and (v) the maximum aggregate SBA loan guarantees to a borrower cannot exceed $3.75 million. The table below provides information on the SBA Section 7(a) Program’s key features, including its eligible uses, maximum loan amount, loan maturity, interest rate, guarantee fee, yearly fee and personal guarantee.

Key Feature

Program Summary

Use of Proceeds

Fixed assets, working capital, financing of start-up or to purchase an existing business. Some debt payment allowed but lender’s loan exposure may not be reduced with the proceeds.

Maximum Loan Amount

$5,000,000

Maturity

Five to seven years for working capital and up to 25 years for equipment and real estate. All other loan purposes have a maximum term of ten years.

Interest Rate

Negotiated between applicant and lender and is subject to maximums. The current maximums are Prime Rate plus 2.25% for maturities fewer than seven years and Prime Rate plus 2.75% for maturities of seven years or longer. Spreads on loans with an initial UPB below $50,000 have higher maximums.

Guaranty Fee

Based on the loan’s maturity and the dollar amount guaranteed. The lender initially pays the guaranty fee and has the option to pass the expense on to the borrower at closing. A fee of 0.25% of the guaranteed portion of the loan is charged for loans with maturities of 12 months or less. For loans with maturities over 12 months, the fees are 2% for loans of $150,000 or less; 3% for loans of $150,001 to $700,000; 3.5% for loans over $700,000; and 3.75% for guaranteed portion over $1 million.

Yearly Fee

The ongoing yearly fee due from lenders to SBA is 0.52% of the guaranteed portion of the outstanding balance on the 7(a) loan.

Personal Guarantee

Required from all owners of 20% or more of the equity of the business. Lenders can require personal guarantees of owners with less than 20% ownership.

13


Sources:  SBA, Business Development Corporation, Office of the Comptroller of the Currency, Congressional Research Service

      Our return on equity related to the SBA 7(a) program is generated through retained yield on the unguaranteed principal balance as well as sale premium and retained servicing on the guaranteed principal balance as displayed by the following:

The following table sets forth certain information as of December 31, 2017 related to our acquired SBA 7(a) loan portfolio (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Contractual Status (1)

Original UPB

Current UPB

Average UPB

Carrying Value (2)

Average Cost

Weighted Average Rate

Weighted Average Maturity

Current

$

906,797

$

413,823

$

255

$

376,625

$

232

5.8

%

February 2031

30 - 89 days delinquent

 

64,399

 

18,788

 

159

 

16,211

 

135

6.0

 

July 2030

90+ days delinquent

 

87,624

 

15,836

 

108

 

7,769

 

38

5.9

 

May 2030

REO

 

13,576

 

714

 

59

 

713

 

59

 —

 

 —

Total

$

1,072,397

$

449,161

$

237

$

401,319

$

210

5.9

%

January 2031

(1) Includes loan assets of consolidated VIEs.
(2) Excludes specific and general allowance for loan losses.

We have originated more than $188.7 million in SBA loans in 37 states since the program’s inception in mid-2015 through December 31, 2017. As of December 31, 2017, our originated SBA loans held in our loan portfolio had a UPB of $58.9 million and a carrying value of approximately $58.0 million.

The following table sets forth certain information as of December 31, 2017 related to our sale of originated SBA loans (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Quarter

 

Proceeds Received for Sale of Guaranteed Portion of Loans

 

UPB Sold

 

Net Proceeds

 

Weighted Average Sales Premium

Q3 2015

 

$

51,767

 

$

49,392

 

$

2,375

 

4.8

%

Q4 2015

 

 

1,252

 

 

1,252

 

 

 —

 

 -

 

Q1 2016

 

 

10,344

 

 

9,271

 

 

1,072

 

11.6

 

Q2 2016

 

 

6,964

 

 

6,186

 

 

778

 

12.6

 

Q3 2016

 

 

14,414

 

 

12,879

 

 

1,535

 

11.9

 

Q4 2016

 

 

12,857

 

 

11,732

 

 

1,125

 

9.6

 

Q1 2017

 

 

10,638

 

 

9,595

 

 

1,044

 

10.9

 

Q2 2017

 

 

23,570

 

 

21,125

 

 

2,445

 

11.6

 

Q3 2017

 

 

32,855

 

 

29,354

 

 

3,501

 

11.9

 

Q4 2017

 

 

28,189

 

 

25,260

 

 

2,929

 

11.6

 

      Total

 

$

192,850

 

$

176,047

 

$

16,804

 

9.5

%

 

 

 

 

 

 

 

 

 

 

 

 

 

14


The following table sets forth certain information as of December 31, 2017, related to our SBA servicing portfolio (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

Origination Vintage

 

Serviced Principal Balance

 

Weighted Average Servicing Fee

 

Weighted Average Remaining Term
(in months)

 

% in Default (1)

< 1999

 

$

3,228

 

2.0

%

 

59

 

24.5

%

2000 - 2004

 

 

51,540

 

1.7

 

 

111

 

5.3

 

2005 - 2009

 

 

216,984

 

2.2

 

 

147

 

10.5

 

2010 - 2014

 

 

42,154

 

1.0

 

 

209

 

16.0

 

2015 +

 

 

113,717

 

1.0

 

 

227

 

0.5

 

    Total

 

$

427,623

 

1.7

%

 

169

 

7.8

%

(1) Greater than or equal to 90-day equivalent

 

 

 

 

 

 

 

 

 

 

 

 

We use the securitization markets to access term financing on the unguaranteed retained portion of the SBA 7(a) Program loans. The following table summarizes our SBA loan securitization activities:

 

 

 

 

 

 

 

Deal Name

Asset Class

Issuance

Ratings

Collateral Securitized

Advance Rate

Weighted Average Debt Cost

RCLT 2015-1

SBA 7(a) Loans

June 2015

S&P(1)

$ 189.5 million

60.6%
2.5%

(1)

S&P is a rating agency and an SEC-registered nationally recognized statistical rating organization.

Residential Mortgage Origination Platform

In connection with our merger with ZAIS Financial on October 31, 2016, as described above, we added a residential mortgage loan origination component through GMFS, our wholly-owned subsidiary.  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 is licensed in 18 states and provides a wide range of residential mortgage services, including home purchase financing, mortgage refinancing, reverse mortgages, new construction loans and condo financing. GMFS operates through 13 retail branches located in Louisiana, Georgia, Mississippi, Alabama, and Texas.GMFS employs both a servicing retained and servicing released execution strategy, while retaining approximately 85-90% of current production.  Our residential mortgage loan portfolio represented approximately 6.3% of the carrying value and 5.9% of the UPB of our total loan portfolio as of December 31, 2017. Our residential mortgage origination platform employed a total of 248 people as of December 31, 2017. 

GMFS adds a residential origination platform to our sourcing capabilities, allowing access to new credit investment opportunities while controlling the origination process.  We believe we can enhance and grow the GMFS origination platform through better access to capital and an expanded product offering. In addition, using this platform we intend to continue to invest in MSRs through retention and secondary market transactions and to selectively pursue new residential product offerings.

15


Highlights of the historical GMFS origination activity by purpose for the year ended December 31, 2017 are as follows:

The following table sets forth certain historical information related to the GMFS servicing of residential mortgage loans:

Highlights of the GMFS operating activity (which is included in our residential mortgage banking segment) for the year ended December 31, 2017 are as follows:

16


Our management team has extensive experience and an established track record of operating through multiple market cycles.  We primarily originate, sell and service conventional, conforming agency and government insured residential mortgage loans that are primarily, but not exclusively, performingoriginated or acquired through our three channels: retail, correspondent and re-performingwholesale. Our mortgage lending operation generates origination and processing fees, net of origination costs, at the time of acquisition. The Company also acquires newly originated non-agencyorigination as well as gains or unexpected losses when the loans through its loan purchase program, which provides approved sellers a web-based platform forare sold to third party investors, including the pricing, lockingGSEs and fundingGinnie Mae. We retain servicing rights from the mortgage originations and earn servicing fees, net of individual loans which must adhere to loan eligibility criteria and underwriting guidelines. The Company also originates and services agency and government guaranteed residentialsub-servicer costs, from our mortgage loans through GMFS.servicing portfolio.

 

Non -Agency RMBS. RMBSWe believe that we have a significant opportunity to expand our footprint within the mortgage banking industry through:

·

Enhancement of our technology systems to drive further efficiency and customer satisfaction.

·

Increased penetration of existing clients and through the addition of new branches and independent originators in our correspondent and wholesale channels.

·

Opportunistic geographic expansion in our retail channel.

·

Expansion of our Texas operation (launched in the Fall of 2015), which originates loans through our retail, correspondent, and wholesale channels. 

Our Loan Pipeline

We have a large and active pipeline of potential acquisition and origination opportunities that are not issuedin various stages of our investment process. We refer to assets as being part of our acquisition pipeline or guaranteedour origination pipeline if:

·

an asset or portfolio opportunity has been presented to us and we have determined, after a preliminary analysis, that the assets fit within our investment strategy and exhibit the appropriate risk/reward characteristics and

·

in the case of acquired loans, we have executed a non-disclosure agreement (“NDA”) or an exclusivity agreement and commenced the due diligence process or we have executed more definitive documentation, such as a letter of intent (“LOI”), and in the case of originated loans, we have issued an LOI, and the borrower has paid a deposit.

As of December 31, 2017, our Manager has identified approximately $682.0 million in potential assets as measured by the fully committed amounts of the loans, comprised of:

·

$223.2 million in potential acquisitions of SBC loans, with $171.0 million relating to potential loan acquisitions for which our Manager has entered into LOIs or for which it has agreed on pricing terms with the sellers,

·

$16.0 million in potential acquisitions of SBA loans,

·

$159.8 million in SBC loan originations,

·

$135.4 million in SBA loan originations, and

·

$147.6 million in commitments to originate residential agency loans.

We operate in a U.S. Government agencycompetitive market for investment opportunities and competition may limit our ability to originate or federally chartered corporation, with an emphasis on securities that, when originally issued, were ratedacquire the potential investments in the highest rating category bypipeline. The consummation of any of the potential loans in the pipeline depends upon, among other things, one or more of the nationally recognized statistical rating organizations.

The mortgage loan collateral for non-Agency RMBS consistsfollowing: available capital and liquidity, our Manager’s allocation policy, satisfactory completion of residential mortgage loans that do not generally conform to underwriting guidelines issued by Fannie Mae, Freddie Mac or Ginnie Mae,our due to certain factors, including mortgage balances in excessdiligence investigation and investment process, approval of agency underwriting guidelines, borrower characteristics, loan characteristics and level of documentation, and therefore are not issued or guaranteed by an agency of the U.S Government. The mortgage loan collateral may be classified as prime, subprime and alternative-A and alternative-B mortgage loans, which may be adjustable-rate, hybrid and/or fixed-rate residential mortgage loans, and pay option ARMs.

MSRs. MSRs provide a mortgage servicerour Manager’s Investment Committee, market conditions, our agreement with the right to service a pool of mortgages in exchange for a portion of the interest payments madeseller on the underlying mortgages.terms and structure of such potential loan, and the execution and delivery of satisfactory transaction documentation. Historically, we have acquired less than a majority of

17


 

Agency RMBS. RMBS that are issued or guaranteed by a federally chartered corporation or a U.S. Government agency. The Agency RMBS Table of Contents

the Company targetsassets in our Manager’s pipeline at any one time and there can be collateralized by either fixed rate loansno assurance the assets currently in its pipeline will be acquired or ARMs. The Company has the discretion to invest in Agency RMBS through TBA contracts, which are forward contracts for the purchase of Agency RMBS at a predetermined price with a stated face amount, coupon and stated maturity at an agreed upon future date.

Other Real Estate-Related and Financial Assets. IOs created from RMBS are mortgage-backed securities structured with two or more classes that receive different distributions of interest on a pool of Agency RMBS or non-Agency RMBS or whole loans. Subject to maintaining its REIT status pursuant to the Internal Revenue Code, the Company may acquire debt and equity tranches of securitizations backed by various asset classes, including small balance commercial mortgages, manufactured housing, aircraft, automobiles, credit cards, equipment, franchises, recreational vehicles and student loans.

7

Asset Allocations. At December 31, 2015, the Company held a diversified portfolio of mortgage loans, RMBS assets and MSRs with an aggregate fair value of $671.2 million, comprised of: (i) performing, re-performing and newly originated loans held for investment with a fair value of $397.7 million, (ii) mortgage loans originated by our Manager in the GMFS mortgage banking platform and held for sale with a fair value of $116.0 million, (iii) RMBS assets with a fair value of $109.3 million, and (iv) MSRs with a fair value of $48.2 million. As market conditions have changed, the Company has adjusted its strategy by shifting its asset allocations across its target asset classes. The Company has relied on the Advisor’s expertise in identifying assets within the target assets described above and, to the extent that leverage was employed, efficiently financing those assets. The Company’s allocation decisions have been based on a variety of factors, including expected risk-adjusted returns, credit fundamentals liquidity and the availability of certain assets.future.

 

FINANCING STRATEGY

 

The Company usesWe use prudent leverage primarily for the purposes of financing its portfolio and increasingto increase potential returns to stockholders rather thanour stockholders. We finance the loans we originate primarily through securitization transactions, as well through other borrowings. We also plan to sell the guaranteed portion of our SBA loan originations in the secondary market.

Our Manager’s extensive experience in non-performing and performing loan acquisition, origination, servicing and securitization strategies has enabled us to complete several securitizations of SBC loan and SBA 7(a) loan assets since January 2011. SBC securitization structures are non-recourse and typically provide debt equal to 50% to 90% of the cost basis of the SBC assets. Non-performing SBC ABS involve liquidating trusts with liquidation proceeds used to repay senior debt. Performing SBC ABS involve longer-duration trusts with principal and interest collections allocated to senior debt and losses on liquidated loans to equity and subordinate tranches. Our strategy is to continue to finance our assets through the securitization market, which will allow us to continue to match fund the SBC loans pledged as collateral to secure these securitizations on a long-term non-recourse basis.

We anticipate using other borrowings as part of our financing strategy, including re-securitizations, repurchase agreements, warehouse facilities, bank credit facilities (including term loans and revolving facilities), and public and private equity and debt issuances.

As of December 31, 2017, our committed and outstanding financing arrangements included:

·

five committed credit facilities and three master repurchase agreements to finance our SBC and residential mortgage loans with $248.7 million of borrowings outstanding;

·

$598.1 million of securitized debt obligations outstanding from $1.9 billion ABS that financed our whole loan acquisitions and SBC originations;

·

master repurchase agreements with four counterparties to fund our acquisition of MBS, short term investments, and SBC loans with $382.6 million of borrowings outstanding;

·

$140.0 million in principal amount of 7.50% senior secured notes due 2022, or “Senior Secured Notes”, to originate or acquire our target assets and for general corporate purposes; and

·

$115.0 million in principal amount of 7.00% convertible senior notes due 2023, our “Convertible Notes”, to originate or acquire our target assets and for general corporate purposes.

Although we are not required to maintain any specific debt-to-equity leverage ratio, the amount of leverage we may employ for particular assets will depend upon the availability of particular types of financing and our Manager’s assessment of the credit, liquidity, price volatility and other risks of those assets and financing counterparties. We are currently targeting on a debt-to-equity basis, 3:1 to 4:1 leverage on performing SBC loans we purchase or originate and finance through non-recourse securitization structures and 1:1 to 3:1 leverage on non-performing SBC loans that we purchase. Our expected leverage ratios for our recourse debt are 1.5:1 to 3:1. We believe that these target leverage ratios are conservative for these asset classes and exemplify the conservative levels of borrowings we intend to use over time. We intend to use leverage for the primary purpose of financing our portfolio and not for the purpose of speculating on changes in interest rates. The Company funds the origination and acquisition of its target assets through the use of prudent amounts of leverage. The borrowings the Company used to fund its portfolio totaled approximately $527.4 million as of December 31, 2015 under the warehouse lines of credit and repurchase agreements with four counterparties, Loan Repurchase Facilities and master securities repurchase agreements with four counterparties. Additionally, $57.5 million aggregate principal amount of the Exchangeable Senior Notes were outstanding as of December 31, 2015.

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. Although the Company is not required to maintain any particular leverage ratio, the amount of leverage it deploys for particular investments in its target assets depends upon the Advisor’s assessment of a variety of factors, whichWe may, include the anticipated liquidity and price volatility of the assets in its investment portfolio, the gap between the duration of its assets and liabilities, including hedges, the availability and cost of financing assets, its opinion of the creditworthiness of its financing counterparties, the health of the U.S. economy and residential and commercial mortgage-related markets, its outlook for the level, slope, and volatility of interest rates, the credit quality of collateral underlying the Company’s residential mortgage loans, non-Agency RMBS and other target assets, its outlook for asset spreads relative to the LIBOR curve and regulatory requirements limiting the permissible amount of leverage tohowever, be utilized. Based on market conditions, the Company has deployed, on a debt-to-equity basis, up to four to one leverage on its seasoned residential whole loans and up to three to one leverage on its non-Agency RMBS assets. Any leverage on newly originated loans may have been significantly greater than the leverage used on its seasoned loan portfolio depending on the characteristics of the newly originated loans. Additionally, to the extent the Company securitizes any residential mortgage loans in the future, it expects that the leverage obtained through such structures will vary considerably depending on the characteristics of the underlying loans.

The Company islimited or restricted in the amount of leverage itwe may employ by the terms and provisions of its existing borrowings as well asany financing or other financing agreements that itwe may enter into in the future. The Companyfuture, and we may also be subject to margin calls as a result of itsour financing activities. In addition, the Company intends to relyactivity. At December 31, 2017, we had a leverage ratio of 2.7x on short-term financing such as warehouse linesa total debt-to-equity basis, and a leverage ratio of credit, the duration of which may be less than 1 year, and repurchase transactions under master repurchase agreements, the duration of which may be 30 days for its securities repurchase agreements and 364 days for its Loan Repurchase Facilities.1.6x on a total recourse debt-to-equity ratio.

 

See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of this annual report on Form 10-K, for a discussion of the Company’s borrowings under the warehouse lines of credit and repurchase agreements, Loan Repurchase Facilities and securities repurchase agreements as of December 31, 2015 and the terms of the Exchangeable Senior Notes.HEDGING STRATEGY

 

The Company utilizes derivative financial instruments to hedge the interest rate risk associated with its borrowings. Subject to maintaining itsour qualification as a REIT, and exemption from registration as an investment company under the 1940 Act, the Companywe may also engage in a variety of interest rate management techniques that seek on one hand to mitigate the influence of interest rate changes on the values of some of its assets and on the other hand help the Company achieve its risk management objectives. The Company’s interest rate management techniques may include:use derivative financial instruments (or hedging instruments), including interest rate swap agreements, interest rate cap agreements, options on interest rate swaps, or

18


swaptions, financial futures, structured credit indices, and options in an effort to hedge the interest rate and credit spread risk associated with the financing of our portfolio. Specifically, we attempt to hedge our exposure to potential interest rate mismatches between the interest we earn on our assets and our borrowing costs caused by fluctuations in short-term interest rates, and we intend to hedge our SBC loan originations from the date the interest rate is locked until the loan is included in a securitization. We also use hedging instruments in connection with our residential mortgage loan origination platform in an attempt to offset some of the impact of prepayments on our loans. In particular, we use MBS forward sales exchange-traded derivativescontracts to manage the interest rate price risk associated with the interest rate lock commitments we make with potential borrowers.  In utilizing leverage and swaptions; putsinterest rate hedges, our objectives include, where desirable, locking in, on a long-term basis, a spread between the yield on our assets and calls on securities or indicesthe cost of securities; U.S. Departmentour financing in an effort to improve returns to our stockholders. We will undertake to hedge our originated loan inventory pending securitization with respect to changes in securitization liability cost resulting from both changes in benchmark treasuries and credit spreads. Hedges are periodically re-balanced to match expected duration of the Treasury securitiessecuritization and options on U.S. Departmentare closed at securitization issuance with the resulting gain or loss allocated to the retained basis in the securitization with the objective of protecting the Treasury securities; IOs and MSRs; and other similar transactions and financial instruments.yield for the aforementioned changes in securitization liabilities.

 

CORPORATE GOVERNANCE

 

The Company strivesWe strive to maintain an ethical workplace in which the highest standards of professional conduct are practiced.

 

The Company’s

·

Our board of directors is composed of a majority of independent directors. The Audit, Nominating and Corporate Governance and Compensation Committees of our board of directors are composed exclusively of independent directors.

 

8

·

In order to foster the highest standards of ethics and conduct in all business relationships, we have adopted a Code of Conduct and Ethics policy, which covers a wide range of business practices and procedures, that applies to our officers, directors, employees, if any, and independent contractors, to our Manager and our Manager’s officers and employees, and to any of our affiliates or affiliates of the Manager, and such affiliates’ officers and employees, who provide services to us or the Manager in respect of our Company. In addition, we have implemented Whistleblowing Procedures for Accounting and Auditing Matters and Code of Conduct and Ethics Violations (the “Whistleblower Policy”) that set forth procedures by which any Covered Persons (as defined in the Whistleblower Policy) may raise, on a confidential basis, concerns regarding, among other things, any questionable or unethical accounting, internal accounting controls or auditing matters and any potential violations of the Code of Conduct and Ethics with our Audit Committee or the Chief Compliance Officer.

In order to foster the highest standards of ethics and conduct in all business relationships, the Company has adopted a Code of Conduct and Ethics policy, which covers a wide range of business practices and procedures, that applies to its officers, directors, employees, if any, and independent contractors, to its Advisor and its Advisor’s officers and employees, to ZAIS and ZAIS’ officers and employees, and to any other affiliates of ZAIS or the Advisor, and such affiliates’ officers and employees, who provide services to the Company or the Advisor in respect of the Company. In addition, the Company has implemented Whistleblowing Procedures for Accounting and Auditing Matters and Code of Conduct and Ethics Violations (the “Whistleblower Policy”) that set forth procedures by which any Covered Persons (as defined in the Whistleblower Policy) may raise, on a confidential basis, concerns regarding, among other things, any questionable or unethical accounting, internal accounting controls or auditing matters and any potential violations of the Code of Conduct and Ethics with the Audit Committee of the Company or the Chief Compliance Officer of ZAIS. 

The Company has adopted an Insider Trading Policy for Trading in the Securities of the Company (the “Insider Trading Policy”), that governs the purchase or sale of the Company’s securities by any of directors, officers, and associates (as defined in the Insider Trading Policy) of the Company, if any, and independent contractors, as well as officers and employees of the Advisor and officers, employees and affiliates of ZAIS, and that prohibits any such persons from buying or selling the Company’s securities on the basis of material nonpublic information.

 

9

·

We have adopted an Insider Trading Policy for Trading in the Securities of our Company (the “Insider Trading Policy”), that governs the purchase or sale of our securities by any of our directors, officers, and associates (as defined in the Insider Trading Policy), if any, and independent contractors, as well as officers and employees of the Manager and our officers, employees and affiliates, and that prohibits any such persons from buying or selling our securities on the basis of material non-public information.

 

COMPETITION

 

The Company’s earnings depend, in large part, on its ability to originate or acquire assets at favorable spreads over its borrowing costsWe compete with numerous regional and its ability to efficiently manage its portfolio risks. In originating or acquiring its target assets and establishing hedge positions, the Company competes with other existing mortgage REITs (both internally and externally managed), mortgage finance and specialty financecommunity banks, specialty-finance companies, savings and loan associations banks, mortgage bankers, insurance companies, hedge funds (including those managed by ZAIS), ZAIS, to the extent that ZAIS holds assets directly on its own behalf or indirectly through one or more of its subsidiaries, affiliates or other newly formed entities, mutual funds, institutional investors, investment banking firms, governmental bodies and other companies with similar asset acquisition objectives. It is likelyentities, and we expect that the Company will also compete with other entities whichothers may be organized in the future. Some of the Company’s competitors may have greater financial resources and access to lower cost of capital. These competitors may not be subject to the same regulatory constraints (such as REIT compliance or maintaining an exemption under the 1940 Act) as the Company. The effect of the existence of additional REITs and other market participantsinstitutions may be to increaseincreased competition for the available supply of mortgageSBC and SBA assets suitable for purchase, which may cause the price for such assets to rise. Additionally, origination of SBC loans, SBA loans and residential agency loans by our competitors may increase the availability of these loans, which may result in a reduction of interest rates on these loans.

In the face of this competition, we expect to have access to our Manager’s professionals and their industry expertise, which may provide us with a competitive advantage in sourcing transactions and help it assess acquisition and origination risks and determine appropriate pricing for potential assets. Additionally, we believe that we are currently one of only a handful of active market participants in the secondary SBC loan market. Due to the special servicing expertise needed to effectively manage these assets, the small size of each loan, the uniqueness of the real properties that collateralize the loans and the need to bring residential mortgage credit analysis into the underwriting process, we expect a competitive demand for these assets to remain constrained. We seek to manage credit risk through our loan-level pre-origination or purchase,pre-acquisition due diligence and underwriting processes, which as well asof December 31, 2017 has limited the amount of financing availablerealized

19


losses. However, we may not be able to achieve our business goals or expectations due to the Company through warehouse lines of credit, repurchase agreementscompetitive risks that we face. For additional information concerning these competitive risks, see “Item 1A - Risk Factors – Risks Related to Our Business – New entrants in the market for SBC loan acquisitions and other financing arrangements.originations could adversely impact our ability to acquire SBC loans at attractive prices and originate SBC loans at attractive risk-adjusted returns.”

 

EMPLOYEES; STAFFING

 

The Company isWe are managed by the Advisor, a subsidiary of ZAIS, pursuant to an amended and restated investment advisory agreement between the Company and the Advisor, dated as of August 11, 2014, as amended from time to time (the “Investment Advisory Agreement”). The Company’s GMFS mortgage banking platform employed a total of 246 people as of December 31, 2015. The Company has no employees other than those employed in connection with its GMFS mortgage banking platform. ZAIS was established in 1997 and is an investment adviser registered with the SEC specializing in structured credit, including residential whole loans, RMBS and ABS. As of December 31, 2015, ZAIS had approximately $4.2 billion of assets under management (comprised primarily of (i) total assets for mark-to-market funds and separately managed accounts; (ii) uncalled capital commitments, if any, for funds that are not in liquidation; and (iii) for issued structured vehicles, all assets being managed calculated per the management fee basis methodology defined in the respective vehicles’ indenture, although in certain circumstances some or all of the referenced management fees may be waived.  Assets under management also includes assets in the warehouse phase for new structured credit vehicles and is based on actual assets managed without reductions for leverage and most other liabilities and includes all assets regardless of whether management fees are being earned. ZAIS possesses a comprehensive analytics and technology infrastructure, credit modeling, loan and securities valuation, loan data management and servicing oversight capabilities and significant structuring and securitization experience. As of December 31, 2015, ZAIS’ team included 95 professionals in the United States and London. ZAIS is the managing member of the Advisor and ZAIS and its employees support the Advisor in providing services to the CompanyWaterfall pursuant to the termsmanagement agreement with Waterfall. Frederick Herbst, who is employed by Waterfall and serves as our Chief Financial Officer, is dedicated exclusively to us, and seven of a shared facilities and servicesWaterfall’s accounting professionals are also dedicated primarily to us. Waterfall or we may in the future hire additional personnel that may be dedicated to our business. Waterfall is not, however, obligated under the management agreement between ZAIS andto dedicate any of its personnel exclusively to our business, nor is it or its personnel obligated to dedicate any specific portion of its or their time to our business. Accordingly, with the Advisor. The Company relies on the Advisor and ZAISexception of our Chief Financial Officer, our executive officers are not required to provide or obtain, on the Company’s behalf, the personnel and services necessarydevote any specific amount of time to our business. We are responsible for the Companycosts of our own employees. However, with the exception of our ReadyCap Commercial, ReadyCap Lending and GMFS subsidiaries, which will employ its own personnel, we do not expect to conduct its business.have our own employees.

 

10

Our corporate headquarters are located at 1140 Avenue of the Americas, 7th Floor, New York, NY 10036, and our telephone number is (212) 257-4600.

 

EXECUTIVE OFFICERS OF THE COMPANY

The Company is externally managed and advised by its Advisor, a subsidiary of ZAIS. The Company relies on its Advisor and ZAIS to provide or obtain, on its behalf, the personnel and services necessary for it to conduct its business because the Company has no employees of its own, other than those employed in connection with its GMFS mortgage banking platform. Pursuant to the terms of the Investment Advisory Agreement, the Advisor and its affiliates provide the Company with its management team, including its Chief Executive Officer, Chief Financial Officer, Chief Investment Officer and Chief Accounting Officer, along with appropriate support personnel. All of the Company’s officers and non-independent directors are also employees of ZAIS and its affiliates.

 

The following sets forth certain information with respect to the Company’sour executive officers:officers.

Name

Age

Position with the Company

Thomas E. Capasse

60

Chariman of the Company Board of Directors and Chief Executive Officer

Jack J. Ross

60

President and Director

Frederick C. Herbst

60

Chief Financial Officer

Tom Buttacavoli

40

Chief Investment Officer

Carole A. Mortensen

46

Chief Operating Officer

Set forth below is biographical information for our executive officers and other key personnel.

 

Michael Szymanski, 49, currentlyThomas E. Capasse is a Manager and co-founder of our Manager. Mr. Capasse also serves as Chairman of our board of directors and our Chief Executive Officer. Prior to founding Waterfall, Mr. Capasse managed the principal finance groups at Greenwich Capital from 1995 until 1997, Nomura Securities from 1997 until 2001, and Macquarie Securities from 2001 until 2004. Mr. Capasse has significant and long-standing experience in the securitization market as a founding member of Merrill Lynch’s ABS Group (1983 – 1994) with a focus on MBS transactions (including the initial Subprime Mortgage and Manufactured Housing ABS) and experience in many other ABS sectors. Mr. Capasse began his career as a fixed income analyst at Dean Witter and Bank of Boston. Mr. Capasse received a Bachelor of Arts degree in Economics from Bowdoin College in 1979.

Jack J. Ross is a Manager and co-founder of our Manager. Mr. Ross also serves as our President and as a member of our board of directors. Prior to founding Waterfall in January 2005, Mr. Ross was the founder of Licent Capital, a specialty broker/dealer for intellectual property securitization. From 1987 until 1999, Mr. Ross was employed by Merrill Lynch where he managed the real estate finance and ABS groups. Mr. Ross began his career at Drexel Burnham Lambert where he worked on several of the early ABS transactions and at Laventhol & Horwath where he served as a senior auditor. Mr. Ross received a Masters of Business Administration degree in Finance with distinction from the University of Pennsylvania’s Wharton School of Business in 1984 and a Bachelor of Science degree in Accounting, cum laude, from the State University of New York at Buffalo in 1978.

Frederick C. Herbst serves as a directorManaging Director of our Manager and as the Company’sour Chief Executive Officer and President. Mr. Szymanski currently serves as President of ZAIS and member of the ZAIS Management Committee, and as Chief Executive Officer of the Advisor and a member of the Advisor’s investment committee. Mr. Szymanski also serves as Chief Executive Officer, President and director of ZAIS Group Holdings, Inc. (“ZGH”), the parent company of ZAIS.Financial Officer. Prior to joining ZAIS,2009, Mr. Szymanski was Chief Executive Officer of XE Capital Management, LLC, an investment management firm specializing in structured products, from 2003 to 2008. Prior to that, Mr. SzymanskiHerbst was Chief Financial Officer of Zurich Capital Markets (“ZCM”)Clayton Holdings, Inc., a subsidiarypublicly traded provider of Zurich Financial Group, from 2000analytics and due diligence services to 2002. At ZCM, Mr. Szymanski managed global finance, accounting, tax, treasury, and risk management for a business specializingparticipants in structured products, including hedge fund linked derivatives and principal investments.the mortgage industry. Prior to that,Clayton Holdings, he was Chief Financial Officer of Arbor Realty Trust, Inc., a publicly traded real estate investment trust, from 2003 until 2005, and of Arbor Commercial Mortgage, LLC from 1999 until 2005. Prior to joining Arbor, Mr. SzymanskiHerbst was aChief Financial Officer of The Hurst Companies, Inc., Controller with The Long Island Savings Bank, FSB, Vice President in the Bank and Insurance Strategies GroupFinance with Eastern States Bankcard Association

20


and advisory services to financial institutions and corporations. Prior to that, Mr. Szymanski spent nine years at Ernst & Young LLP advising financial services clients, leaving as a Senior Manager with Ernst & Young. Mr. Herbst received a Bachelor of Arts degree in the Capital Markets/M&A Advisory GroupAccounting from Wittenberg University in New York.1979. Mr. Szymanski servedHerbst became a CPA in E&Y’s National Office-Financial Services Industries Group, providing internal consultation services1983.

Thomas Buttacavoli is a Manager, Managing Director and co-founder of our Manager. Mr. Buttacavoli serves as our Chief Investment Officer and Portfolio Manager of our SBC loan portfolio. Prior to resolve clients’ accounting and regulatory issues,joining Waterfall in 2005, Mr. Buttacavoli was a Structured Finance Analyst specializing in financial instruments.intellectual property securitization at Licent Capital. Prior to joining Licent Capital, he was a Strategic Planning Analyst at BNY Capital Markets. Mr. Szymanski isButtacavoli started his career as a CPA andFinancial Analyst within Merrill Lynch’s Partnership Finance Group. Mr. Buttacavoli received a B.A.Bachelor of Arts degree in Business Administration with a concentration in Accountancy from the University of Notre DameFinance and an Executive M.B.A. with a concentration in FinanceAccounting from New York University’s Stern School of Business.Business in 1999.

 

Donna Blank, 55, currentlyCarole A. Mortensen serves as the Company’sa Managing Director of our Manager and as our Chief Financial Officer and also serves as Chief Financial Officer at ZAIS and ZGH.Operating Officer. Prior to joining Waterfall in 2011, Ms. Mortensen held several positions within the Company,financial services industry including Ally Bank (GMAC ResCap), UBS Investment Bank, Credit Suisse and Moody's Investors Service. Ms. Blank served as the Executive Vice President and Chief Financial Officer of National Financial Partners from 2008 to 2013. From 2003 to 2008, Ms. Blank was the Chief Financial Officer of Financial Guaranty Insurance Company. Ms. BlankMortensen received a B.A.Bachelor of Arts degree in Political Science from theSeton Hall University of Michigan. She holds an MBA in Finance, and a Master in International Affairs, both from Columbia University.1992.

 

Christian M. Zugel, 55, founded ZAIS in 1997 and currently serves as the Chairman of the Company’s board of directors and its Chief Investment Officer. Mr. Zugel also serves as Chairman of the board of directors of ZGH and as Chief Investment Officer of ZGH. Prior to founding ZAIS Group, Mr. Zugel was a senior executive with J.P. Morgan Securities Inc., where he led J.P. Morgan’s entry into many new trading initiatives. At J.P. Morgan, Mr. Zugel also served on the Asia Pacific management-wide and firm-wide market risk committees. Mr. Zugel received a Masters in Economics from the University of Mannheim, Germany.

Nisha Motani, 44, currently serves as the Company’s Chief Accounting Officer and Chief Accounting Officer of ZGH. She also serves as and Director of Fund Reporting at ZAIS where she oversees annual audits, monthly net asset value reporting, quarterly and annual financial statement reporting, and informational requests from investors for all entities managed by ZAIS. Ms. Motani is also responsible for setting internal accounting policies and procedures, researching accounting issues, and serving as a direct liaison to the auditors and tax preparers for entities managed by ZAIS. Prior to joining ZAIS in October 2003, Ms. Motani worked as a senior manager in the Financial Services audit practice of Deloitte & Touche where she specialized in investment management. She is a CPA with a B.S. in Accounting from Rutgers School of Business.

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AVAILABLE INFORMATION

 

The Company maintainsWe maintain a website at www.zaisfinancial.comwww.sutherlandam.com and will make available, free of charge, on itsour website (a) itsour annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K (including any amendments thereto), proxy statements and other information (collectively, “Company Documents”) filed with, or furnished to, the SEC, as soon as reasonably practicable after such documents are so filed or furnished, (b) Corporate Governance Guidelines, (c) director independence standards,Director Independence Standards, (d) Code of Conduct and Ethics and (e) written charters of the Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee of the board of directors. Company Documents filed with, or furnished to, the SEC are also available for review and copying by the public at the SEC’s Public Reference Room at 100 F Street, NE., Washington, DC 20549 and at the SEC’s website at www.sec.gov. Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The Company providesWe provide copies of itsour Corporate Governance Guidelines and Code of Conduct and Ethics, free of charge, to stockholders who request such documents. Requests should be directed to Marilyn Meek, Financial Relations Board, an MWW CompanyJacques Cornet, ICR, Inc., at 304 Park685 Third Avenue, South, 8th2nd Floor, New York, New York 10010.NY 10017.

 

Item 1A. Risk Factors.Factors

 

The Company'sOur business and operations are subject to a number of risks and uncertainties, the occurrence of which could adversely affect itsour business, financial condition, consolidated results of operations and ability to make distributions to stockholders and could cause the value of the Company'sour capital stock to decline. Please refer to the section entitled "Forward-Looking“Forward-Looking Statements."

 

Risks RelatingRelated to the Company'sOur Business

IfWe anticipate that a significant portion of our investments will be in the Companyform of SBC loans that are subject to increased risks.

Our acquired non-performing loans represented in the aggregate 2.1% of the UPB and 1.3% of the carrying value, of our total loan portfolio as of December 31, 2017. As of December 31, 2017, our 345 non-performing loans had a current unpaid principal balance of $45.7 million and a carrying value of $26.9 million. We consider a loan to be performing if the borrower is current on 100% of the contractual payments due for principal and interest during the most recent 90 days. We consider a loan to be non-performing if the borrower does not meet the criteria of a performing loan. Non-performing SBC loans are subject to increased risks of credit loss for a variety of reasons, including, the underlying property is too highly-leveraged or the borrower has experienced financial distress. Whatever the reason, the borrower may be unable to consummatemeet its contractual debt service obligation to us or our subsidiaries. Non-performing SBC loans may require a strategic transaction, its financial conditionsubstantial amount of workout negotiations and/or restructuring, which may divert our attention from other activities and resultsentail, among other things, a substantial reduction in the interest rate or capitalization of operations may be adversely affected.

As described elsewhere in this annual report on Form 10-K, the Company has engaged a financial advisor to assist it in evaluating potential strategic alternatives to enhance stockholder value. The continuing strategic review includes the exploration of merger or sale transactions involving the Company or a liquidation of Company's assets. The Company and its financial advisor have engaged in preliminary discussions with several potential counterparties. While the Company is currently engaged in discussions with a potential counterparty about a potential merger or sale transaction, there is no assurancepast due interest. However, even if restructurings are successfully accomplished, risks still exist that the potential strategic alternativesborrowers will lead to a definitive merger or sale transaction, which would be subject to approval by the Company's board of directors and its stockholders. The Company does not intend to disclose further developments until the review is complete and the Company’s board of directors has taken action with respect to the strategic review.  If the Company is unable to consummate such a strategic transaction, or if there is any significant delay in closing such a transaction, the Company may not be able or willing to re-establish amaintain the restructured payments or refinance the restructured mortgage relatedupon maturity. Additional risks inherent in the acquisition of non-performing SBC loans include undisclosed claims, undisclosed tax liens that may have priority, higher legal costs and greater difficulties in determining the value of the underlying property.

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As of December 31, 2017 the average loan-to-value (“LTV”), of ReadyCap’s originated portfolio was 65%. The weighted LTV of our acquired loans was 63% as of December 31, 2017. If such SBC loans with higher LTV ratios become delinquent, we may experience greater credit losses compared to lower-leveraged properties. Additional risks inherent in its residential mortgage investments segment with equally attractive returnthe acquisition of delinquent SBC loans include undisclosed claims, undisclosed tax liens that may have priority, higher legal costs and credit risk characteristics and its financial condition and resultsgreater difficulties in determining the value of operations may be adversely affected.the underlying property.

 

The lack of liquidity in the Company'sof our assets may adversely affect its business.our business, including our ability to value and sell our assets.

 

A portion of the assets the Company owns, originatesSBC loans and ABS we own, acquire or acquiresoriginate may be subject to legal and other restrictions on resale or will otherwise be less liquid than publicly-traded securities. In light of the strategic review and in order to reduce current market risk in its investment portfolio, the Company has recently begun the process of selling its seasoned, re-performing mortgage loans from its residential mortgage investments segment. A sale of these assets is expected to be completed early in the second quarter of 2016. Additionally, as part of the strategic review, the Company has made the decision to cease the purchase of newly originated residential mortgage loans as part of its mortgage conduit program and will begin the unwinding of the Company’s mortgage conduit business. The illiquidity of the Company'sour assets may make it difficult for itus to sell such assets.assets if the need or desire arises. In addition, if the Company iswe are required to liquidate its remainingall or a portion of our portfolio quickly, itwe may realize significantly less value than the value at which it haswe have previously recorded itsour assets. As a result, the Company'sour ability to vary itsour portfolio in response to changes in economic and other conditions may be relatively limited, which could adversely affect our results of operations and financial condition.

Waterfall’s due diligence of potential SBC loans and ABS assets may not reveal all of the liabilities associated with such SBC loans and ABS assets and may not reveal the other combined weaknesses in such SBC loans and ABS assets, which could lead to investment losses.

Before making an investment, Waterfall calculates the level of risk associated with the SBC loan to be acquired or originated based on several factors which include the following: a complete review of seller’s data files, including data integrity, compliance review and custodial file review; rent rolls and other property operating data; personal credit reports of the borrower and owner and/or operator; property valuation review; environmental review; and tax and title search. In making the assessment and otherwise conducting customary due diligence, we will employ standard documentation requirements and require appraisals prepared by local independent third party appraisers it selects. Additionally, we will seek to have sellers provide representations and warranties on SBC loans we acquire, and if we are unable to obtain representations and warranties, we will factor the increased risk into the price we pay for such loans. Despite our review process, there can be no assurance that our due diligence process will uncover all relevant facts or that any investment will be successful.

If Waterfall underestimates the credit analysis and the expected risk adjusted return relative to other comparable investment opportunities, we may experience losses.

Waterfall expects to value our SBC and SBC ABS investments based on an initial credit analysis and the investment’s expected risk adjusted return relative to other comparable investment opportunities available to us, taking into account estimated future losses on the mortgage loans, and the estimated impact of these losses on expected future cash flows. Waterfall’s loss estimates may not prove accurate, as actual results may vary from estimates. In the event that Waterfall underestimates the losses relative to the price we pay for a particular SBC or SBC ABS investment, we may experience losses with respect to such investment.

The failure of a third-party servicer or the failure of our own internal servicing system to effectively service our portfolio of mortgage loans would materially and adversely affect us.

Most mortgage loans and securitizations of mortgage loans require a servicer to manage collections for each of the underlying loans. We will service our loan portfolio under a “component servicing” model (which includes the use of primary servicing by nationally recognized servicers and sub-servicing by participants in our Qualified Partner Program (“QPP”), who specialize in assets for the particular region in which the asset sits), which allows for highly customized loss mitigation strategies for non-performing and performing loans. Performing SBC loans (either loans purchased with historical activity, i.e., not originated, purchased in the secondary market or ReadyCap originations) will be securitized with us retaining the subordinate tranches. KeyBank Real Estate Capital, performs both primary and special servicing with all loss mitigation decisions directed by Waterfall (which also maintains an option to purchase delinquent loans from the securitization trust). Non-performing SBC loans are serviced either through an approved SBC primary servicer providing both primary and special servicing or providing only primary servicing with special servicing contracted to smaller regionally focused SBC operators and servicers who gain eligibility to participate in its consolidatedQPP. Servicers’ responsibilities include providing collection activities, loan workouts, modifications and refinancings, foreclosures, short sales, sales of foreclosed real estate and financings to facilitate such sales. Both default frequency and default severity of loans may depend upon the quality of the servicer. If a servicer is not vigilant in encouraging the borrowers to make their monthly

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payments, the borrowers may be far less likely to make these payments, which could result in a higher frequency of default. If a servicer takes longer to liquidate non-performing assets, loss severities may be higher than originally anticipated. Higher loss severity may also be caused by less competent dispositions of real estate owned (“REO”), properties.

We will seek to increase the value of non-performing loans through special servicing activities that will be performed by our participating special servicers. Servicer quality is of prime importance in the default performance of SBC loans and SBC ABS. Many servicers have gone out of business in recent years, requiring a transfer of loan servicing to another servicer. Should we have to transfer loan servicing to another servicer, the transfer of loans to a new servicer could result in more loans becoming delinquent because of confusion or lack of attention. Servicing transfers involve notifying borrowers to remit payments to the new servicer, and these transfers could result in misdirected notices, misapplied payments, data input errors and other problems. Industry experience indicates that mortgage loan delinquencies and defaults are likely to temporarily increase during the transition to a new servicer and immediately following the servicing transfer. Further, when loan servicing is transferred, loan servicing fees may increase, which may have an adverse effect on the credit support of assets held by us.

Effectively servicing our portfolio of SBC loans is critical to our success, particularly given our strategy of maximizing the value of our portfolio with our loan modifications, loss mitigation, restructuring and other special servicing activities, and therefore, if one of our servicers fails to effectively service the portfolio of mortgage loans, it could have a material and adverse effect on our business, results of operations and financial condition.

 

The Company operatesbankruptcy of a third-party servicer would adversely affect our business, results of operation and financial condition.

Depending on the provisions of the agreement with the servicer of any of our SBC loans, the servicer may be allowed to commingle collections on the mortgage loans owned by us with its own funds for certain periods of time (usually a few business days) after the servicer receives them. In the event of a bankruptcy of a servicer, we may not have a perfected interest in any collections on the mortgage loans owned by us that are in that servicer’s possession at the time of the commencement of the bankruptcy case. The servicer may not be required to turn over to us any collections on mortgage loans that are in its possession at the time it goes into bankruptcy. To the extent that a servicer has commingled collections on mortgage loans with its own funds, we may be required to return to that servicer as preferential transfers all payments received on the mortgage loans during a period of up to one year prior to that servicer’s bankruptcy.

If a servicer were to go into bankruptcy, it may stop performing its servicing functions (including any obligations to advance moneys in respect of a mortgage loan) and it may be difficult to find a third party to act as that servicer’s successor. Alternatively, the servicer may take the position that unless the amount of its compensation is increased or the terms of its servicing obligations are otherwise altered it will stop performing its obligations as servicer. If it were to be difficult to find a third party to succeed the servicer, we may have no choice but to agree to a servicer’s demands. The servicer may also have the power, with the approval of the bankruptcy court, to assign its rights and obligations to a third party without our consent, and even over its objections, and without complying with the terms of the applicable servicing agreement. The automatic stay provisions of Title 11 of the United States Code (the “Bankruptcy Code”), would prevent (unless the permission of the bankruptcy court were obtained) any action by us to enforce the servicer’s obligations under its servicing agreement or to collect any amount owed to us by the servicer. The Bankruptcy Code also prevents the removal of the servicer as servicer and the appointment of a successor without the permission of the bankruptcy court or the consent of the servicer.

Any costs or delays involved in the completion of a foreclosure or liquidation of the underlying property may further reduce proceeds from the property and may increase the loss.

In the future, it is possible that we may find it necessary or desirable to foreclose on some, if not many, of the SBC loans we acquire, and the foreclosure process may be lengthy and expensive. Borrowers may resist mortgage foreclosure actions by asserting numerous claims, counterclaims and defenses against us including, without limitation, numerous lender liability claims and defenses, even when such assertions may have no basis in fact, in an effort to prolong the foreclosure action and force us into a modification of the SBC loan or a favorable buy-out of the borrower’s position. In some states, foreclosure actions can sometimes take several years or more to litigate. At any time prior to or during the foreclosure proceedings, the borrower may file for bankruptcy, which would have the effect of staying the foreclosure actions and further delaying the foreclosure process. Foreclosure may create a negative public perception of the related mortgaged property, resulting in a highly competitive market for investment opportunities and competition may limit its ability to originate or acquire desirable investmentsdecrease in its target assetsvalue. Even if we are successful in foreclosing on a SBC loan, the

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liquidation proceeds upon sale of the underlying real estate may not be sufficient to recover its cost basis in the SBC loan, resulting in a loss to us. Furthermore, any costs or delays involved in the completion of a foreclosure of the SBC loan or a liquidation of the underlying property will further reduce the proceeds and thus increase the loss. Any such reductions could alsomaterially and adversely affect the pricingvalue of these assets.the commercial SBC loans in which we invests and, therefore, could have a material and adverse effect on our business, results of operations and financial condition.

Inaccurate and/or incomplete information received in connection with our due diligence and underwriting process could have a negative impact on our financial condition and results of operation.

Our credit and underwriting philosophy for both acquired and originated SBC loans will encompass individual borrower and property diligence, taking into consideration several factors, including (i) the seller’s data files, including data integrity, compliance review and custodial file review; (ii) rent rolls and other property operating data; (iii) personal credit reports of the borrower, owner and/or operator; (iv) property valuations; (v) environmental reviews; and (vi) tax and title searches. We will also ask sellers to provide representations and warranties on SBC loans we acquire, and if we are unable to obtain representations and warranties, we will factor the increased risk into the price we pay for such loans. Our financial condition and results of operations could be negatively impacted to the extent we rely on information that is misleading, inaccurate or incomplete.

 

The Company operates in a highly competitive market for investment opportunities. The Company's profitability depends, in large part, on its ability to originate or acquire its target assets at attractive prices. In originating or acquiring its target assets, the Company will compete with a varietyuse of institutional investors, including other REITs, specialty finance companies, public and private funds (including other funds managed by ZAIS), ZAIS, to the extent that ZAIS holds assets directly on its own behalf or indirectly through one or more of its subsidiaries, affiliates or other newly formed entities, commercial and investment banks, commercial finance and insurance companies and other financial institutions. Many of the Company's competitors are substantially larger and have considerably greater financial, technical, marketing and other resources compared to the Company. Some competitors may have a lower cost of funds and access to funding sources that may not be available to the Company. Many of the Company's competitors are not subject to the operating constraints associated with REIT tax compliance or maintenance of an exemption from the 1940 Act. In addition, some of the Company's competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships than the Company. Furthermore, competition for investmentsunderwriting guideline exceptions in the Company's target assetsSBC loan origination process may lead to the price of such assets increasing, which may further limit the Company's ability to generate desired returns. The Company cannot provide assurance that the competitive pressures it faces will not have a material adverse effect on its business, financial conditionresult in increased delinquencies and consolidated results of operations. Also, as a result of this competition, desirable investmentsdefaults.

Although SBC loan originators generally underwrite mortgage loans in the Company's target assets may be limited in the future and the Company may not be able to take advantage of attractive investment opportunitiesaccordance with their pre-determined loan underwriting guidelines, from time to time asand in the ordinary course of business, originators, including the Company, can provide no assurancewill make exceptions to these guidelines. On a case-by-case basis, our underwriters may determine that it will be able to identifya prospective borrower that does not strictly qualify under our underwriting guidelines warrants an underwriting exception, based upon compensating factors. Compensating factors may include a lower LTV ratio, a higher debt coverage ratio, experience as a real estate owner or investor, borrower net worth or liquidity, stable employment, longer length of time in business and make investments that are consistentlength of time owning the property. Loans originated with its investment objectives.

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The Company is highly dependent on information systemsexceptions may result in a higher number of delinquencies and communication systems; systems failures and other operational disruptions could significantly affect its business, which may, in turn, negatively affect its operating results and its ability to pay dividends to its stockholders.

The Company's business is highly dependent on the communications and information systems of ZAIS and GMFS, which may interface with or depend on systems operated by third parties, including market counterparties, loan originators and other service providers. Any failure or interruption of these systems could cause delays or other problems in the Company's activities, including in its target asset origination or acquisition activities,defaults, which could have a material and adverse effect on our business, results of operations and financial condition.

Deficiencies in appraisal quality in the Company's operatingmortgage loan origination and acquisition process may result in increased principal loss severity.

During the mortgage loan underwriting process, appraisals are generally obtained on the collateral underlying each prospective mortgage. The quality of these appraisals may vary widely in accuracy and consistency. The appraiser may feel pressure from the broker or lender to provide an appraisal in the amount necessary to enable the originator to make the loan, whether or not the value of the property justifies such an appraised value. Inaccurate or inflated appraisals may result in an increase in the severity of losses on the mortgage loans, which could have a material and adverse effect on our business, results of operations and negativelyfinancial condition.

We may be exposed to environmental liabilities with respect to properties to which we take title, which may in turn decrease the value of the underlying properties.

In the course of our business, we may take title to real estate, and, if we do take title, we could be subject to environmental liabilities with respect to these properties. In such a circumstance, we may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or we may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity, and results of operations could be materially and adversely affected. In addition, an owner or operator of real property may become liable under various federal, state and local laws, for the costs of removal of certain hazardous substances released on its property. Such laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the release of such hazardous substances. The presence of hazardous substances may adversely affect an owner’s ability to sell real estate or borrow using real estate as collateral. To the extent that an owner of an underlying property becomes liable for removal costs, the ability of the owner to make debt payments may be reduced, which in turn may adversely affect the value of its common stock and its ability to pay dividends to its stockholders.the relevant mortgage-related assets held by us.

 

Additionally, the Company relies heavily on financial, accounting and other data processing systems and operational risks arising from mistakes made in the confirmation or settlement

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Cybersecurity risk and cyber incidents may adversely affect the Company's business by causing a disruption to its operations, a compromise or corruption of its confidential information and/or damage to its business relationships, all of which could negatively impact its financial results.

A cyber incident is considered to be any adverse event that threatens the confidentiality, integrity or availability of the Company's information resources. These incidents may be an intentional attack or an unintentional event and could involve gaining unauthorized access to the Company's information systems for purposes of misappropriating assets, stealing confidential information, corrupting data or causing operational disruption. The result of these incidents may include disrupted operations, misstated or unreliable financial data, liability for stolen assets or information, increased cybersecurity protection and insurance cost, litigation and damage to the Company's investor relationships. As the Company's reliance on technology has increased, so have the risks posed to both its information systems, both internal and those provided by ZAIS, the Advisor and third-party service providers. ZAIS has implemented processes, procedures and internal controls to help mitigate cybersecurity risks and cyber intrusions, but these measures, as well as the Company's increased awareness of the nature and extent of a risk of a cyber incident, do not guarantee that the Company's financial results, operations or confidential information will not be negatively impacted by such an incident.

The AdvisorWaterfall will utilize analytical models and data in connection with the valuation of the Company'sour SBC loans and securities,SBC ABS, and any incorrect, misleading or incomplete information used in connection therewith would subject the Companyus to potential risks.

 

Given the complexityAs part of the Company's investment strategies, the Advisor must rely heavily on analytical models (bothrisk management process Waterfall intends to use detailed proprietary models, developedincluding loan-level non-performing loan models, to evaluate collateral liquidation timelines and price changes by ZAIS and those supplied by third parties) andregion, along with the impact of different loss mitigation plans. Additionally, Waterfall intends to use information, models and data supplied by third parties. Models and data will be used to value origination opportunities and potential target assets and also in connection with hedging the Company's acquisitions.assets. In the event models and data prove to be incorrect, misleading or incomplete, any decisions made in reliance thereon expose the Companyus to potential risks. For example, by relying on incorrect models and data, especially valuation models, the AdvisorWaterfall may be induced to buy certain target assets at prices that are too high, to sell certain other assets at prices that are too low, or to miss favorable opportunities altogether. Similarly, any hedging based on faulty models and data may prove to be unsuccessful.

 

Any disruption in the availability and/or functionality of our technology infrastructure and systems and any failure of our security measures related to these systems could adversely impact our business.

Our ability to acquire and originate SBC loans and manage any related interest rate risks and credit risks is critical to our success and is highly dependent upon the efficient and uninterrupted operation of our computer and communications hardware and software systems. For example, we will rely on our proprietary database to track and maintain all loan performance and servicing activity data for loans in our portfolio. This data is used to manage the portfolio, track loan performance, develop and execute asset disposition strategies. In addition, this data is used to evaluate and price new investment opportunities. Some of these systems will be located at our facility and some will be maintained by third party vendors. Any significant interruption in the availability and functionality of these systems could harm our business. In the event of a systems failure or interruption by our third party vendors, we will have limited ability to affect the timing and success of systems restoration. If such interruptions continue for a prolonged period of time, it could have a material and adverse impact on our business, results of operations and financial condition.

Our security measures may not effectively prohibit others from obtaining improper access to our information. If a person is able to circumvent our security measures, he or she could destroy or misappropriate valuable information or disrupt our operations. Any security breach could expose us to risks of data loss, litigation and liability and could seriously disrupt our operations and harm our reputation.

Difficult conditions in the mortgage, residential and commercial real estate markets the financial markets and the economy generally may cause the Companyus to experience market losses related to itsour holdings, and there is no assurance that these conditions will improve in the near future.

 

The Company's consolidatedOur results of operations are materially affected by conditions in the mortgage market, the residential and commercial real estate markets, the financial markets and the economy generally. TheContinuing concerns about the mortgage market and a declining real estate market, as well as inflation, energy costs, geopolitical issues, unemployment and the availability and cost of credit, have contributed to increased volatility and diminished expectations for the economy and markets going forward. In particular, the U.S. mortgage market has been severely affected by changes in the lending landscape and has experienced defaults, credit losses and significant liquidity concerns, and there is no assurance that these conditions have fully stabilized or that they will not worsen. DisruptionThis is especially true in the SBC loan sector. Disruptions in mortgage marketmarkets negatively impactsimpact new demand for homes and home price performance. There is a strong inverse correlation between home price growth rates and mortgage loan delinquencies.real estate. A deterioration of the RMBS marketSBC or SBC ABS markets may cause the Companyus to experience losses related to itsour assets and to sell assets at a loss. DeclinesOur profitability may be materially adversely affected if we are unable to obtain cost effective financing. A continuation or increase in the volatility and deterioration in the SBC and SBC ABS markets as well as the broader financial markets may adversely affect the performance and fair market values of the Company's residential mortgage loans or RMBSour SBC loan and SBC ABS assets and may adversely affect its consolidatedour results of operations and credit availability, which may reduce earnings and, in turn, cash available for distribution to itsour stockholders.

 

Dramatic declinesNew entrants in the residentialmarket for SBC loan acquisitions and commercial real estate markets duringoriginations could adversely impact our ability to acquire SBC loans at attractive prices and originate SBC loans at attractive risk-adjusted returns.

Although we believe that we are currently one of only a handful of active market participants in the financial crisis resultedsecondary SBC loan market, new entrants in significant asset write-downs by financial institutions, which caused many financial institutionsthis market could adversely impact our ability to seekacquire and originate SBC loans at attractive prices. In acquiring and originating our target assets, we may compete with numerous regional and community banks, specialty finance companies, savings and loan associations, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, other lenders and other entities, and we expect that others may be organized in the future. The effect of the existence of additional capital, to merge withREITs and other institutions and, in some cases, to fail. Institutions from which the Company may seek to obtain financing may have owned or financed residential or commercial mortgage loans, real estate-related securities and real estate loans, which declined in value and caused them to suffer losses during the financial crisis. Many lenders and institutional investors reduced and, in some cases, ceased to provide funding to borrowers, including other financial institutions. If these conditions exist, these institutions may become insolvent or tighten their lending standards, which could make it more difficult be increased competition

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for the Companyavailable supply of SBC assets suitable for purchase, which may cause the price for such assets to obtain financing on favorable terms or at all.

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The Company's profitabilityrise, which may be adversely affected iflimit our ability to generate desired returns. Additionally, origination of SBC loans by our competitors may increase the Company is unable to obtain cost-effective financing for its assets. These consequences could be exacerbated in the eventavailability of potential future credit rating downgrades of the U.S. and certain European countries and the failure to resolve issues related to the "fiscal cliff" and the U.S. debt ceiling,SBC loans which could create broader financial and global banking turmoil and lead to a significant rise in interest rates and a decrease in the fair market value of the Company's assets.

The diminished level of Agency participation in, and other changes in the role of the Agencies in, the mortgage market may adversely affect the Company's business.

If Agency participation in the mortgage market were reduced or eliminated, or their structures were to change radically (i.e., limitation or removal of the guarantee obligation), or their market share reduced because of required price increases or lower limits on the loans they can guarantee, the Company could be unable to acquire Agency RMBS or unable to originate Agency and government guaranteed mortgage loans on attractive terms or at all. The Company could be negatively affected in a number of ways depending on the manner in which related events unfold for Fannie Mae, Freddie Mac and other such agencies. GMFS, its mortgage banking platform, is an approved Fannie Mae Seller-Servicer, Freddie Mac Seller-Servicer, Ginnie Mae issuer, Department of Housing and Urban Development ("HUD") / Federal Housing Administration ("FHA") Mortgagee, U.S. Department of Agriculture ("USDA") approved originator and U.S. Department of Veterans Affairs ("VA") Lender, and any diminished participation by the Agencies may result in GMFS becoming unablea reduction of interest rates on SBC loans. Some competitors may have a lower cost of funds and access to sell its originated mortgage loansfunding sources that may not be available to us. Many of our competitors are not subject to the Agencies on attractive termsoperating constraints associated with REIT tax compliance or at all. Additionally, althoughmaintenance of an exemption from the Company does not own any Agency RMBS as1940 Act. In addition, some of December 31, 2015, itour competitors may rely on Agency RMBS it may acquire (as well as residential mortgagehave higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of SBC loans and non Agency RMBSABS assets and establish more relationships than us.

We cannot assure you that the competitive pressures we may face will not have a material adverse effect on our business, financial condition and results of operations. Also, as a result of this competition, desirable investments in our target assets may be limited in the future and we may not be able to take advantage of attractive investment opportunities from time to time, as we can provide no assurance that it owns) as collateral for its financings under securities repurchase agreements. Any decline inwill be able to identify and make investments that are consistent with our investment objectives.

We cannot predict the valueunintended consequences and market distortions that may stem from far-ranging regulatory reform of Agency RMBS, or perceived market uncertainty about their value or their structures, would make it more difficult for the Companyoversight of financial markets.

In response to obtain financing on acceptable terms or at all. Further, the current support providedfinancial issues affecting the banking system and financial markets and ongoing concerns of, and threats to, commercial banks, investment banks and other financial institutions, the Emergency Economic Stabilization Act (“EESA”), was enacted by the U.S. TreasuryCongress in 2008. There can be no assurance that the EESA or any other U.S. Government actions will have a beneficial impact on the financial markets. To the extent the markets do not respond favorably to Fannie Mae and Freddie Mac, and any additional support it may provide in the future, could have the effect of lowering the interest rates the Company expects to receive from Agency RMBS it may acquire, thereby tightening the spread between the interest the Company may earn on Agency RMBS and the cost of financing such assets. A reduction in the supply of Agency RMBS could also negatively affect the pricing of Agency RMBSactions by reducing the spread between the interest the Company may earn on an investment portfolio of Agency RMBS and its cost of financing such a portfolio. Future legislation could further change the relationship between Fannie Mae and Freddie Mac and the U.S. Government and could also nationalize, privatize, or eliminate such entities entirely In March 2013, the Federal Housing Finance Agency announced that it would establish a new institutional body, which later became knownactions do not function as the Federal Mortgage Insurance Corporation (the "FMIC"), to replace Fannie Mae and Freddie Mac once they wind down operations. In 2013 and 2014, members of Congress proposed draft bills that would phase out Fannie Mae and Freddie Mac over a specified period of time, including one proposal where the FMIC would be modeled after the Federal Deposit Insurance Corporation (the "FDIC") and provide catastrophic reinsurance in the secondary market for MBS, and also take over multi-family guarantees. While prospects for passage are uncertain, these legislative measures underscore the potential for change to the Agencies. Any law affecting these Agencies may create market uncertainty and have the effect of reducing the actual or perceived credit quality of RMBS and may make it more expensive for GMFS to originate Agency related mortgage loans or impact its ability to sell its originated mortgage loans to the Agencies on attractive terms or at all. As a result, such laws could increase the risk of loss on RMBS the Company may acquire and loans GMFS originates. It also is possible that such laws could adversely impact the market for such securities and loans and spreads at which they trade. All of the foregoing could materially and adversely affect the Company's financial condition and consolidated results of operations.

Actions of the U.S. Government, including the U.S. Congress, Federal Reserve, U.S. Treasury and other governmental and regulatory bodies, including the SEC, to stabilize or reform the financial marketsintended, our business may not achievereceive the intended effectanticipated positive impact from the legislation and such result may adversely affect the Company's business.have broad adverse market implications.

 

In July 2010, the U.S. Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act which includes extensive changes(the “Dodd-Frank Act”) in part to the laws regulatingimpose significant investment restrictions and capital requirements on banking entities and other organizations that are significant to U.S. financial services firm. Among other things,markets. For instance, the Dodd-Frank Act imposeshas imposed significant restrictions on the proprietary trading activities of certain banking entities and has subjected other systemically significant organizations regulated by the U.S. Federal Reserve to increased capital requirements and quantitative limits for engaging in such activities. The new law includes significant changesDodd-Frank Act also seeks to reform the regulationasset-backed securitization market (including the MBS market) by requiring the retention of financial institutions includinga portion of the creationcredit risk inherent in the pool of (1) the CFPB within the Federal Reserve to regulate consumer financial servicessecuritized assets and productsby imposing additional registration and (2) the Financial Stability Oversight Council to identify, monitor and address emerging systemic risks posed by the activities of financial services firms and make recommendations to the Federal Reserve to alleviate those risks. The CFPB has sole rulemaking and interpretive authority under existing and future consumer financial services laws and supervisory, examination and enforcement authority over institutions subject to its jurisdiction.disclosure requirements. The Dodd-Frank Act also provides for enhanced regulation of derivativesimposes significant regulatory restrictions on the origination and securitization transactions (includingof commercial mortgage loans. Also, the addition of risk retention requirements, third-party due diligence disclosure requirements, expanded asset-level data requirementsSEC has proposed significant changes to Regulation AB, which, if adopted in their present form, could have sweeping changes to commercial and new standards relatingresidential mortgage loan securitization markets as well as to eligibility of securities as "mortgage-related securities" under the Exchange Act), restrictions on executive compensation and enhanced oversight of credit rating agencies. In addition, the Dodd-Frank Act providesmarket for the eliminationre-securitization of prepayment penalties for mortgage loans and expanded consumer protection in respect of high-cost loans. In many cases the provisions of the statute will take effect only after regulations are adopted by the applicable Federal agencies.

MBS. The Dodd-Frank Act also prohibits lenders from originating residential mortgage loans unlesscreated a new regulator, the lender determines that the borrower has a reasonable ability to repay the loan. Under the Dodd-Frank Act, a lender and its assignees will not have liability under this prohibition with respect to any "qualified mortgage." The CFPB has issued a final rule amending Regulation Z promulgated under the Federal Truth-in-Lending Act (“TILA”Consumer Financial Protection Bureau (the “CFPB”), which became effective on January 10, 2014, specifying the ability-to-repay requirements and the characteristics of a qualified mortgage (the "ATR/Qualified Mortgage Rule"). Interest-only loans, hybrid mortgage loans and certain balloon loans, as well as loans with a debt-to-income ratio exceeding 43%, will not meet the requirements for a qualified mortgage. With respect to qualified mortgages, the ATR/Qualified Mortgage Rule provides a safe harbor from liability if certain requirements are satisfied, or a rebuttable presumption from such liability if only certain of these requirements are satisfied. To the extent that a mortgage loan originated by the Company does not satisfy the requirements of a "qualified mortgage" under either set of requirements, the Company and its assignees could be liable for actual damages suffered by the borrower, litigation costs, statutory damages and special statutory damages. Various state and local legislatures may adopt similar or more onerous provisions in the future.

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Oneoversees many of the CFPB's areas of focus has been on whethercore laws which regulate the mortgage originators take appropriate steps to ensure that business arrangements with service providers do not present risks to consumers. The sub-servicer the Company may retain to directly service residential mortgage loans (when the Company owns the associated MSRs) is one of the Company's most significant service providers with respect to the Company's residential mortgage loan business and the Company's failure to take steps to ensure that this sub-servicer is servicing these residential mortgage loans in accordance with applicable law and regulation could result in enforcement action by the CFPB against the Company that could restrict the Company's business and expose it to penalties or other claims. The Company generally uses a small number of sub-servicers on its residential whole loan portfolio and, as a result, the risks associated with the Company's use of sub-servicers are concentrated around a small number of sub-servicer counterparties. On January 17, 2013, the CFPB promulgated final rules implementing the Dodd-Frank Act's amendments to TILA andindustry, including the Real Estate Settlement Procedures Act (“RESPA”) (the "Servicing Rules"), which became effective on January 10, 2014. The Servicing Rules are part of a broader effort to establish minimum national standards for mortgage servicing. Among other things, the Servicing Rules incorporate many of the provisions of a settlement reached by federal regulators and state attorneys general representing 49 states and five large mortgage servicers in 2012, target early intervention with borrowers following initial delinquency and impose detailed requirements applicable in each step of a servicer's loss mitigation process. In particular, the Servicing Rules restrict so-called "dual tracking," in which a servicer simultaneously evaluates a mortgagor for a loan modification or other loss mitigation alternatives at the same time that it prepares to foreclose on the mortgaged property. In addition, the State of California recently enacted the Homeowner's Bill of Rights, which requires similar changes in delinquent loan servicing and foreclosure procedures and creates a private right of action permitting borrowers to bring legal actions against lenders that violate the law. The Servicing Rules and the similar state regulations therefore could resultTruth in increased delays in foreclosure orLending Act. While the inability to foreclose, which could in turn result in losses with respect to the Company's residential whole loan portfolio.

In October 2014, the FDIC, the Federal Housing Finance Agency, the Office of the Comptroller of the Currency (the "OCC"), the SEC, the Federal Reserve and the HUD adopted a final rule implementing the credit risk retention requirements of Section 941full impact of the Dodd-Frank Act for asset-backed securities (the "Risk Retention Rules"). As required byand the role of the CFPB cannot be assessed until all implementing regulations are released, the Dodd-Frank Act, the Risk Retention Rules generally require "securitizers" to retain not less than 5% of the credit risk of the mortgage loans securitized (the "Required Risk") for a certain period of time (not to exceed seven years). The Risk Retention Rules prohibit hedging Required Risk if payments on the hedge instrument are materially related to the Required Risk and the hedge position would limit the financial exposure of the securitizer to the Required Risk. A securitizer may not pledge its interest in any Required Risk as collateral for any financing unless such financing is full recourse to the securitizer. However, the Risk Retention Rules do not apply to RMBS backed solely by qualified mortgages. The Risk Retention Rules applicable to RMBS became effective on December 24, 2015, and to the extent that the Company sponsors a securitization of non-qualified mortgages after such date, the Company will be required to comply with the Risk Retention Rules, which could subject the Company to losses in respect of the related RMBS. The Company would be subject to various enforcement options by the regulators for the failure to comply with the Risk Retention Rules.

In addition to the ATR/Qualified Mortgage Rule and the servicing rules described above, the Company cannot predict what actions, if any, that the CFPB will take in the mortgage markets, nor what the impact of such actions will be on the mortgage markets or the Company's results of operations, financial condition and business. In addition to the foregoing, the U.S. Government, Federal Reserve, U.S. Department of the Treasury and other governmental and regulatory bodies such as the Financial Stability Oversight Council, a panel comprising top U.S. financial regulators, may scrutinize or seek to implement changes to regulation which could in recent years negatively impact mortgage REITs, such as the Company. For example, in recent years, a number of local governmental authorities have considered eminent domain as one of several potential alternatives to help resolve housing finance challenges. This type of legislation and action could have a severe negative impact on the mortgage markets and may introduce risks that are difficult, if not impossible, to quantify. There is no certainty as to whether any governmental bodies will take steps to acquire any mortgage loans under such programs, or ultimately pass other legislation that will affect the mortgage markets. Such eminent domain programs would authorize governmental authorities to acquire certain mortgage loans by voluntary purchase or eminent domain and to modify those mortgage loans to allow homeowners to continue to own and occupy their homes, irrespective of whether the mortgage loans are actually in default or foreclosure. No such eminent domain programs have become operational, but there can be no assurance that jurisdictions will not take steps to acquire mortgage loans under an eminent domain program (or other programs or initiatives) in the future and what purchase price would be paid for any such mortgage loans.

The Dodd-Frank Act'sAct’s extensive requirements may have a significant effect on the financial markets, and may affect the availability or terms of financing from the Company'sour lender counterparties and the availability or terms of residential mortgageSBC loans and RMBS,MBS, both of which may have an adverse effect on the Company'sour financial condition and consolidated results of operations.

 

In addition, the U.S. Government, Federal Reserve, U.S. Treasury, the SEC and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis that began in 2007. The CompanyWe cannot predict whether or when such actions may occur or what effect, if any, such actions could have on itsour business, consolidated results of operations and financial condition. In addition, because the programs are designed, in part, to provide liquidity to restart the market for certain of our targeted assets, the establishment of these programs may result in increased competition for opportunities in its targeted assets. It is also possible that our competitors may utilize the programs which would provide them with debt and equity capital funding from the U.S. government.

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The elimination or reductionincreasing number of the mortgage-interest tax deductionproposed United States federal, state and local laws may affect certain mortgage-related assets in which we intend to invest and could negatively affect the U.S. housing marketmaterially increase our cost of doing business.

 

Various tax reform proposals continuebankruptcy legislation has been proposed that, among other provisions, could allow judges to circulatemodify the terms of residential mortgages in Congress, somebankruptcy proceedings, could hinder the ability of the servicer to foreclose promptly on defaulted mortgage loans or permit limited assignee liability for certain violations in the mortgage loan origination process, any or all of which could adversely affect our business or result in us being held responsible for violations in the mortgage

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loan origination process even where we were not the originators of the loan. We do not know what impact this type of legislation, which has been primarily, if not entirely, focused on residential mortgage originations, would changehave on the mannerSBC loan market. We are unable to predict whether United States federal, state or local authorities, or other pertinent bodies, will enact legislation, laws, rules, regulations, handbooks, guidelines or similar provisions that will affect our business or require changes in our practices in the future, and any such changes could materially and adversely affect our cost of doing business and profitability.

Failure to obtain or maintain required approvals and/or state licenses necessary to operate our mortgage-related activities may adversely impact our investment strategy.

We may be required to obtain and maintain various approvals and/or licenses from federal or state governmental authorities, government sponsored entities or similar bodies in connection with some or all of our activities. There is no assurance that we can obtain and maintain any or all of the approvals and licenses that we desire or that we will avoid experiencing significant delays in seeking such approvals and licenses. Furthermore, we will be subject to various disclosure and other requirements to obtain and maintain these approvals and licenses, and there is no assurance that we will satisfy those requirements. Our failure to obtain or maintain licenses will restrict our options and ability to engage in desired activities, and could subject the us to fines, suspensions, terminations and various other adverse actions if it is determined that we have engaged without the requisite approvals or licenses in activities that required an approval or license, which homecould have a material and adverse effect on our business, results of operation and financial condition.

Some of our SBC loans will have interest deductionsrate features that adjust over time, and any interest rate caps on these loans may reduce our income or cause it to suffer a loss during periods of rising interest rates.

Our ARMs are treated. Itsubject to periodic and lifetime interest rate caps. Periodic interest rate caps limit the amount an interest rate can increase during any given period. Lifetime interest rate caps limit the amount an interest rate can increase through maturity of a loan. Our borrowings, including our repurchase agreement and securitizations, are not subject to similar restrictions. Accordingly, in a period of rapidly increasing interest rates, the interest rates paid on our borrowings could increase without limitation while interest rate caps would limit the interest rates on our ARMs. This problem is unclear whethermagnified for our ARMs that are not fully indexed. Further, some ARMs may be subject to periodic payment caps that result in a portion of the interest being deferred and added to the principal outstanding. As a result, we could receive less cash income on ARMs than we need to pay interest on our related borrowings. These factors could lower our net interest income or cause us to suffer a loss during periods of rising interest rates.

Our inability to manage future growth effectively could have an adverse impact on our financial condition and results of operations.

Our ability to achieve our investment objectives will depend on our ability to grow, which will depend, in turn, on Waterfall’s ability to identify, acquire, originate and invest in SBC loans and ABS that meet our investment criteria. Our ability to grow our business will depend in large part on our ability to expand our SBC loan origination activities. Any failure to effectively manage our future growth, including a failure to successfully expand our SBC loan origination activities could have a material and adverse effect on our business, financial condition and results of operations.

Accounting rules for certain of our transactions are highly complex and involve significant judgment and assumptions, and changes in such rules, accounting interpretations or our assumptions could adversely impact our ability to timely and accurately prepare our consolidated financial statements.

We are subject to Financial Accounting Standards Board standards and interpretations that can result in significant accounting changes that could have a material and adverse impact on our results of operations and financial condition. Accounting rules for financial instruments, including the acquisition and sales or securitization of mortgage loans, investments in ABS, derivatives, investment consolidations and other aspects of our anticipated operations are highly complex and involve significant judgment and assumptions. For example, the Company estimates and judgments are based on a number of factors, including projected cash flows from the collateral securing our SBC loans, the likelihood of repayment in full at the maturity of a loan, potential for an SBC loan refinancing opportunity in the future and expected market discount rates for varying property types. These complexities could lead to a delay in the preparation of financial information and the delivery of this information to our stockholders.

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Changes in accounting rules, interpretations or our assumptions could also undermine our ability to prepare timely and accurate financial statements, which could result in a lack of investor confidence in our financial information and could materially and adversely affect the market price of our common stock.

We will depend on Waterfall and its key personnel for our success. We may not find a suitable replacement for Waterfall if the management agreement with Waterfall is terminated, or if key personnel leave the employment of Waterfall or otherwise become unavailable to us.

We will be dependent on Waterfall for our day-to-day management. Frederick Herbst, who is employed by Waterfall and serves as our Chief Financial Officer, is dedicated exclusively to our business, and seven of Waterfall’s accounting professionals are also dedicated exclusively to our business, and such persons are expected to be dedicated to us. In addition, Waterfall or we may in the future hire additional personnel that may be dedicated to our business. Waterfall is not, however, obligated under the management agreement to dedicate any of its personnel exclusively to our business, nor is it or its personnel obligated to dedicate any specific portion of its or their time to our business. We will also be responsible for the costs of our own employees. However, with the exception of our ReadyCap and GMFS subsidiaries, which will employ their own personnel, we do not expect to have our own employees. Accordingly, we believe that our success will depend to a significant extent upon the efforts, experience, diligence, skill and network of business contacts of the executive officers and key personnel of Waterfall. The executive officers and key personnel of Waterfall will evaluate, negotiate, structure, close and monitor our acquisitions of assets, and our success will depend on its continued service. The departure of any of the pending tax reform proposalsexecutive officers or key personnel of Waterfall could have a material adverse effect on our performance. In addition, we offer no assurance that Waterfall will remain our Manager or that we will continue to have access to Waterfall’s principals and professionals. The initial term of our management agreement with Waterfall only extends for three years from the closing of the ZAIS Financial merger, with automatic one-year renewal terms starting on the third anniversary of the closing of the ZAIS Financial merger. If the management agreement is terminated and no suitable replacement is found to manage the Company, we may not be able to execute our business plan.

Should one or more of Waterfall’s key personnel leave the employment of Waterfall or otherwise become unavailable to the Company, Waterfall may not be able to find a suitable replacement and the Company may not be able to execute certain aspects of our business plan.

There are various conflicts of interest in our relationship with Waterfall which could result in decisions that are not in the best interests of our stockholders.

We are subject to conflicts of interest arising out of our relationship with Waterfall and its affiliates. Frederick Herbst, who is employed by Waterfall and will serve as the Company’s Chief Financial Officer, is dedicated exclusively to the Company and seven of Waterfall’s accounting professionals also are expected to be dedicated exclusively to our Company. With the exception of our ReadyCap and GMFS subsidiaries, which will employ their own personnel, we do not expect to have our own employees. In addition, we expect that the Chief Executive Officer, President, portfolio managers and any other appropriate personnel of Waterfall will devote such portion of their time to our affairs as is necessary to enable us to effectively operate its business. Waterfall and our officers may have conflicts between their duties to us and their duties to, and interests in, Waterfall and its affiliates. Waterfall is not required to devote a specific amount of time or the services of any particular individual to our operations. Waterfall manages or provides services to other clients, and we will compete with these other clients for Waterfall’s resources and support. The ability of Waterfall and its officers and personnel to engage in other business activities may reduce the time they spend advising us.

There may also be conflicts in allocating assets that are suitable for us and other clients of Waterfall and its affiliates. Waterfall manages a series of funds and a limited number of separate accounts, which focus on a range of ABS and other credit strategies. With the exception of the Waterfall Olympic Offshore Fund, Ltd. (the “Olympic Fund”) discussed below, none of these other funds or separate accounts focus on SBC loans as their primary business strategy.

To address certain potential conflicts arising from our relationship with Waterfall or its affiliates, Waterfall has agreed in the side letter agreement that, for so long as the management agreement is in effect, neither it nor any of its affiliates will (i) sponsor or manage any additional investment vehicle where we do not participate as an investor whose primary investment strategy will involve SBC mortgage loans, unless Waterfall obtains the prior approval of a majority of our board of directors (including a majority of our independent directors), or (ii) acquire a portfolio of assets, a majority of which (by value or UPB) are SBC mortgage loans on behalf of another investment vehicle (other than acquisitions of SBC

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ABS), unless we are first offered the investment opportunity and a majority of our board of directors (including a majority of our independent directors) decide not to acquire such assets.

In March 2014, due to the size of SBC mortgage loan opportunities, which exceeded our financing capacity at that time, Waterfall sponsored the Olympic Fund. The Olympic Fund was established to invest in assets that may not be qualifying assets for REIT purposes or to invest in SBC loan assets that we decline to purchase for any reason. These opportunities were first presented to us and a majority of our board of directors (including a majority of our independent directors) decided not to acquire such assets and consented to the formation of the Olympic Fund. Waterfall will continue to seek the consent of the Company board of directors (including a majority of the Company’s independent directors) before allocating asset opportunities to the Olympic Fund, and anticipates that as our debt and equity financing sources continue to grow, Waterfall will only allocate asset opportunities to the Olympic Fund that are not qualifying REIT assets.

The side letter agreement does not cover SBC ABS acquired in the market and non-real estate secured loans and we may compete with other existing clients of Waterfall and its affiliates, including the Olympic Fund, other funds managed by Waterfall that focus on a range of ABS and other credit strategies and separately managed accounts, and future clients of Waterfall and its affiliates in acquiring SBC ABS, non-real estate secured loans and portfolios of assets less than a majority of which (by value or UPB) are SBC loans, and in acquiring other target assets that do not involve SBC loans.

We will pay Waterfall substantial management fees regardless of the performance of our portfolio. Waterfall’s entitlement to a base management fee, which is not based upon performance metrics or goals, might reduce its incentive to devote its time and effort to seeking assets that provide attractive risk-adjusted returns for our portfolio. This in turn could hurt both our ability to make distributions to our stockholders and the market price of our common stock.

The management agreement was negotiated between related parties and their terms, including fees payable, may not be as favorable to us as if they had been negotiated with unaffiliated third parties.

The termination of the management agreement may be difficult and require payment of a substantial termination fee or other amounts, including in the case of termination for unsatisfactory performance, which may adversely affect our inclination to end our relationship with Waterfall.

Termination of the management agreement without cause is difficult and costly. Our independent directors will review Waterfall’s performance and the management fees annually and, following the initial term, the management agreement may be terminated annually upon the affirmative vote of at least two-thirds of our independent directors, or by a vote of the holders of at least a majority of the outstanding shares of the Company common stock (other than shares held by members of our senior management team and affiliates of Waterfall), based upon: (i) Waterfall’s unsatisfactory performance that is materially detrimental to our Company, or (ii) a determination that the management fees or incentive distribution payable to Waterfall are not fair, subject to Waterfall’s right to prevent termination based on unfair fees by accepting a reduction of management fees or incentive distribution agreed to by at least two-thirds of our independent directors. We must provide Waterfall with 180 days prior notice of any such termination. Additionally, upon such a termination without cause, the management agreement provides that we will pay Waterfall a termination fee equal to three times the average annual base management fee earned by Waterfall during the prior 24-month period immediately preceding the date of termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination, except upon an internalization. Additionally, if the management agreement is terminated under circumstances in which we are obligated to make a termination payment to Waterfall, our operating partnership shall repurchase, concurrently with such termination, the Class A special unit for an amount equal to three times the average annual amount of the incentive distribution paid or payable in respect of the Class A special unit during the 24-month period immediately preceding such termination, calculated as of the end of the most recently completed fiscal quarter before the date of termination. These provisions may increase the cost to our Company of terminating the management agreement and adversely affect our ability to terminate Waterfall without cause.

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If we internalize our management functions or if Waterfall is internalized by another sponsored program, we may be unable to obtain key personnel, and the consideration we pay for any such internalization could exceed the amount of any termination fee, either of which could have a material and adverse effect on our business, financial condition and results of operations.

We may engage in an internalization transaction, become self-managed and, if this were to occur, certain key employees may not become our employees but may instead remain employees of Waterfall or its affiliates. An inability to manage an internalization transaction effectively could thus result in us incurring excess costs and suffering deficiencies in our disclosure controls and procedures or our internal control over financial reporting. Such deficiencies could cause us to incur additional costs, and our management’s attention could be diverted from most effectively managing our investments. Additionally, if another program sponsored by Waterfall internalizes Waterfall, key personnel of Waterfall, who also are key personnel of the other sponsored program, would become employees of the other program and would no longer be available to us. Any such loss of key personnel could adversely impact our ability to execute certain aspects of our business plan. Furthermore, in the case of any internalization transaction, we expect that we would be required to pay consideration to compensate Waterfall for the internalization in an amount that we will negotiate with Waterfall in good faith and which will require approval of at least a majority of our independent directors. It is possible that such consideration could exceed the amount of the termination fee that would be due to Waterfall if the conditions for terminating the management agreement without cause are satisfied and we elected to terminate the management agreement and payment of such consideration could have a material and adverse effect on our business, financial condition and results of operations.

Waterfall and its affiliates have limited prior experience operating a REIT and therefore may have difficulty in successfully and profitably operating our business or complying with regulatory requirements, including the REIT provisions of the Code, which may hinder their ability to achieve our objectives or result in loss of our qualification as a REIT.

Prior to the completion of our private placement in 2013, Waterfall and its affiliates had no experience operating a REIT or complying with regulatory requirements, including the REIT provisions of the Code. The REIT rules and regulations are highly technical and complex, and the failure to comply with the income, asset, and other limitations imposed by these rules and regulations could prevent us from qualifying as a REIT or could force us to pay unexpected taxes and penalties. Waterfall and its affiliates have limited experience operating a business in compliance with the numerous technical restrictions and limitations set forth in the Code or the 1940 Act, applicable to REITs. We cannot assure you that Waterfall or our management team will perform on our behalf as they have in their previous endeavors. The inexperience of Waterfall and its affiliates described above may hinder our ability to achieve our objectives or result in loss of our qualification as a REIT or payment of taxes and penalties. As a result, we cannot assure you that we will be enacted, either piecemealable to successfully operate as revenue raisersa REIT, execute our business strategies or as partcomply with regulatory requirements applicable to REITs.

Waterfall’s base management fee may reduce its incentive to devote its time and effort to seeking attractive assets for our portfolio because the fee is payable regardless of our performance.

We will pay Waterfall a more comprehensive packagebase management fee regardless of tax reforms. Elimination or further restrictionsthe performance of our portfolio. Waterfall’s entitlement to non-performance-based compensation might reduce its incentive to devote its time and effort to seeking assets that provide attractive risk-adjusted returns for our portfolio. This in turn could hurt both our ability to make distributions to our stockholders and the market price of Company’s common stock.

The Class A special unit entitling Waterfall to an incentive distribution may induce Waterfall to make certain investments that may not be favorable to us, including speculative investments.

Under the partnership agreement of our operating partnership, Waterfall, the holder of the Class A special unit, will be entitled to receive an incentive distribution that may cause Waterfall to place undue emphasis on the mortgage-interest tax deductionmaximization of our “core earnings” as defined under the partnership agreement at the expense of other criteria, such as preservation of capital, to achieve a higher incentive distribution. Investments with higher yield potential are generally riskier or more speculative. This could result in increased risk to the value of our portfolio.  For a discussion of the calculation of core earnings under the partnership agreement, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Incentive Distribution Payable to Our Manager” included in this annual report on Form 10-K.

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Our board of directors will not approve each investment and financing decision made by Waterfall unless required by our investment guidelines.

We expect to authorize Waterfall to follow broad investment guidelines established by our board of directors. Our board of directors will periodically review our investment guidelines and investment portfolio but will not, and will not be required to, review all of our proposed investments. These investment guidelines may be changed from time to time by our board of directors without the approval of our stockholders. To the extent that our board of directors approves material changes to the investment guidelines, we will inform stockholders of such changes through disclosure in our periodic reports and other filings required under the Exchange Act. In addition, in conducting its periodic reviews, our board of directors may rely primarily on information provided to them by Waterfall. Furthermore, Waterfall may use complex strategies, and transactions entered into may be costly, difficult or impossible to unwind by the time they are reviewed by our board of directors. Accordingly, Waterfall will have great latitude in determining the types and amounts of target assets it may decide are attractive investments for us, which could result in investment returns that are substantially below expectations or that result in losses, which would materially and adversely affect our business operations and results.

We are highly dependent on information systems and communication systems; systems failures and other operational disruptions could significantly affect our business, which may, in turn, negatively affect our operating results and our ability to pay dividends to our stockholders.

Our business is highly dependent on our communications and our information systems, which may interface with or depend on systems operated by third parties, including market counterparties, loan originators and other service providers. Any failure or interruption of these systems could cause delays or other problems in our activities, including in our target asset origination or acquisition activities, which could have a material adverse effect on our operating results and negatively affect the U.S. housing market or the market value of mortgage loans.our common stock and our ability to pay dividends to our stockholders.

 

The CompanyAdditionally, we rely heavily on financial, accounting and other data processing systems and operational risks arising from mistakes made in the confirmation or settlement of transactions, from transactions not being properly booked, evaluated or accounted for or other similar disruption in our operations may cause us to suffer financial loss, the disruption of our business, liability to third parties, regulatory intervention or reputational damage.

We may be subject to liability in connection with itsour residential mortgage loans for potential violations of consumer protection laws and regulations.

 

Federal consumer protection laws and regulations have been enacted and promulgated that are designed to regulate residential mortgage loan underwriting and originators'originators’ lending processes, standards, and disclosures to borrowers. These laws and regulations include the ATR/Qualified Mortgage Rule and the Servicing Rules. In addition, there are various other federal, state, and local laws and regulations that are intended to discourage predatory lending practices by residential mortgage loan originators. For example, the federal Home Ownership and Equity Protection Act of 1994 prohibits inclusion of certain provisions in residential mortgage loans that have mortgage rates or origination costs in excess of prescribed levels and requires that borrowers be given certain disclosures prior to origination. Some states have enacted, or may enact, similar laws or regulations, which in some cases may impose restrictions and requirements greater than those in place under federal laws and regulations. In addition, under the anti-predatory lending laws of some states, the origination of certain residential mortgage loans, including loans that are not classified as "high cost"“high cost” loans under applicable law, must satisfy a net tangible benefits test with respect to the borrower. This test, as well as certain standards set forth in the ATR/Qualified Mortgage Rule, may be highly subjective and open to interpretation. As a result, a court may determine that a residential mortgage loan did not meet the standard or test even if the originator reasonably believed such standard or test had been satisfied.

 

Mortgage loans also are subject to various other federal laws, including:

 

·

the Equal Credit Opportunity Act of 1974, as amended (the "ECOA") and Regulation B promulgated under the ECOA,thereunder, which prohibit discrimination on the basis of age, race, color, sex, religion, marital status, national origin, receipt of public assistance or the exercise of any right under the Consumer Credit Protection Act of 1968, as amended, in the extension of credit;

 

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·

the TILATruth in Lending Act (“TILA”) and Regulation Z promulgated under TILA, which both require certain disclosures to the mortgagors regarding the terms of residential loans;

 

·

the RESPAReal Estate Settlement Procedures Act (“RESPA”) and Regulation X promulgated under RESPA, which (among other things) prohibit the payment of referral fees for real estate settlement services (including mortgage lending and brokerage services) and regulate escrow accounts for taxes and insurance and billing inquiries made by mortgagors;

 

·

the Americans with Disabilities Act of 1990, as amended which, among other things, prohibits discrimination on the basis of disability in the full and equal enjoyment of the goods, services, facilities, privileges, advantages or accommodations of any place of public accommodation;

 

·

the Fair Credit Reporting Act of 1970, as amended, which regulates the use and reporting of information related to the borrower'sborrower’s credit experience;

 

·

the Consumer Financial Protection Act, enacted as part of the Dodd-Frank Act, which (among other things) created the CFPB and gave it broad rulemaking, supervisory and enforcement jurisdiction over mortgage lenders and servicers, and proscribes any unfair, deceptive or abusive acts or practices in connection with any consumer financial product or service;

 

·

the Home Equity Loan Consumer Protection Act of 1988, which requires additional disclosures and limits changes that may be made to the loan documents without the mortgagor'smortgagor’s consent, and restricts a mortgagee'smortgagee’s ability to declare a default or to suspend or reduce a mortgagor'smortgagor’s credit limit to certain enumerated events;

 

·

the Depository Institutions Deregulation and Monetary Control Act of 1980, which preempts certain state usury laws;

 

·

the Dodd-Frank Act, including as described above under "—Actions“— We cannot predict the unintended consequences and market distortions that may stem from far-ranging regulatory reform of the U.S. Government, including the U.S. Congress, Federal Reserve, U.S. Treasury and other governmental and regulatory bodies, including the SEC, to stabilize or reform theoversight of financial markets may not achieve the intended effect and may adversely affect the Company's business"markets”; and

 

·

the Service membersMembers Civil Relief Act, as amended, which provides relief to borrowers who enter into active military service or who were on reserve status but are called to active duty after the origination of their mortgage loans; and

 

·

the Alternative Mortgage Transaction Parity Act of 1982, which preempts certain state lending laws which regulate alternative mortgage transactions.

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Failure of the Company,us, residential mortgage loan originators, mortgage brokers or servicers to comply with these laws and regulations, could subject the Companyus to monetary penalties and defenses to foreclosure, including by recoupment or setoff of finance charges and fees collected, and could result in rescission of the affected residential mortgage loans, which could adversely impact the Company'sour business and financial results.

 

GMFS is a seller/servicer approved to sell residential mortgage loans to Freddie Mac, and Fannie Mae, the HUD/ FHA, the USDA, and the VA and failure to maintain its status as an approved seller/servicer could harm the Company'sour business.

 

GMFS is an approved Fannie Mae Seller-Servicer, Freddie Mac Seller-Servicer, Ginnie Mae issuer, HUD Department of Housing and Urban Development (“HUD”)/ FHA Mortgagee,mortgagee, USDA approved originator, and VA Lender.lender. As an approved seller/servicer, GMFS is required to conduct certain aspects of its operations in accordance with applicable policies and guidelines published by these entities and GMFS is required to pledge a certain amount of cash to them to collateralize potential obligations to these entities. Failure to maintain GMFS'sGMFS’s status as an approved seller/servicer would mean it would not be able to sell mortgage loans to these entities, could result in it being required to re-purchase loans previously sold to these entities, or could otherwise restrict the itsour business and investment options and could harm itsour business and expose itus to losses or other claims. Fannie Mae, Freddie Mac or these other entities may, in the future, require GMFS to hold additional capital or pledge additional cash or assets in order to maintain approved seller/servicer status, which, if required, would adversely impact the Company'sour financial results.

 

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GMFS operates within a highly regulated industry on a federal, state and local level and the business results of GMFS are significantly impacted by the laws and regulations to which GMFS is subject.

 

As a mortgage loan originator, GMFS is subject to extensive and comprehensive regulation under federal, state and local laws in the United States. These laws and regulations significantly affect the way that GMFS conducts its business and restrict the scope of the existing business of GMFS and limit the ability of GMFS to expand its product offerings or can make the cost to originate and service mortgage loans higher, which could impact the Company’sour financial results.

 

The CFPB issued proposed changes to its Servicing Rules in November 2014. The proposed changes, if adopted, may increase the costs of loss mitigation and increase foreclosure timelines. Other new regulatory requirements or changes to existing requirements that the CFPB may promulgate could require changes in the business of GMFS, result in increased compliance costs and impair the profitability of such business. In addition, as a result of the Dodd-Frank Act'sAct’s potential expansion of the authority of state attorneys general to bring actions to enforce federal consumer protection legislation, GMFS could be subject to state lawsuits and enforcement actions, thereby further increasing the legal and compliance costs relating to GMFS. The proposed amendments to the Servicing Rules will increase the complexity of the loss mitigation and foreclosure processes and an inadvertent failure to comply with these rules could lead to losses in the value of the mortgage loans, be an event of default under various servicing agreements or subject GMFS to fines and penalties. The cumulative effect of these changes could result in a material impact on the Company’sour earnings.

 

Additionally, the Dodd-Frank Act directed the CFPB to integrate certain mortgage loan disclosures under the TILA and RESPA, and effective October 3, 2015, new disclosure rules went into effect for newly originated residential mortgage loans. These rules include new consumer disclosure document forms, new processes for determining when disclosures must be updated and new timelines for providing disclosure documents to borrowers. These new rules have created the need for substantial system and process changes at GMFS and new training for its employees. Failure to comply with these new requirements may result in penalties for disclosure violations under the TILA and RESPA.

 

GMFS could be subject to additional regulatory requirements or changes under the Dodd FrankDodd-Frank Act beyond those currently proposed, adopted or contemplated, particularly given the ongoing heightened regulatory environment in which financial institutions operate. The ongoing implementation of the Dodd FrankDodd-Frank Act, including the implementation of the Servicing Rules and the rules related to mortgage loan disclosures by the CFPB, could increase the regulatory compliance burden and associated costs of GMFS and place restrictions on the operations of GMFS, which could in turn adversely affect the Company’s,our financial condition and results of operations.

 

Mortgage loan modification and refinance programs as well as future legislative action may adversely affect the value of, and the returns on, the target assets in which the Company invests.we invest.

 

The U.S. Government, through the Federal Reserve, the FHA and the FDIC, commenced implementation of programs designed to provide homeowners with assistance in avoiding residential or commercial mortgage loan foreclosures, including the Home Affordable Modification Program, ("HAMP"), which provides homeowners with assistance in avoiding residential mortgage loan foreclosures, and the Home Affordable Refinance Program, ("HARP"),which we refer to as HARP, which allows borrowers who are current on their mortgage payments to refinance and reduce their monthly mortgage payments at loan-to-value ratios without new mortgage insurance. The programs may involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans or the rate of interest payable on the loans, or to extend the payment terms of the loans.

 

Loan modification and refinance programs may adversely affect the performance of residential mortgage loans, Agency RMBS and non-Agency RMBS. Especially with non-Agency RMBS, a significant number of loan modifications with respect to a given security, including those related to principal forgiveness and coupon reduction, could negatively impact the realized yields and cash flows on such security. These loan modification programs, future legislative or regulatory actions, including possible amendments to the bankruptcy laws, which result in the modification of outstanding residential mortgage loans, as well as changes in the requirements necessary to qualify for refinancing mortgage loans with Fannie Mae, Freddie Mac or Ginnie Mae, may adversely affect the value of, and the returns on, residential mortgage loans, non-Agency RMBS, Agency RMBS and the Company'sour other target assets that itwe may purchase.

 

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We may be affected by alleged or actual deficiencies in servicing and foreclosure practices of third parties, as well as related delays in the foreclosure process.

Allegations of deficiencies in servicing and foreclosure practices among several large sellers and servicers of residential mortgage loans that surfaced in 2010 raised various concerns relating to such practices, including the improper execution of the documents used in foreclosure proceedings, inadequate documentation of transfers and registrations of mortgages and assignments of loans, improper modifications of loans, violations of representations and warranties at the date of securitization, and failure to enforce put-backs.

As a result of alleged deficiencies in foreclosure practices, a number of servicers temporarily suspended foreclosure proceedings beginning in the second half of 2010 while they evaluated their foreclosure practices. In late 2010, a group of state attorneys general and state bank and mortgage regulators representing nearly all 50 states and the District of Columbia, along with the U.S. Justice Department and HUD, began an investigation into foreclosure practices of banks and servicers. The investigations and lawsuits by several state attorneys general led to a settlement agreement in March 2012 with five of the nation’s largest banks, pursuant to which the banks agreed to pay more than $25 billion to settle claims relating to improper foreclosure practices. The settlement does not prohibit the states, the federal government, individuals or investors in RMBS from pursuing additional actions against the banks and servicers in the future.

 

The increasingintegrity of the servicing and foreclosure processes are critical to the value of the residential mortgage loans and the RMBS collateralized by residential mortgage loans in which we will invest, and our financial results could be adversely affected by deficiencies in the conduct of those processes. For example, delays in the foreclosure process that have resulted from investigations into improper servicing practices may adversely affect the values of, and our losses on, the residential mortgage loans and non-Agency RMBS we own or may originate or acquire. Foreclosure delays may also increase the administrative expenses of any securitization trusts that we may sponsor for non-Agency RMBS, thereby reducing the amount of funds available for distribution to our stockholders. In addition, the subordinate classes of securities issued by any such securitization trusts may continue to receive interest payments while the defaulted loans remain in the trusts, rather than absorbing the default losses. This may reduce the amount of credit support available for the senior classes we may own, thus possibly adversely affecting these securities.

In addition, in these circumstances, we may be obligated to fund any obligation of the servicer to make advances on behalf of a delinquent loan obligor. To the extent that there are significant amounts of advances that need to be funded in respect of loans where we own the servicing right, it could have a material adverse effect on our business and financial results.

While we believe that the sellers and servicers would be in violation of their servicing contracts to the extent that they have improperly serviced mortgage loans or improperly executed documents in foreclosure or bankruptcy proceedings, or do not comply with the terms of servicing contracts when deciding whether to apply principal reductions, it may be difficult, expensive and time consuming for us to enforce our contractual rights.

We will continue to monitor and review the issues raised by the alleged improper foreclosure practices. While we cannot predict exactly how the servicing and foreclosure matters or the resulting litigation or settlement agreements will affect our business, there can be no assurance that these matters will not have an adverse impact on our consolidated results of operations and financial condition.

Homeowner association super priority liens, special assessments and energy efficiency liens may take priority over the mortgage lien.

Homeowner association super priority liens may take priority over the mortgage lien. In some jurisdictions it is possible that the first lien of a mortgage may be extinguished by super priority liens of homeowners associations(“HOAs”), potentially resulting in a loss of the outstanding principal balance of the mortgage loan. In a number of proposedstates, HOA or condominium association assessment liens can take priority over first lien mortgages in certain circumstances. The number of these so called superlien jurisdictions has increased in the past few decades and may increase further. Recent rulings by the highest courts in Nevada and the District of Columbia have held that the superlien statute provides the HOA or condominium association with a true lien priority rather than a payment priority from the proceeds of the sale, creating the ability to extinguish the existing senior mortgage and greatly increasing the risk of losses on mortgage loans secured by homes whose owners fail to pay HOA or condominium fees. If an HOA, or a purchaser of an HOA superlien, completes a foreclosure in respect of an HOA superlien on a mortgaged property, the related mortgage loan may be extinguished. In

34


those circumstances, a loan owner could suffer a loss of the entire principal balance of such mortgage loan. A servicer might be able to attempt to recover, on an unsecured basis, by suing the related mortgagor personally for the balance, but recovery in these circumstances will be problematic if the related mortgagor has no meaningful assets against which to recover. Special assessments and energy efficiency liens may take priority over the mortgage lien. Mortgaged properties securing mortgage loans may be subject to the lien of special property taxes and/or special assessments. These liens may be superior to the liens securing the mortgage loans, irrespective of the date of the mortgage. In some instances, individual mortgagors may be able to elect to enter into contracts with governmental agencies for property assessed clean energy or similar assessments that are intended to secure the payment of energy and water efficiency and distributed energy generation improvements that are permanently affixed to their properties, possibly without notice to or the consent of the mortgagee. These assessments may also have lien priority over the mortgages securing mortgage loans. No assurance can be given that a mortgaged property so assessed will increase in value to the extent of the assessment lien. Additional indebtedness secured by the assessment lien would reduce the amount of the value of a mortgaged property available to satisfy the affected mortgage loan. Such actions could have a dramatic impact on our business, results of operations and financial condition, and the cost of complying with any additional laws and regulations could have a material adverse effect on our business, financial condition, results of operations, the market price of our common stock and our ability to pay dividends to our stockholders.

Our MSRs will expose us to significant risks.

Fannie Mae and Freddie Mac generally require mortgage servicers to be paid a minimum servicing fee that significantly exceeds the amount a servicer would charge in an arm’s-length transaction.

Our residential MSRs are recorded at fair value on our balance sheet based upon significant estimates and assumptions, with changes in fair value included in our consolidated results of operations. Such estimates and assumptions would include, without limitation, estimates of future cash flows associated with our residential MSRs based upon assumptions involving interest rates as well as the prepayment rates, delinquencies and foreclosure rates of the underlying serviced mortgage loans.

The ultimate realization of the value of MSRs may be materially different than the fair values of such MSRs as may be reflected in our financial statements as of any particular date. The use of different estimates or assumptions in connection with the valuation of these assets could produce materially different fair values for such assets, which could have a material adverse effect on our consolidated financial position, results of operations and cash flows. Accordingly, there may be material uncertainty about the value of our MSRs.

Changes in interest rates are a key driver of the performance of MSRs. Historically, the value of MSRs has increased when interest rates rise and decreased when interest rates decline due to the effect those changes in interest rates have on prepayment estimates. We may pursue various hedging strategies to seek to reduce our exposure to adverse changes in interest rates. Our hedging activity will vary in scope based on the level and volatility of interest rates, the type of assets held and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us. To the extent the we do not utilize derivatives to hedge against changes in the fair value of MSRs, our balance sheet, consolidated results of operations and cash flows would be susceptible to significant volatility due to changes in the fair value of, or cash flows from, MSRs as interest rates change.

Prepayment speeds significantly affect excess mortgage servicing fees. Prepayment speed is the measurement of how quickly borrowers pay down the unpaid principal balance of their loans or how quickly loans are otherwise brought current, modified, liquidated or charged off. We will base the price we pay for MSRs and the rate of amortization of those assets on factors such as our projection of the cash flows from the related pool of mortgage loans. Our expectation of prepayment speeds will be a significant assumption underlying those cash flow projections. If prepayment speeds are significantly greater than expected, the carrying value of MSRs could exceed their estimated fair value. If the fair value of MSRs decreases, we would be required to record a non-cash charge, which would have a negative impact on our financial results. Furthermore, a significant increase in prepayment speeds could materially reduce the ultimate cash flows we receive from MSRs, and we could ultimately receive substantially less than what we paid for such assets.

Moreover, delinquency rates have a significant impact on the valuation of any excess mortgage servicing fees. An increase in delinquencies will generally result in lower revenue because typically we will only collect servicing fees from agencies or mortgage owners for performing loans. If delinquencies are significantly greater than we expect, the estimated

35


fair value of the MSRs could be diminished. When the estimated fair value of MSRs is reduced, we could suffer a loss, which could have a negative impact on our financial results.

Furthermore, MSRs are subject to numerous U.S. federal, state and local laws and licensingregulations and may be subject to various judicial and administrative decisions imposing various requirements may increase the Company's risk of liability with respectand restrictions on our business. Our failure to certain mortgage loans and could increase the Company's cost of doing business.

The U.S. Congress and various state and local legislatures are considering, and in the future may consider, legislation which, among other provisions, would permit limited assignee liability for certain violations in the mortgage loan origination process. The Company cannot predict whether or in what form the U.S. Congresscomply, or the various state and local legislatures may enact legislation affecting its business. The Company will evaluate the potential impact of any initiatives which, if enacted, could affect its practices and consolidated results of operations. The Company is unable to predict whether federal, state or local authorities will require changes in its practices in the future. These changes, if required, could adversely affect its profitability, particularly if the Company makes such changes in response to new or amended laws, rules, regulations or ordinances in any state where the Company originates or acquires a significant portion of its mortgage loans, or if such changes result in the Company being held responsible for any violations in the mortgage loan origination process.

While the Company is not required to obtain licenses to purchase RMBS, the origination of residential mortgage loans requires and, the purchase of performing, re-performing and newly originated residential mortgage loans in the secondary market may, in some circumstances, require it to maintain various state licenses. Acquiring the right to service residential mortgage loans may also, in some circumstances, require the Company to maintain various state licenses. As a result, the Company could be delayed in conducting certain business if it were first required to obtain a state license. There can be no assurance that the Company will be able to obtain allfailure of the licenses it needs or that it will not experience significant delays in obtaining these licenses. Furthermore, once licenses are issued, the Company is requiredservicer to comply, with various information reporting and other regulatory requirementsthe laws, rules or regulations to maintain those licenses, and there is no assurance that it will be able to satisfy those requirements or other regulatory requirements applicable to the Company's business of originating or acquiring performing, re-performing and newly originated residential mortgage loans on an ongoing basis. The Company's failure to obtain or maintain required licenseswhich we or the Company's failureservicer are subject by virtue of ownership of MSRs, whether actual or alleged, could expose us to comply with regulatory requirements that are applicable to the Company's business of originating or acquiring residential mortgage loans may restrict the Company's business and investment options and could harm the Company's business and expose the Company tofines, penalties or other claims.

In addition, environmental protection laws that apply to properties that secure or underlie the Company's residential mortgage loans could result in losses to the Company. The Company may also be exposed to environmentalpotential litigation liabilities, with respect to properties of which it becomes a direct or indirect owner or to which it takes title, which could adversely affect the Company's businessincluding costs, settlements and financial results.

Risks Associated with the Company's Management and the Company's Relationship with its Advisor

The Company is dependent on certain key personnel for its success, and the Company may not find a suitable replacement for its Advisor if the Investment Advisory Agreement is terminated, or if key personnel leave the employment of ZAIS or GMFS or otherwise become unavailable to the Company.

The Company is dependent on its Advisor for its day-to-day management, as the Company does not have any independent officers or any employees, other than those employed in connection with its GMFS mortgage banking platform. The Advisor has significant discretion as to the implementation of the Company's asset acquisition and operating policies and strategies. The Company believes that its success will depend to a significant extent upon the efforts, experience, diligence, skill and network of business contacts of the executive officers and key personnel of its Advisor and the key personnel of its GMFS mortgage banking platform, as they will evaluate, negotiate, structure, close and monitor the Company's originations and asset acquisitions, and the Company's success will depend on their continued service. The departure ofjudgments, any of the executive officers or key personnel of the Advisor or GMFSwhich could have a material adverse effect on the Company's performance.

In addition, the Company offers no assurance that the Advisor will remain the Company's advisor or that the Company will continue to have access to the Advisor's principals and professionals, including those of ZAIS. The initial term of the Investment Advisory Agreement with the Advisor only extends until the third anniversary of the Company's listing, with automatic one-year renewal terms on each anniversary date thereafter unless previously terminated. If the Investment Advisory Agreement is terminated and no suitable replacement is found to advise the Company, the Company may not be able to execute itsour business, plan.

Termination by the Company of the Investment Advisory Agreement with the Advisor without cause is difficult and costly.

Termination of the Investment Advisory Agreement with the Advisor without cause is difficult and costly. The Company's board of directors will review the Advisor's performance and the advisory fees annually and, following the three-year initial term, the Investment Advisory Agreement may be terminated annually upon the affirmative vote of at least two-thirds of its independent directors, or by a vote of the holders of at least two-thirds of the outstanding shares of the Company's common stock (other than shares held by the ZAIS Parties), 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 termination based on unfair fees by accepting a reduction of advisory fees agreed to by at least two-thirds of the Company's independent directors. The Company must provide the Advisor with 180 days' prior notice of any such termination. 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. These provisions may increase the cost to the Company of terminating the Investment Advisory Agreement and adversely affect the Company's ability to terminate the Advisor without cause.

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The Advisor is only contractually committed to serve the Company until the third anniversary of the Company's listing. Thereafter, the Investment Advisory Agreement is automatically renewable on an annual basis; provided, however, that the Advisor may terminate the Investment Advisory Agreement annually upon 180 days' prior notice. If the Investment Advisory Agreement is terminated and no suitable replacement is found to advise the Company, the Company may not be able to execute its business plan.

The Company has no recourse to ZAIS if it does not fulfill its obligations under the shared facilities and services agreement.

Neither the Company nor its Advisor has any employees or separate facilities, other than those employed in connection with the Company's GMFS mortgage banking platform. The Company's day-to-day operations outside of its mortgage banking platform will be conducted by employees of ZAIS, the parent company of the Advisor, pursuant to a shared facilities and services agreement between the Advisor and ZAIS. Under the shared facilities and services agreement, the Advisor will also be provided with the services and other resources necessary for the Advisor to perform its obligations and responsibilities under the Investment Advisory Agreement in exchange for certain fees payable by the Advisor. ZAIS may assign its rights and obligations thereunder to any of its majority-owned and controlled affiliates. In addition, because the Company will not be a party to the shared facilities and services agreement, the Company does not have any recourse to ZAIS if it does not fulfill its obligations under the shared facilities and services agreement or if it elects to assign the agreement to one of its affiliates. Also, the Advisor only has nominal assets and the Company will have limited recourse against the Advisor under the Investment Advisory Agreement to remedy any liability to the Company from a breach of contract or fiduciary duties.

There are conflicts of interest in the Company's relationship with the Advisor and its affiliates, which could result in decisions that are not in the best interests of the Company's stockholders.

The Company is subject to conflicts of interest arising out of its relationship with the Advisor and its affiliates, including ZAIS. Specifically, each of the Company's officers and directors is also an employee of ZAIS or its affiliates. ZAIS and the Company's officers may have conflicts between their duties to the Company and their duties to, and interests in, the Advisor or its affiliates. The Advisor is not required to devote a specific amount of time or the services of any particular individual to the Company's operations. ZAIS manages or provides services to its own accounts and certain other funds and managed accounts for which ZAIS serves as the investment adviser and ZAIS may in the future hold assets directly on its own behalf or indirectly through one or more of its subsidiaries, affiliates or other newly formed entities (collectively the "Other Accounts") and the Company will compete with these Other Accounts for ZAIS' resources and support through the Advisor. During turbulent conditions in the mortgage industry, distress in the credit markets or other times when the Company will need focused support and assistance from ZAIS through the Advisor, entities for which ZAIS also acts as an investment advisor will likewise require greater focus and attention, placing ZAIS' resources in high demand. In such situations, the Company may not receive the necessary support and assistance the Company requires or would otherwise receive if the Company were internally managed or if ZAIS did not act as an advisor for other entities or hold assets directly or indirectly for its own account. The ability of ZAIS and its officers and personnel to engage in other business activities may reduce the time they spend assisting the Advisor advising the Company.

The Company and certain of its affiliates and ZAIS' Other Accounts and their affiliates may compete to acquire the Company's target assets.

There may be conflicts in allocating assets that are suitable for the Company and Other Accounts of ZAIS and its affiliates. Other Accounts of ZAIS and its affiliates may compete with the Company with respect to certain assets which the Company may want to acquire and, as a result, the Company may either not be presented with the opportunity or have to compete with such Other Accounts to acquire these assets. Certain of these Other Accounts may have significant uninvested capital and will likely compete with the Company. Additionally, certain conflicts of interest may exist with respect to funds that have only limited reinvestment capacity including circumstances where the Company may purchase assets being disposed of by certain Other Accounts as they begin to liquidate various assets. In addition to the Other Accounts, ZAIS may, in the future, establish new funds or enter into new managed account arrangements with investment strategies that are the same or substantially similar to the Company's strategy, including funds and accounts investing primarily in the Company's target assets, including residential mortgage loans and RMBS. Such Other Accounts may compete with the Company for its target assets. The Company may also make investments in other entities which are managed by ZAIS or one of its affiliates. The Company will not, however, purchase any assets from, or issued by, any Other Account or any entity managed by the Advisor or its affiliates, or sell any asset to any Other Account or any such other entity without the consent of a majority of the Company's independent directors. A majority of the Company's independent directors may amend this affiliated investment policy at any time without stockholder consent. There may be certain situations where ZAIS allocates assets that may be suitable for the Company to Other Accounts managed by ZAIS or its affiliates instead of to the Company. Further, the Company may liquidate its investments at different times than Other Accounts due to, among other things, differences in investment strategies.

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The Investment Advisory Agreement with the Advisor was not negotiated on an arm's-length basis and may not be as favorable to the Company as if it had been negotiated with an unaffiliated third party.

Because each of the Company's officers are employees of the Advisor or its affiliates, and, at the time the Investment Advisory Agreement was executed, all of the Company's directors were employees of the Advisor or its affiliates, the Investment Advisory Agreement was not negotiated on an arm's-length basis, and the Company did not have the benefit of arm's-length negotiations of the type normally conducted with an unaffiliated third party. As a result, the terms, including the fees payable, may not be as favorable to the Company as an arm's-length agreement. Furthermore, because each of the Company's officers and non-independent directors is also an employee of the Advisor or its affiliates, the Company may choose not to enforce, or to enforce less vigorously, the Company's rights under the Investment Advisory Agreement because of its desire to maintain its ongoing relationship with the Advisor.

The Advisor's liability is limited under the Investment Advisory Agreement, and the Company has agreed to indemnify the Advisor against certain liabilities.

Pursuant to the Investment Advisory Agreement, the Advisor will not assume any responsibility other than to render the services called for thereunder and will not be responsible for any action of the Company's board of directors in following or declining to follow its advice or recommendations. Under the terms of the Investment Advisory Agreement, the Advisor, its principals, stockholders, members, managers, partners, directors and personnel, any person controlling or controlled by the Advisor, including ZAIS, and any person providing sub-advisory services to the Advisor will not be liable to the Company, any subsidiary of the Company, the Company's directors, the Company's stockholders or any of the Company's subsidiary's stockholders, members or partners for acts or omissions performed in accordance with and pursuant to the Investment Advisory Agreement, except acts or omissions constituting bad faith, willful misconduct, gross negligence, or reckless disregard of their duties under the Investment Advisory Agreement, as determined by a final non-appealable order of a court of competent jurisdiction. In addition, the Company has agreed to indemnify the Advisor, its principals, stockholders, members, managers, partners, directors and personnel, any person controlling or controlled by the Advisor and any person providing sub-advisory services to the Advisor with respect to all expenses, losses, damages, liabilities, demands, charges and claims arising from acts or omissions of the Advisor not constituting bad faith, willful misconduct, gross negligence, or reckless disregard of duties, performed in good faith in accordance with and pursuant to the Investment Advisory Agreement.

The Advisor may have difficulty in complying with regulatory requirements applicable to REITs, including the REIT provisions of the Internal Revenue Code, which may hinder its ability to achieve the Company's objectives or result in loss of the Company's qualification as a REIT.

The Advisor's management team has limited experience managing a REIT. The REIT rules and regulations are highly technical and complex, and the failure to comply with the income, asset, and other limitations imposed by these rules and regulations could prevent the Company from qualifying as a REIT or could force it to pay unexpected taxes and penalties. Failure to comply with the income, asset and other limitations imposed by the REIT rules and regulations may hinder the Company's ability to achieve its objectives or result in loss of the Company's qualification as a REIT or payment of taxes and penalties. As a result, the Company cannot provide assurance that it will be able to successfully operate as a REIT or comply with regulatory requirements applicable to REITs.

The Company's board of directors has approved broad guidelines for the Advisor and will not approve each origination or acquisition decision made by the Advisor.

The Advisor is authorized to follow broad guidelines in pursuing the Company's origination and asset acquisition strategies. The Company's board of directors will periodically review the Company's guidelines and the Company's portfolio of assets but will not, and will not be required to, review all of the Company's proposed originations, acquisitions or any type or category of asset, except that an acquisition of any security from, or issued by, an entity managed by the Advisor or its affiliates, must be approved by a majority of the independent members of the board of directors. In addition, in conducting periodic reviews, the directors will rely primarily on information provided to them by the Advisor. Furthermore, the Advisor may use complex strategies, and transactions entered into by the Advisor may be costly, difficult or impossible to unwind by the time they are reviewed by the Company's board of directors. The Advisor will have great latitude within the broad parameters of the Company's guidelines in determining the types of assets it may decide are proper for the Company, which could result in returns that are substantially below expectations or that result in losses, which would materially and adversely affect the Company's business operations and results. Further, decisions and acquisitions made by the Advisor may not fully reflect the best interests of the Company's stockholders.

The Company may change any of its strategies, guidelines, policies or procedures without stockholder consent, which could result in its making originations and acquisitions that are different from, and possibly riskier than, those described in this annual report on Form 10-K.

The Company may change any of its strategies, guidelines, policies or procedures with respect to originations, acquisitions, asset allocation, growth, operations, indebtedness, financing strategy, hedging strategy and distributions at any time without the consent of the Company's stockholders, which could result in the Company's strategies becoming different from, and possibly riskier than, strategies described in this annual report on Form 10-K. A change in the Company's strategy may increase its exposure to interest rate risk, prepayment risk, financing risk, credit risk, default risk and real estate market fluctuations. Furthermore, a change in the Company's asset allocation could result in the Company making originations and acquisitions in asset categories different from those described in this annual report on Form 10-K. In addition, the Company's charter provides that its board of directors may revoke or otherwise terminate the Company's REIT election, without the approval of its stockholders, if it determines that it is no longer in the Company's best interests to qualify as a REIT. These changes could adversely affect the Company's financial condition, consolidated results of operations the value of the Company's common stock and its ability to make distributions to the Company's stockholders.or cash flows.

 

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The Advisor's advisory fee may reduce its incentive to devote its time and effort to seeking attractive assets for the Company's portfolio because the fee is payable regardless of the performance of the Company's portfolio and there is no incentive fee associated with the management of the Company's assets.

The Company pays to the Advisor an advisory fee, calculated and payable (in cash) quarterly in arrears, equal to 1.5% per annum of the Company's Stockholders' Equity (as defined in the Investment Advisory Agreement). The Company will pay the Advisor an advisory fee regardless of the performance of the Company's portfolio and there is no incentive fee associated with the management of the Company's assets. The Advisor's entitlement to nonperformance-based compensation might reduce its incentive to devote sufficient time and effort to seeking assets that provide attractive risk-adjusted returns for the Company's portfolio. This in turn could negatively affect the Company's ability to make distributions to its stockholders and the value of its common stock.

The Advisor's loan sourcing fee is payable regardless of the future performance of the newly originated residential mortgage loans which might encourage the Advisor to source and acquire a higher volume of loans, including loans with potentially lower yields or underwritten pursuant to lesser standards.

Pursuant to the Investment Advisory Agreement, the Company pays the 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 conduit program and acquired by the Company's subsidiaries. The Company will pay the Advisor a loan servicing fee regardless of the future performance of the newly originated residential mortgage loans. The Advisor's entitlement to nonperformance-based compensation might encourage it to source and acquire a higher volume of loans, including loans with potentially lower yields or underwritten pursuant to lesser standards. This in turn could negatively affect the Company's ability to make distributions to its stockholders and the value of its common stock.

Risks Related to Financing and Hedging

 

The Company usesWe will use leverage in executing its businessas part of our investment strategy which may adversely affect the return on the Company's assets and may reduce cash available for distribution to the Company's stockholders, as well as increase losses when economic conditions are unfavorable.

The Company leverages the origination and acquisition of its target assets through private funding sources, including borrowings structured as repurchase agreements, warehouse facilities, notes issued by the Operating Partnership, securitizations, term financings and derivative contracts. Leverage can enhance the Company's potential returns but can also exacerbate losses. Although the Company iswe will not required to maintain any particular assets-to-equity leverage ratio,have a formal policy limiting the amount of debt we may incur. Our board of directors may change our leverage the Company deploys for particularpolicy without stockholder consent.

We will use prudent leverage to increase potential returns to our stockholders. We have completed several securitizations of predominantly SBC loan and SBA 7(a) loan assets depends upon the Advisor's assessmentsince January 2011, issuing bonds with an aggregate face value of short-term interest rates, overall$1.9 billion. As of December 31, 2017, our committed and outstanding financing arrangements included:

·

five committed credit facilities and three master repurchase agreements to finance our SBC and residential mortgage loans with $248.7 million of borrowings outstanding;

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$598.1 million of securitized debt obligations outstanding from $1.9 billion ABS that financed our whole loan acquisitions and SBC originations;

·

master repurchase agreements with four counterparties to fund our acquisition of MBS, short term investments, and SBC loans with $382.6 million of borrowings outstanding;

·

$140.0 million in principal amount of 7.50% senior secured notes due 2022 to originated or acquire our target assets and for general corporate purposes; and

·

$115.0 million in principal amount of 7.00% convertible senior notes due 2023 to originate or acquire our target assets and for general corporate purposes.

For further information on these funding sources see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” included in this annual report on Form 10-K. Over time, as market conditions change, we plan to use these and the particular risks of the assets being financed. The Company's percentage of leverage varies over time depending on its ability to enter into or issue repurchase agreements, warehouse facilities, notes issued by the Operating Partnership, term financings and derivative contracts, financing rates, type and/or amount of collateral required to be pledged, the Company's assessment of the appropriate amount of leverage for the particular assets the Company is funding and regulatory requirements limiting the permissible amount of leverage to be utilized.other borrowings.

 

The return on the Company'sour assets and cash available for distribution to itsour stockholders may be reduced to the extent that market conditions prevent the Companyus from leveraging itsour assets or cause the cost of itsour financing to increase relative to the income that can be derived from the assets originated or acquired. The Company'sOur financing costs will reduce cash available for distribution to stockholders. The CompanyWe may not be able to meet itsour financing obligations and, to the extent that the Companywe cannot, the Company riskswe risk the loss of some or all of the Company'sour assets to liquidation or sale to satisfy the obligations. A decrease in the value of the Company'sour assets that are subject to repurchase agreement and certain warehouse financingsfinancing may lead to margin calls which the Companythat we will have to satisfy. The CompanyWe may not have the funds available to satisfy any such margin calls and may be forced to sell assets at significantly depressed prices due to market conditions or otherwise, which may result in losses. The satisfaction of any such margin calls may reduce cash flow available for distribution to the Company'sour stockholders. Any reduction in distributions to the Company'sour stockholders may cause the value of the Company'sour common stock to decline.

 

We may not be able to successfully complete additional securitization transactions, which could limit potential future sources of financing and could inhibit the growth of our business.

We may use our existing credit facilities or repurchase agreements or, if we are successful in entering into definitive documentation in respect of our other potential financing facilities, other borrowings to finance the origination and/or acquisition of SBC loans until a sufficient quantity of eligible assets has been accumulated, at which time we would refinance these short-term facilities or repurchase agreements through the securitization market, which could include the

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creation of CMBS, collateralized debt obligations (“CDOs”), or the private placement of loan participations or other long-term financing. When we employ this strategy, we are subject to the risk that we would not be able to obtain, during the period that our short-term financing arrangements are available, a sufficient amount of eligible assets to maximize the efficiency of a CMBS, CDO or private placement issuance. We are also subject to the risk that we will not able to obtain short-term financing arrangements or will not be able to renew any short-term financing arrangements after they expire should we find it necessary to extend such short-term financing arrangements to allow more time to obtain the necessary eligible assets for a long-term financing.

The Company'sinability to consummate securitizations of our portfolio to finance our SBC loan and ABS assets on a long-term basis could require us to seek other forms of potentially less attractive financing or to liquidate assets at an inopportune time or price, which could have a material and adverse effect on our business, financial condition and results of operations.

We may be required to repurchase mortgage loans or indemnify investors if we breach representations and warranties, which could harm our earnings.

We have sold and, on occasion, consistent with our qualification as a REIT and our desire to avoid being subject to the “prohibited transaction” penalty tax, we may sell some of our loans in the secondary market or as a part of a securitization of a portfolio of our loans. When we sell loans, we are required to make customary representations and warranties about such loans to the loan purchaser. Our mortgage loan sale agreements may require us to repurchase or substitute loans in the event we breach a representation or warranty given to the loan purchaser. In addition, we may be required to repurchase loans as a result of borrower fraud or in the event of early payment default on a mortgage loan. Likewise, we may be required to repurchase or substitute loans if we breach a representation or warranty in connection with our securitizations, if any.

The remedies available to a purchaser of mortgage loans are generally broader than those available to us against the originating broker or correspondent. Further, if a purchaser enforces its remedies against us, we may not be able to enforce the remedies we have against the sellers. The repurchased loans typically can only be financed at a steep discount to their repurchase price, if at all. They are also typically sold at a significant discount to the UPB. Significant repurchase activity could harm our cash flow, results of operations, financial condition and business prospects.

Our financing arrangements will contain financial covenants that could restrict our borrowings or subject it to additional risks.

Our financing arrangements, including the our senior secured notes issued in February 2017 by ReadyCap Holdings, LLC (“ReadyCap Holdings”), an indirect wholly-owned subsidiary of our Company, contain various financial and other restrictive covenants, including covenants that require us to maintain a certain interest coverage ratio and net asset value and that create a maximum balance sheet leverage ratio. For further information on these covenants see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” included in this annual report on Form 10-K. If we fail to satisfy any of the financial or other restrictive covenants, or otherwise default under these financings, the lender or noteholders may have the right to take certain actions, including accelerating repayment or repurchase and terminating the financing. Accelerating repayment or repurchase or terminating the facility would require immediate repayment by us of the borrowed funds, which may require us to liquidate assets at a disadvantageous time, causing us to incur further losses and adversely affecting our results of operations and financial condition, which may impair our ability to maintain our current level of distributions.

Certain financing arrangements restrict our operations and expose us to additional risk.

Our existing financing arrangements, including the Senior Secured Notes, Convertible Notes, and our future financing arrangements are or will be governed by a credit agreement, indenture or other instrument containing covenants restricting our operating flexibility. Additionally, any convertible or exchangeable securities that we issue in the future may have rights, preferences and privileges more favorable than those of our common stock. We will bear the cost of issuing and servicing such credit facilities, arrangements or securities.

These restrictive covenants and operating restrictions could have a material adverse effect on our operating results, cause us to lose our REIT status, restrict our ability to finance or securitize new originations and acquisitions, force us to liquidate collateral and negatively affect the market price of our common stock and our ability to pay dividends. For further

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information on these covenants see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” included in this annual report on Form 10-K.

Our securitizations may also reduce and/or restrict our available cash needed to pay dividends to our stockholders in order to satisfy the REIT requirements. Under the terms of the securitization, excess interest collections with respect to the securitized loans are distributed to us as the trust certificate holder once the overcollateralization target is reached and maintained. If the securitized loans experience delinquencies exceeding default triggers specified in the securitizations, the excess interest collections will be paid to the noteholders as additional principal payments on the notes. If excess interest collections are paid to noteholders rather than to us, we will be required to use cash from other sources to pay dividends to our stockholders in order to satisfy the REIT requirements or to fund our ongoing operations.

Our inability to access funding could have a material adverse effect on the Company's consolidatedour results of operations, financial condition and business. We will rely on short-term financing and thus are especially exposed to changes in the availability of financing.

 

TheWe will use short-term borrowings, the Company usedsuch as our existing credit facilities and repurchase agreements, to fund its portfolio totaled approximately $527.4 million asthe acquisition of December 31, 2015our assets, pending our completion of longer-term matched funded financings. Our use of short-term financings exposes us to the risk that our lenders may respond to market conditions by making it more difficult for us to renew or replace on a continuous basis our maturing short-term borrowings. If we are not able to renew our then existing short-term facilities or arrange for new financing on terms acceptable to us, or if we default on our covenants or are otherwise unable to access funds under the Loan Repurchase Facilities, master securities repurchase agreements with four counterparties, warehousethese types of financing, we may have to curtail our asset acquisition and repurchase agreement facilities related to its GMFS mortgage banking platform with four counterparties and notes issued by the Operating Partnership. The Company'sorigination activities and/or dispose of assets.

Our ability to fund itsour target asset originations and acquisitions may be impacted by the Company'sour ability to secure further such borrowings as well as securitizations, term financings and derivative contracts on acceptable terms. Because repurchase agreements and warehouse facilities are short-term commitments of capital, lenders may respond to market conditions making it more difficult for the Companyus to renew or replace on a continuous basis itsour maturing short-term borrowings. If the Company iswe are not able to renew itsour then existing facilities or arrange for new financing on terms acceptable to the Company,us, or if the Company defaultswe default on the Company'sour covenants or isare otherwise unable to access funds under the Company'sour financing facilities, the Companywe may have to curtail the Company'sour origination and asset acquisition activities and/or dispose of assets.

 

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It is possible that the lenders that will provide the Companyus with financing could experience changes in their ability to advance funds to it,us, independent of itsour performance or the performance of itsour portfolio of assets. Furthermore,Further, if many of the Company'sour potential lenders are unwilling or unable to provide itus with financing, the Companywe could be forced to sell itsour assets at an inopportune time when prices are depressed. In addition, if the regulatory capital requirements imposed on the Company'sour lenders change, they may be required to significantly increase the cost of the financing that they provide to the Company. The Company'sus. Our lenders also may revise their eligibility requirements for the types of assets they are willing to finance or the terms of such financings, based on, among other factors, the regulatory environment and their management of perceived risk, particularly with respect to assignee liability. Moreover, the amount of financing the Company receiveswe receive under its repurchase agreementsour short-term borrowing arrangements will be directly related to the lenders'lenders’ valuation of the Company'sour target assets that cover the outstanding borrowings. Typically, repurchase agreements grant the lender the absolute right to reevaluate the fair market value of the assets that cover outstanding borrowings at any time. If a lender determines in its sole discretion that the value of the assets has decreased, it has the right to initiate a margin call. A margin call would require the Company to transfer additional assets to such lender without any advance of funds from the lender for such transfer or to repay a portion of the outstanding borrowings. Any such margin call could have a material adverse effect on the Company's consolidated results of operations, financial condition, business, liquidity and ability to make distributions to the Company's stockholders, and could cause the value of the Company's common stock to decline. The Company may be forced to sell assets at significantly depressed prices to meet such margin calls and to maintain adequate liquidity, which could cause it to incur losses.

 

The dislocations in the residential mortgage sector in the financial crisis that began in 2007 have caused many lenders to tighten their lending standards, reduce their lending capacity or exit the market altogether. Further contraction among lenders, insolvency of lenders or other general market disruptions could adversely affect one or more of the Company'sour potential lenders and could cause one or more of the Company'sour potential lenders to be unwilling or unable to provide the Companyus with financing on attractive terms or at all. This could increase the Company'sour financing costs and reduce itsour access to liquidity.

The Exchangeable Senior Notes are recourse obligations to the Company and the indenture governing the Exchangeable Senior Notes contains cross-default provisions.

As of December 31, 2015, $57.5 million of principal balance of the Exchangeable Senior Notes were outstanding. These amounts are full recourse obligations of the Company.

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 Company is not able to extend, refinance or repurchase these borrowings, the Company may not have the ability to repay these amounts when they come due. The Company’s inability to repay any of the Exchangeable senior Notes could cause the acceleration of its borrowings which would have a material adverse effect on its business.

The indenture governing the Exchangeable Senior Notes contains cross-default provisions whereby a default under one agreement could result in a default and acceleration of borrowings under other agreements. If a cross-default occurred, the Company may not be able to pay its liabilities or access capital from external sources in order to refinance its borrowings. If some or all of the Company's borrowings default and it causes a default under other borrowings, the Company's business, financial condition and consolidated results of operations could be materially and adversely affected.

The accounting for the Exchangeable Senior Notes has resulted in the Company having to recognize interest expense in excess of the stated interest rate of the Exchangeable Senior Notes and may result in volatility to Company's consolidated statement of operations.

The Operating Partnership will deliver cash in respect of any shares that would otherwise be deliverable in excess of the "aggregate share cap" based on a daily exchange value calculated on a proportionate basis for each trading day of the 40 trading day averaging period. The conversion option that is part of the Exchangeable Senior Notes is accounted for as a derivative under ASC 815 "Derivatives and Hedging" ("ASC 815"). In general, this has resulted in an initial valuation of the conversion option, which has been bifurcated from the debt component of the Exchangeable Senior Notes resulting in an original issue discount. The original issue discount is accreted to interest expense over the term of the Exchangeable Senior Notes, which resulted in an effective interest rate reported in Company's consolidated statement of operations in excess of the stated coupon rate of the Exchangeable Senior Notes. This reduced the Company's earnings and could adversely affect the price at which Company's common stock trades, but will have no effect on the amount of cash interest paid to holders or on the Operating Partnership's or the Company's cash flows.

For each financial statement period after issuance of the Exchangeable Senior Notes, a change in unrealized gain (or loss) may be reported in the Company's consolidated statement of operations to the extent the valuation of the conversion option changes from the previous period, which may result in volatility to the Company's consolidated statement of operations.

 

The repurchase agreements that the Company useswe will use to finance itsour assets may require the Company to provide additional collateral and maywill restrict the Companyus from leveraging itsour assets as fully as desired.desired, and may require us to provide additional collateral.

 

The Company usesIn June 2017, we extended our master repurchase agreement to finance our acquisition of SBC loans for up to $200.0 million, $102.6 million of which is committed, with $97.4 million outstanding as of December 31, 2017. In December 2015, we closed on a master repurchase agreement to fund the origination of our SBC loans for up to $275.0 million, with $173.8 million outstanding as of December 31, 2017, which was extended in February 2017 and further extended in February 2018 through February 14, 2020. In June 2016, we closed on a master repurchase agreement to fund the origination of transitional loans and acquisition of mezzanine loans for up to $250.0 million, with $60.5 million outstanding as of December 31, 2017. In June 2017, we extended the maturity date under this repurchase agreement through June

38


2018. We also entered into master repurchase agreements to fund our acquisition of SBC ABS and short-term investments with four counterparties and had $65.4 million of borrowings as of December 31, 2017. We also entered into a promissory note agreement with $6.1 million outstanding as of December 31, 2017. We may use these facilities together with other borrowings structured as repurchase agreements to finance certain of itsour assets. If the fair market value of the assets pledged or sold by the Companyus under a repurchase agreement borrowing to a financing institution declines, the Company maywe will normally be required by the financing institution to provide additional collateral or pay down a portion of the funds advanced, but the Companywe may not have the funds available to do so, which could result in defaults. Repurchase agreements that we may use in the future may also require us to provide additional collateral if the market value of the assets pledged or sold by us to a financing institution declines. Posting additional collateral to support the Company'sour credit will reduce itsour liquidity and limit itsour ability to leverage itsour assets, which could adversely affect itsour business. In the event the Company doeswe do not have sufficient liquidity to meet such requirements, financing institutions can accelerate repayment of the Company'sour indebtedness, increase interest rates, liquidate itsour collateral or terminate itsour ability to borrow. Such a situation would likely result in a rapid deterioration of the Company'sour financial condition and possibly necessitate a filing for bankruptcy protection. For further information on our repurchase agreements see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations —  Liquidity and Capital Resources” included in this annual report on Form 10-K.

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Further, financial institutions providing the repurchase facilities may require the Companyus to maintain a certain amount of cash that is not invested or to set aside non-leveraged assets sufficient to maintain a specified liquidity position whichthat would allow the Companyus to satisfy itsour collateral obligations. As a result, the Companywe may not be able to leverage the Company'sour assets as fully as the Companywe would choose, which could reduce itsour return on equity. If the Company iswe are unable to meet these collateral obligations, the Company'sour financial condition could deteriorate rapidly.

 

If a counterparty to the Company'sour repurchase transactions defaults on its obligation to resell the underlying asset back to the Companyus at the end of the transaction term, or if the value of the underlying asset has declined as of the end of that term, or if the Company defaultswe default on itsour obligations under the repurchase agreement, the Companywe will lose moneyincur losses on itsour repurchase transactions.

 

Under the Company's repurchase transactions, the Companyagreement financings, we generally sellssell assets to lenders (that is, repurchase agreement counterparties) and receivesreceive cash from the lenders. The lenders are obligated to resell the same assets back to the Companyus at the end of the term of the transaction, which typically ranges from 30 to 90 days, for RMBS related repurchase agreements, andbut which may have terms of up to 364 days or longer for residential loan related repurchase agreements.longer. Because the cash the Companywe will receive from the lender when the Companyit initially sells the assets to the lender is less than the value of those assets (this is referred to as the haircut), if the lender defaults on its obligation to resell the same assets back to it the Companyus, we would incur a loss on the transaction equal to the amount of the haircut (assuming there was no change in the value of the assets). The CompanyWe would also lose moneyincur losses on a repurchase transaction if the value of the underlying assets has declined as of the end of the transaction term, as the Companywe would have to repurchase the assets for their initial value but would receive assets worth less than that amount. Further, if the Company defaultswe default on one of itsour obligations under a repurchase transaction, the lender will be able to terminate the transaction and cease entering into any other repurchase transactions with the Company. The Company'sus. It is also possible that our repurchase agreements maywill contain cross-default provisions, suchso that if a default occurs under any one agreement, the lenders under the Company'sour other agreements could also declare a default. If a default occurs under any of the Company'sour repurchase agreements and the lenders terminate one or more of the Company'sour repurchase agreements, the Companywe may need to enter into replacement repurchase agreements with different lenders. There can be no assurance that the Companywe will be successful in entering into such replacement repurchase agreements on the same terms as the repurchase agreements that were terminated or at all. Any losses the Company incurswe incur on itsour repurchase transactions could adversely affect the Company'sour earnings and thus the Company'sour cash available for distribution to itsour stockholders.

 

An increase in the Company'sour borrowing costs relative to the interest it receiveswe receive on itsour leveraged assets may adversely affect the Company'sour profitability and the Company'sour cash available for distribution to itsour stockholders.

 

As the Company's repurchase agreements, warehouse facilities and other short-term borrowingsour financings mature, the Companywe will be required either to enter into new borrowings or to sell certain of itsour assets. An increase in short-term interest rates at the time that the Company seekswe seek to enter into new borrowings would reduce the spread between the returns on the Company'sour assets and the cost of the Company'sour borrowings. This would adversely affect the returns on the Company'sour assets, which might reduce earnings and, in turn, cash available for distribution to the Company'sour stockholders.

 

The Company's

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Our rights under the Company'sour repurchase agreements may be subject to the effects of the bankruptcy laws in the event of the bankruptcy or insolvency of theour Company or itsour lenders under the repurchase agreements, which may allow the Company'sour lenders to repudiate the Company'sour repurchase agreements.

 

In the event of the Company's insolvency or bankruptcy, certain repurchase agreements maynormally qualify for special treatment under the U.S. Bankruptcy Code, the effect of which, among other things, would be to allow the lender under the applicable repurchase agreement to avoid the automatic stay provisions of the U.S. Bankruptcy Code and to foreclose on the collateral agreement without delay. In the event of the insolvency or bankruptcy of a lender during the term of a repurchase agreement, the lender may be permitted, under applicable insolvency laws, to repudiate the contract, and the Company'sour claim against the lender for damages may be treated simply as an unsecured creditor. In addition, if the lender is a broker or dealer subject to the Securities Investor Protection Act of 1970, or an insured depository institution subject to the Federal Deposit Insurance Act, the Company'sour ability to exercise itsour rights to recover its assetsour securities under a repurchase agreement or to be compensated for any damages resulting from the lender'slender’s insolvency may be further limited by those statutes. These claims would be subject to significant delay and, if and when received, may be substantially less than the damages we actually incur.

The change of control provisions in the Senior Secured Notes and the related indenture could deter, delay or prevent an otherwise beneficial merger, acquisition, tender offer or other takeover attempt involving our Company.

The change of control provisions in the Notes and the related indenture could make it more difficult or more expensive for a third-party to acquire our Company.  If a merger, acquisition, tender offer or other takeover attempt involving our Company actually incurs.by a third-party constitutes a change of control under the Indenture, ReadyCap Holdings may be required to offer to repurchase all of the Notes. As a result, our obligations under the Notes could increase the cost of acquiring our Company or otherwise discourage a third party from acquiring our Company.

We may enter into hedging transactions that could expose us to contingent liabilities in the future and adversely impact our financial condition.

Subject to maintaining our qualification as a REIT, part of our strategy involves entering into hedging transactions that could require us to fund cash payments in certain circumstances (such as the early termination of a hedging instrument caused by an event of default or other early termination event). The amount due would be equal to the unrealized loss of the open swap positions with the respective counterparty and could also include other fees and charges, and these economic losses will be reflected in our results of operations. We may also be required to provide margin to our counterparties to collateralize our obligations under hedging agreements. Our ability to fund these obligations will depend on the liquidity of our assets and access to capital at the time. The need to fund these obligations could adversely impact our financial condition.

 

Through certain of itsour subsidiaries the Companywe may engage in securitization transactions relating to residential mortgage loans, which would expose itus to potentially material risks.

 

Through certain of itsour subsidiaries the Companywe may engage in securitization transactions relating to residential mortgage loans, which generally would require the Companyus to prepare marketing and disclosure documentation, including term sheets and prospectuses, thatwhich include disclosures regarding the securitization transactions and the assets being securitized. If the Company'sour marketing and disclosure documentation are alleged or found to contain inaccuracies or omissions, the Companywe may be liable under federal and state securities laws (or under other laws) for damages to third parties that invest in these securitization transactions, including in circumstances where the Companywe relied on a third party in preparing accurate disclosures, or the Companywe may incur other expenses and costs in connection with disputing these allegations or settling claims.

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In recent years there has also been debate as to whether there are defects in the legal process and legal documents governing transactions in which securitization trusts and other secondary purchasers take legal ownership of residential mortgage loans and establish their rights as first priority lien holders on underlying mortgaged property. To the extent there are problems with the manner in which title and lien priority rights were established or transferred, securitization transactions that the Companywe may sponsor and third-party sponsored securitizations that the Company holdswe hold investments in may experience losses, which could expose the Companyus to losses and could damage itsour ability to engage in future securitization transactions.

 

The Company's

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Our potential securitization activities could expose itus to litigation, which may adversely affect itsour business and financial results.

 

Through certain of itsour subsidiaries the Companywe may engage in or participate in securitization transactions relating to residential mortgage loans. As a result of declining property values, increasing defaults, changes in interest rates, or other factors, the aggregate cash flows from the loans held by any securitization entity that the Companywe may sponsor and the securities and other assets held by these entities may be insufficient to repay in full the principal amount of ABS issued by these securitization entities. The Company doesWe do not expect to be directly liable for any of the ABS issued by these entities. Nonetheless, third parties who hold the ABS issued by these entities may try to hold the Companyus liable for any losses they experience, including through claims under federal and state securities laws or claims for breaches of representations and warranties the Companywe would make in connection with engaging in these securitization transactions.

 

Defending a lawsuit can consume significant resources and may divert management'smanagement’s attention from the Company'sour operations. The CompanyWe may be required to establish reserves for potential losses from litigation, which could be material. To the extent the Company iswe are unsuccessful in itsour defense of any lawsuit, the Companywe could suffer losses, which could be in excess of any reserves established relating to that lawsuit, and these losses could be material.

The Company enters into hedging transactions that could expose it to contingent liabilities in the future and adversely impact its financial condition.

Subject to maintaining the Company's qualification as a REIT, part of the Company's strategy involves entering into hedging transactions that could require it to fund cash payments in certain circumstances (such as the early termination of a hedging instrument caused by an event of default or other early termination event, or the decision by a counterparty to request margin assets it is contractually owed under the terms of the hedging instrument). The amount due would be equal to the unrealized loss of the open swap positions with the respective counterparty and could also include other fees and charges. These economic losses will be reflected in the Company's consolidated results of operations. The Company's ability to fund these obligations will depend on the liquidity of its assets and access to capital at the time. The need to fund these obligations could adversely impact the Company's financial condition.

Hedging against interest rate exposure may adversely affect the Company's earnings, which could reduce its cash available for distribution to its stockholders.

Subject to maintaining its qualification as a REIT, the Company pursues various hedging strategies to seek to reduce its exposure to adverse changes in interest rates. The Company's hedging activity varies in scope based on the level and volatility of interest rates, the type of assets held and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect the Company because, among other things:

·interest rate hedging can be expensive, particularly during periods of volatile interest rates;

·available interest rate hedges may not correspond directly with the interest rate risk for which protection is sought;

·the value of derivatives used for hedging may be adjusted from time to time in accordance with accounting rules to reflect changes in fair value. Downward adjustments or "mark to market" losses would reduce earnings or stockholders' equity;

·the amount of income that a REIT may earn from non-qualifying hedging transactions (other than through taxable REIT subsidiaries (“TRSs”) to offset interest rate losses is limited by U.S. federal tax provisions governing REITs;

·the credit quality of the hedging counterparty owing money on the hedge may be downgraded to such an extent that it impairs the Company's ability to sell or assign the Company's side of the hedging transaction;

·the hedging counterparty owing money in the hedging transaction may default on its obligation to pay; and

·the duration of the hedge may not match the duration of the related liability.

In general, when the Company originates or acquires a fixed-rate mortgage loan or hybrid ARM or a RMBS collateralized by such 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 fixed for the duration of the fixed-rate portion of the related asset.

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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 end of the hedging instrument while the income earned on the asset would remain fixed. This situation may also cause the fair market value of the Company's asset 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 the Company's 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.

The Company's hedging transactions, which are intended to limit losses, may actually adversely affect the Company's earnings, which could reduce its cash available for distribution to its stockholders.

The Company's use of derivatives may expose it to counterparty and other risks.

Certain of the Company's subsidiaries have entered into over-the-counter interest rate swap agreements to hedge risks associated with movements in interest rates. Because interest rate swaps were not cleared through a central counterparty, the Company remains exposed to the counterparty's ability to perform its obligations under each such swap and cannot look to the creditworthiness of a central counterparty for performance. As a result, if an over-the-counter swap counterparty cannot perform under the terms of an interest rate swap, the Company's subsidiary would not receive payments due under that agreement, the Company may lose any unrealized gain associated with the interest rate swap and the hedged liability would cease to be hedged by the interest rate swap. While the Company would seek to terminate the relevant over-the-counter swap transaction and may have a claim against the defaulting counterparty for any losses, including unrealized gains, there is no assurance that the Company would be able to recover such amounts or to replace the relevant swap on economically viable terms or at all. In such case, the Company could be forced to cover its unhedged liabilities at the then current market price. The Company may also be at risk for any collateral the Company has pledged to secure the Company's obligations under the over-the-counter interest rate swap if the counterparty becomes insolvent or files for bankruptcy.

Furthermore, the Company's swap transactions are subject to increasing statutory and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. Recently, new regulations have been promulgated by U.S. and foreign regulators attempting to strengthen oversight of derivative contracts. Any actions taken by regulators could constrain the Company's strategy and could increase its costs, either of which could materially and adversely impact its consolidated results of operations.

In particular, the Dodd-Frank Act requires certain derivatives, including certain interest rate swaps, to be executed on a regulated market and cleared through a central counterparty. Unlike uncleared swaps, the counterparty for the cleared swaps is the clearing house, which reduces counterparty risk. However, cleared swaps require the Company to appoint clearing brokers and to post margin in accordance with the clearing house's rules, which has resulted in increased costs for cleared swaps over uncleared swaps. Margin requirements for uncleared swaps have recently been issued by certain regulators. Starting March 1, 2017, these rules will require the Company to post margin for uncleared swaps with swap dealers. The margin for both cleared and uncleared swaps will generally be limited to cash and certain types of securities. These requirements may increase the costs of hedging and induce the Company to change or reduce its use of hedging transactions.

Derivative instruments are also subject to liquidity risk and may be difficult or impossible to sell, close out or replace quickly and at the price that reflects the fundamental value of the instrument. Although both over-the-counter and exchange-traded markets may experience lack of liquidity, over-the-counter non-standardized derivative transactions are generally less liquid than exchange-traded instruments.

Regulation as a commodity pool operator could subject the Company to additional regulation and compliance requirements which could materially adversely affect the Company's business and financial condition.

The Dodd-Frank Act extended the reach of commodity regulations for the first time to include not just traditional futures and options contracts but also derivative contracts referred to as "swaps." As a consequence of this change, any investment fund that trades in swaps may be considered a "commodity pool" under regulations issued by the relevant regulator, the U.S. Commodity Futures Trading Commission ("CFTC"). If the Company is a commodity pool, unless an exemption applies, its operator will be regulated as a commodity pool operator ("CPO"). Under revised requirements issued by the CFTC, CPOs must register or file for an exemption from registration with the National Futures Association, the self-regulatory organization for CFTC-regulated swaps and other financial instruments, and become subject to regulation by the CFTC, including with respect to disclosure, recordkeeping and reporting.

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On December 7, 2012, the CFTC issued a No-Action Letter that provides mortgage REITs relief from such registration ("No-Action Letter") if they meet certain conditions and submit a claim for such no-action relief by email to the CFTC. The Company believes it meets the conditions set forth in the No-Action Letter and it has filed its claim with the CFTC to permit the use of the no-action relief from registration. However, if in the future the Company does not meet the conditions set forth in the No-Action Letter or the relief provided by the No-Action Letter becomes unavailable for any other reason and the Company is unable to obtain another exemption from registration, the Company may be required to reduce or eliminate its use of interest rate swaps or vary the manner in which it deploys interest rate swaps in its business in order to mitigate the cost of compliance with the commodity pool regulations. Further, the Company or its directors may be required to register with the CFTC as CPOs and the Advisor may be required to register as a "commodity trading advisor" with the CFTC in order to execute or maintain the Company's hedging strategy. This will subject the Company, its directors and the Advisor to regulation by the CFTC and require compliance with the CFTC's swap rules. In the event registration for the Company, its directors or the Advisor is required but is not obtained, the Company, its directors or the Advisor may be subject to fines, penalties and other civil or governmental actions or proceedings. The costs of compliance with the CFTC regulations, or the changes to the Company's hedging strategy necessary to avoid their application, could have a material adverse effect on the Company's business, financial condition and consolidated results of operations.

If the Company attempts to qualify for hedge accounting treatment for its derivative instruments, but the Company fails to so qualify, it may suffer because losses on the derivatives that the Company enters into may not be offset by a change in the fair value of the related hedged transaction.

If the Company attempts to qualify for hedge accounting treatment for the Company's derivative instruments, but it fails to so qualify for a number of reasons, including if the Company uses instruments that do not meet the definition of a derivative (such as short sales), the Company fails to satisfy hedge documentation and hedge effectiveness assessment requirements or the Company's instruments are not highly effective, the Company may suffer because losses on the derivatives the Company holds may not be offset by a change in the fair value of the related hedged transaction.

Declines in the fair market values of the Company's assets may adversely affect periodic reported results and credit availability, which may reduce earnings and, in turn, cash available for distribution to the Company's stockholders.

Changes in the fair market values of most of the Company's assets will be directly charged or credited to stockholders' equity. As a result, a decline in values may reduce the book value of the Company. Moreover, if the decline in value of an available-for-sale security is other than temporary or if the Company elects the fair value option in respect of such security, such decline will reduce earnings.

A decline in the fair market value of the Company's assets may adversely affect it, particularly in instances where the Company has borrowed money based on the fair market value of those assets. If the fair market value of those assets declines, the lender may require the Company to post additional collateral to support the loan. If the Company were unable to post the additional collateral, it would have to sell the assets at a time when it might not otherwise choose to do so. A reduction in credit available may reduce the Company's earnings and, in turn, cash available for distribution to stockholders.

Risks Related to the Company's Assets and the Company's Target Assets

The Company may not realize gains or income from its assets, which could cause the value of its common stock to decline.

The Company seeks to generate both current income and capital appreciation for its stockholders. However, the Company's assets may not appreciate in value and, in fact, may decline in value, and the debt assets the Company owns, originates or acquires may default on interest and/or principal payments. Accordingly, the Company may not be able to realize gains or income from the Company's assets. Any gains that the Company does realize may not be sufficient to offset any other losses the Company experiences. Any income that the Company realizes may not be sufficient to offset the Company's expenses.

The Company's portfolio of assets may be concentrated and will be subject to risk of default.

While the Company has diversified its portfolio of assets in the manner described in this annual report on Form 10-K, the Company is not required to observe specific diversification criteria, except as may be set forth in the guidelines adopted by the Company's board of directors. Therefore, the Company's portfolio of assets may at times have been concentrated in certain property types that are subject to higher risk of foreclosure, or secured by properties concentrated in a limited number of geographic locations. For example, as of December 31, 2015, the five states that represented the largest portion of mortgage loans held for investment (measured by outstanding principal balance) were: California (26.2%); Florida (16.1%); Georgia (6.1%); New York (4.8%); and New Jersey (4.3%). To the extent that the Company's portfolio is concentrated in any one region or type of security, downturns relating generally to such region or type of security may result in defaults on a number of its assets within a short time period, which may reduce the Company's net income and the value of its common stock and accordingly reduce its ability to pay dividends to its stockholders.

The spread between swap rates and residential mortgage loans and non-Agency RMBS may widen due to difficult market conditions, which may adversely affect lending terms for these assets and have a negative impact on the Company's stated book value.

Since the onset of the financial crisis that began in 2007, the spread between swap rates and residential mortgage loans and non-Agency RMBS has 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.

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GMFS originates residential mortgage loans which have risks of losses due to mortgage loan defaults or fraud.

 

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. The CompanyWe also expectsexpect GMFS to originate loans that are not guaranteed or insured by such agencies or channels, and the origination of these residential mortgage loans have risks of losses due to mortgage loan defaults or fraud. The ability of borrowers to make timely principal and interest payments could be adversely affected by changes in their personal circumstances, a rise in interest rates, a recession, declining real estate property values or other economic events, resulting in losses. Moreover, if a borrower defaults on a mortgage loan that GMFS or the Company ownswe own and if the liquidation proceeds from the sale of the property do not cover the loan amount and the legal, broker and selling costs, GMFS or the Companywe would experience a loss. The CompanyWe could experience losses if it failswe fail to detect fraud, where a borrower or lending partner has misrepresented its financial situation or purpose for obtaining the loan, or an appraisal misrepresented the value of the property collateralizing its loan.

 

Currently, and in the future, some of the loans the Companywe may originate may be insured in part by mortgage insurers or financial guarantors. Mortgage insurance protects the lender or other holder of a loan up to a specified amount, in the event the borrower defaults on the loan. Mortgage insurance is generally obtained only when the principal amount of the loan at the time of origination is greater than 80% of the value of the property (loan-to-value), although it may not always be obtained in these circumstances. Any inability of the mortgage insurers to pay in full the insured portion of the loans that the Company holdswe hold would adversely affect the value of itsour loans, which could increase itsour credit risk, reduce itsour cash flows, or otherwise adversely affect itsour business.

 

The Company holdsWe will hold and may originate or acquire additional residential mortgage loans and non-Agencynon-agency RMBS collateralized by subprime mortgage loans, which are subject to increased risks.

 

The Company,We, through GMFS and other subsidiaries, holdswill hold and may originate or acquire additional subprime residential mortgage loans and non Agencynon-agency RMBS backed by collateral pools of subprime mortgage loans that have been originated using underwriting standards that are less restrictive than those used in underwriting other higher quality mortgage loans. These lower standards include mortgage loans made to borrowers having imperfect or impaired credit histories, mortgage loans where the amount of the loan at origination is 80% or more of the value of the mortgage property, mortgage loans made to borrowers with low credit scores, mortgage loans made to borrowers who have other debt that represents a large portion of their income and mortgage loans made to borrowers whose income is not required to be disclosed or verified. Due to economic conditions, including lower home prices, as well as aggressive lending practices, subprime mortgage loans have in recent years experienced increased rates of delinquency, foreclosure, bankruptcy and loss, and they are likely to continue to experience delinquency, foreclosure, bankruptcy and loss rates that are higher, and that may be substantially higher, than those experienced by mortgage loans underwritten in a more traditional manner. Thus, because of the higher delinquency rates and losses associated with subprime mortgage loans, the performance of subprime mortgage loans and non Agencynon-agency RMBS backed by subprime mortgage loans that the Company holdswe hold and may originate or acquire could be correspondingly adversely affected, which could adversely impact the Company'sour consolidated results of operations, financial condition and business.business.

 

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Deficiencies in the underwriting of newly originated residential mortgage loans may result in an increase in the severity of losses on the Company'sour residential mortgage loans.

 

The underwriting of newly originated residential mortgage loans is different than the underwriting and investment process related to seasoned mortgage loans and RMBS, which focuses, in part, on performance history.

 

Prior to originating or acquiring residential mortgage loans or other assets, GMFS or other Company subsidiaries may undertake underwriting and due diligence efforts with respect to various aspects of the loan or asset. When underwriting or conducting due diligence, GMFS or other Company subsidiaries rely on available resources and data, which may be limited, and on investigations by third parties.

The mortgage loan originator may also only conduct due diligence on a sample of a pool of loans or assets it is acquiring and assume that the sample is representative of the entire pool. These underwriting and due diligence efforts may not reveal matters whichthat could lead to losses. If the underwriting process is not robust enough or if it doeswe do not conduct adequate due diligence, or the scope of the underwriting or due diligence is limited, the Companywe may incur losses.

 

During the mortgage loan underwriting process, appraisals are generally obtained on the collateral underlying each prospective mortgage. The quality of these appraisals may vary widely in accuracy and consistency. The appraiser may feel pressure from the broker or lender to provide an appraisal in the amount necessary to enable the originator to make the loan, whether or not the value of the property justifies such an appraised value. Inaccurate or inflated appraisals may result in an increase in the severity of losses on the residential mortgage loans.

 

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Although mortgage originators generally underwrite mortgage loans in accordance with their predeterminedpre-determined loan underwriting guidelines, from time to time and in the ordinary course of business, originators may make exceptions to these guidelines. On a case by casecase-by-case basis, underwriters may determine that a prospective borrower that does not strictly qualify under the underwriting guidelines warrants an underwriting exception, based upon compensating factors. Compensating factors may include a lower loan-to-value ratio,LTV, a higher debt coverage ratio, experience as an owner or investor, higher borrower net worth or liquidity, stable employment, longer length of time in business and length of time owning the property. Loans originated with exceptions may result in a higher number of delinquencies and defaults.

 

Losses could occur due to a counterparty that sold loans to GMFS or other Company subsidiaries refusing to or being unable to repurchase that loan or pay damages related to breaches of representations made by the seller.

 

Losses could occur due to a counterparty that sold loans or other assets to GMFS or other Company subsidiaries refusing to or being unable to (e.g., due to its financial condition) repurchase loans or pay damages if it is determined subsequent to purchase that one or more of the representations or warranties made to GMFS or other Company subsidiaries in connection with the sale was inaccurate.

 

Even if GMFS or another Company subsidiary obtains representations and warranties from the loan seller counterparties they may not parallel the representations and warranties GMFS or other Company subsidiaries make to subsequent purchasers of the loans or may otherwise not protect the seller from losses, including, for example, due to the counterparty being insolvent or otherwise unable to make payments arising out of damages for a breach of representation or warranty. Furthermore, to the extent the counterparties from which loans were acquired have breached their representations and warranties, such breaches may adversely impact the Company'sour business relationship with those counterparties, including by reducing the volume of business Companyour subsidiaries conduct with those counterparties, which could negatively impact their ability to acquire loans and the larger mortgage origination business. To the extent our Company subsidiaries have significant exposure to representations and warranties made to itthem by one or more counterparties, the Companywe may determine, as a matter of risk management, to reduce or discontinue loan acquisitions from those counterparties, which could reduce the volume of mortgage loans available for acquisition and negatively impact the Company'sour business and financial results.

 

The Company and GMFSWe are subject to risks and can be exposed to significant losses relating to inaccurate representations made in connection with loan sales to third parties.

 

When selling loans (including sales to Agenciesagencies and into a securitization trust), GMFS has historically made and GMFS and other Company subsidiaries will in the future continue to make representations and warranties to the purchaser regarding characteristics of the mortgage loans, information about the mortgage borrower and the completeness of records

42


and documentation relating to the mortgage loans. Similarly, in lightconnection with, and prior to the completion of, the strategic review and in order to reduce current market risk in its investment portfolio, as discussed elsewhere in this annual report on Form 10-K, the Company has recently begun the process of sellingmerger, ZAIS Financial sold its seasoned, re-performing mortgage loans from its residential mortgage investments segment. Additionally, as part of the strategic review, the Company hasloans. ZAIS Financial made the decision to cease the purchase of newly originated residential mortgage loans as part of its mortgage conduit program and will begin the unwinding of the Company’s mortgage conduit business. The Company has made and will be required to make representations and warranties to the purchaser regarding the characteristics of whole loan assets included in any such sales. If the representations and warranties are inaccurate with respect to any mortgage loan, the seller of that loan may be obligated to repurchase the mortgage loan or pay damages, which may result in a loss.

 

In the aftermath of the financial crisis that began in 2007, a significant amount of litigation has been commenced by mortgage loan purchasers and their successors against mortgage loan originators and sellers, seeking to recover damages for losses incurred when purchased or securitized loans eventually defaulted. GMFS, which has been originating

As previously disclosed in the Joint Proxy Statement Prospectus filed on August 26, 2016 and selling mortgage loans toin our annual report on Form 10-K for the year ended December 31, 2016, a range of different counterparties, including during periods prior to and leading up to the 2007 financial crisis, faces risks that counterparties that hadcounterparty (the “Counterparty”) whose predecessor purchased mortgage loans from GMFS, will assertwhich is currently our subsidiary, asserted claims against GMFS for breach of representations and warranties arising out these historical mortgage loan sales. As disclosed in the Company's prior filings, GMFS had executed a statute of limitations tolling agreement with at least one counterparty with respect to mortgage loans that were sold by GMFS to the predecessor to this counterparty. This tolling agreement extends the time period by which this counterparty could bring claims against GMFS.

 The initial tolling agreement was executed by GMFS on December 12, 2013 and then further amended to extend the expiration date. Based on communications received in April 2015 from this counterparty, the Company believes that when this tolling agreement expires, absent further extension of the tolling agreement or settlement of the counterparty's claims, it is probable that the counterparty will initiate litigation against GMFS seeking substantial damages based on alleged breaches of representations and warranties made by GMFS. The most recent amendment of the tolling agreement extended the expiration date to June 2, 2016 and can be further extended by agreement of the parties. The Company also understands that this counterparty has commenced or threatened litigation arising out of historical mortgage loan purchases by its predecessor against a number of other mortgage loan originators. The Company estimatessales (the “Claims”).  We estimate that dating back to a period that began approximately 17 years ago in 1999 and ended in 2006, approximately $1 billion of mortgage loans were sold servicing released by GMFS to the predecessor to this counterparty. While the historicalCounterparty.  As we have also previously disclosed, GMFS entered into a statute of limitations tolling agreement with the Counterparty on December 12, 2013 related to the Claims, which was further amended to extend the expiration date, most recently to May 15, 2017.

On April 25, 2017, our Company and GMFS entered into a definitive agreement (the “Settlement Agreement”) to settle all Claims with the Counterparty and provide for mutual releases.  Pursuant to the Settlement Agreement, our Company has paid a total of $6,000,000 in cash and issued 275,862 shares of our Company’s common stock to the Counterparty (the “Settlement Shares”).  The Settlement Shares were issued within seven days of the Settlement Agreement in a private placement transaction effected in reliance on an exemption from the registration requirements of the Securities Act; pursuant to Section 4(2) thereof and Regulation D promulgated thereunder.  As part of the settlement, our Company granted the Counterparty customary resale registration rights.

During the period beginning on the 24-month anniversary of the date of the Settlement Agreement (and ending 30 days thereafter), the Counterparty will have the right, but not the obligation, to require that our Company repurchase any and all of the Settlement Shares that the Counterparty then owns at a price per share equal 65% of the then last reported book value per share of our Company’s common stock.

GMFS was an indirect subsidiary of ZAIS Financial when our Company completed its merger transaction with ZAIS Financial on October 31, 2016.  As disclosed in the Joint Proxy Statement Prospectus used in connection with the merger transaction and in our annual report on Form 10-K for the year ended December 31, 2016, ZAIS Financial had originally acquired GMFS on October 31, 2014 (the “GMFS 2014 acquisition”) from investment partnerships that were advised by our Manager, and from certain other entities controlled by GMFS management (together, the “2014 GMFS sellers”).  The terms of the GMFS 2014 acquisition provided for the payment of both cash consideration and the possible payment of additional contingent consideration based on the achievement by GMFS of certain financial milestones specified in the GMFS 2014 acquisition agreement.

The GMFS 2014 acquisition agreement contained representations and warranties related to GMFS, as well as indemnification obligations to cover breaches of representations and warranties, repurchase claims experience of GMFS withor demands from investors in respect to purchasers of mortgage loans from GMFS over the 1999 to 2006 period has not resulted in material damages claimed againstoriginated, purchased or paidsold by GMFS claims brought by this counterparty or other parties could expose GMFS to substantial damages that may be material, cause the Company and GMFS to devote significant management time and attention and other resources to resolving or defending these claims, require GMFS, the Company or its other subsidiaries to incur significant costs, or cause significant losses that may be material.

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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 dueprior to the early stage of this matter and the limited information available, the Company is not able to determine the likelihoodclosing date of the outcome. Losses in excessacquisition.  The GMFS 2014 acquisition agreement also established an escrow fund to support the payment of indemnification claims and allowed for indemnification claims to be offset against the contingent consideration that would otherwise be payable to the GMFS 2014 sellers under the GMFS 2014 acquisition agreement.  In accordance with the terms of the loan indemnification reserve willGMFS 2014 acquisition agreement, we applied the amounts paid to the Counterparty in settlement of the Claims to offset the amount of contingent consideration that we would otherwise be recovered byrequired to pay to the CompanyGMFS 2014 sellers under the GMFS 2014 acquisition agreement. We also recorded the amounts paid under the Settlement Agreement as either a reduction of the total$14.5 million liability that was accrued on our balance sheet as of December 31, 2016 to cover the possible payment of contingent consideration owed underpursuant to the GMFS Merger Agreement given2014 acquisition. As a result, we do not expect that the settlement will result in a charge to our earnings or otherwise adversely impact our results of operations.

Under the terms of the indemnification provisions contained in the GMFS Merger Agreement or by withdrawing funds from an escrow account established by2014 acquisition agreement, the 2014 GMFS sellers at the time of the acquisition (as of December 31, 2015, the balance of the escrow account was $4,004,424). The Company has delayed the first year installment payment of the contingent consideration. The Company believes that 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 indemnificationare liable for any losses or any amounts paid in settlement althoughof Claims made with their consent, which consent was not to be unreasonably withheld or delayed. Certain of the 2014 GMFS sellers did not consent to the settlement, and as a result, there can be no assurance that such claimsthe exercise of the right to indemnification by our Company under the terms of the GMFS 2014 acquisition agreement would be successful or that any amountssuccessful.

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Hedging against interest rate exposure may adversely affect our earnings, which could reduce our cash available for indemnificationdistribution to our stockholders.

Subject to maintaining our qualification as a REIT, we will likely pursue various hedging strategies to seek to reduce our exposure to adverse changes in interest rates. Our hedging activity will vary in scope based on the level and volatility of interest rates, the type of assets held and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:

·

interest rate hedging can be expensive, particularly during periods of volatile interest rates;

·

available interest rate hedges may not correspond directly with the interest rate risk for which protection is sought;

·

the value of derivatives used for hedging may be adjusted from time to time in accordance with accounting rules to reflect changes in fair value. Downward adjustments or “mark-to-market” losses would reduce earnings or stockholders’ equity;

·

the market value of derivatives used for hedging may decrease from time to time, which may require us to deliver additional margin to our counterparties;

·

the amount of income that a REIT may earn from non-qualifying hedging transactions (other than through taxable REIT subsidiaries (“TRSs”)) to offset interest rate losses is limited by U.S. federal tax provisions governing REITs;

·

the credit quality of the hedging counterparty owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction;

·

the hedging counterparty owing money in the hedging transaction may default on its obligation to pay; and

·

the duration of the hedge may not match the duration of the related liability.

In general, when we acquire an SBC loan or ABS, we may, but are not required to, enter into an interest rate swap agreement or other hedging instrument that effectively fixes our 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 us from rising interest rates, because the borrowing costs are fixed for the duration of the fixed-rate portion of the related SBC loan or ABS.

44


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 our results of operations, as borrowing costs would no longer be adequate.fixed after the end of the hedging instrument while the income earned on the SBC loan or ABS would remain fixed. This situation may also cause the market value of our SBC loan or ABS to decline, with little or no offsetting gain from the related hedging transactions. In extreme situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses.

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

Our hedging transactions, which are intended to limit losses, may actually adversely affect our earnings, which could reduce our cash available for distribution to our stockholders.

Our use of derivatives may expose us to counterparty and other risks.

We will likely enter into over-the-counter interest rate swap agreements to hedge risks associated with movements in interest rates. Because such interest rate swaps are not cleared through a central counterparty, the counterparty’s performance is not guaranteed by a clearing house. As a result, if a swap counterparty cannot perform under the terms of an interest rate swap, we would not receive payments due under that agreement, we may lose any unrealized gain associated with the interest rate swap and the hedged liability would cease to be hedged by the interest rate swap. We may also be at risk for any collateral we have pledged to secure our obligation under the interest rate swap if the counterparty becomes insolvent or files for bankruptcy.

 

The residentialbusiness failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in its default. Default by a party with whom we enter into a hedging transaction may result in the loss of unrealized profits and force us to cover our commitments, if any, at the then current market price. Although generally we will seek to reserve the right to terminate our hedging positions, we may not always be able to dispose of or close out a hedging position without the consent of the hedging counterparty and we may not be able to enter into an offsetting contract in order to cover our risk. We cannot provide any assurances that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.

Derivative instruments are also subject to liquidity risk and may be difficult or impossible to sell, close out or replace quickly and at the price that reflects the fundamental value of the instrument. Although both over-the-counter and exchange-traded markets may experience lack of liquidity, over-the-counter, non-standardized derivative transactions are generally less liquid than exchange-traded instruments.

Furthermore, derivative transactions are subject to increasing statutory and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. Recently, new regulations have been promulgated by U.S. and foreign regulators attempting to strengthen oversight of derivative contracts. Any actions taken by regulators could constrain our strategy and could increase our costs, either of which could materially and adversely impact our operations.

In particular, the Dodd-Frank Act requires certain derivatives, including certain interest rate swaps, to be executed on a regulated market and cleared through a central counterparty. Unlike uncleared swaps, the counterparty for the cleared swaps is the clearing house, which reduces counterparty risk. However, cleared swaps require us to appoint clearing brokers and to post margin in accordance with the clearing house’s rules, which has resulted in increased costs for cleared swaps over uncleared swaps. Margin requirements for uncleared swaps have recently been issued by certain regulators, and requirements from other regulators are expected to be issued soon. Starting March 1, 2017, these rules will require us to post margin for uncleared swaps with swap dealers. The margin for both cleared and uncleared swaps will generally be limited to cash and certain types of securities. These requirements may increase the costs of hedging and induce us to change or reduce our use of hedging transactions.

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Regulation as a commodity pool operator could subject us to additional regulation and compliance requirements, which could materially adversely affect our business and financial condition.

The Dodd-Frank Act extended the reach of commodity regulations for the first time to include not just traditional futures contracts but also derivative contracts referred to as “swaps.” As a consequence of this change, any investment fund that trades in swaps may be considered a “commodity pool,” which would cause its operator to be regulated as a commodity pool operator (“CPO”). Under the new requirements, CPOs must register or file for an exemption from registration with the National Futures Association, the self-regulatory organization for swaps and other financial instruments regulated by the U.S. Commodity Futures Trading Commission (“CFTC”), and become subject to regulation by the CFTC, including with respect to disclosure, recordkeeping and reporting.

On December 7, 2012, the CFTC issued a no-action letter that provides mortgage loansREITs relief from such registration, or the No-Action Letter, if they meet certain conditions and submit a claim for such no-action relief by email to the mortgage loans underlyingCFTC. We believe we will meet the RMBS thatconditions set forth in the No-Action Letter and we have filed our claim with the CFTC to perfect the use of the no-action relief from registration. However, if in the future we do not meet the conditions set forth in the No-Action Letter or the relief provided by the No-Action Letter becomes unavailable for any other reason and we are unable to obtain another exemption from registration, we may be required to reduce or eliminate our use of interest rate swaps or vary the manner in which we deploy interest rate swaps in our business and we or our directors may be required to register with the CFTC as CPOs and our Manager may be required to register as a “commodity trading advisor” with the CFTC, which will require compliance with CFTC rules and subject us, our board of directors and our Manager to regulation by the CFTC. In the event registration for our Company, holds and intends to originateour directors or acquireour Manager is required but is not obtained, we, our board of directors or our Manager may be subject to defaults, foreclosure timeline extension, fraudfines, penalties and residential price depreciation and unfavorable modificationother civil or governmental actions or proceedings, any of loan principal amount, interest rate and amortization of principal, which could result in losseshave a material adverse effect on our business, financial condition and results of operations. The costs of compliance with the CFTC regulations, or the changes to the Company.our hedging strategy necessary to avoid their application, could have a material adverse effect on our business, financial condition and results of operations.

 

If we attempt to qualify for hedge accounting treatment for our derivative instruments, but we fail to qualify, we may suffer losses because losses on the derivatives that we enter into may not be offset by a change in the fair value of the related hedged transaction.

We record derivative and hedging transactions in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Under these standards, we may fail to qualify for, or choose not to elect, hedge accounting treatment for a number of reasons, including if we use instruments that do not meet the definition of a derivative (such as short sales), we fail to satisfy hedge documentation, and hedge effectiveness assessment requirements or our instruments are not highly effective. If we fail to qualify for, or choose not to elect, hedge accounting treatment, our operating results may be volatile because changes in the fair value of the derivatives that we enter into may not be offset by a change in the fair value of the related hedged transaction or item.

Declines in the fair market values of our assets may adversely affect periodic reported results and credit availability, which may reduce earnings and, in turn, cash available for distribution to our stockholders.

Our SBC loans held-for-sale and SBC ABS are carried at fair value and future mortgage related assets may also be carried at fair value. Accordingly, changes in the fair value of these assets may impact the results of our operations for the period in which such change in value occurs. The residential mortgageexpectation of changes in real estate prices, which is beyond our control, is a major determinant of the value of SBC loans and SBC ABS.

Many of the mortgageassets in our portfolio are and will likely be SBC loans underlyingand SBC ABS that are not publicly traded. The fair value of assets that are not publicly traded may not be readily determinable. We value these assets quarterly at fair value, as determined in accordance with applicable accounting standards, which may include unobservable inputs. Because such valuations are subjective, the RMBSfair value of certain of our assets may fluctuate over short periods of time and our determinations of fair value may differ materially from the values that would have been used if a ready market for these assets existed.

A decline in the Company holdsfair market value of our assets may adversely affect us, particularly in instances where we have borrowed money based on the fair market value of those assets. If the fair market value of those assets declines, the lender may require us to post additional collateral to support the loan. If we are unable to post the additional collateral, we would have to sell the assets at a time when we might not otherwise choose to do so. A reduction in credit available may reduce our earnings and, intendsin turn, cash available for distribution to originatestockholders.

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Our loans are dependent on the ability of the commercial property owner to generate net income from operating the property, which may result in the inability of such property owner to repay a loan, as well as the risk of foreclosure.

Our loans are generally secured by multi-family, office, retail, mixed use, commercial or acquirewarehouse properties and are subject to risks of delinquency, foreclosure and loss that may be subject togreater than similar risks associated with loans made on the riskssecurity of defaults, foreclosure timeline extension, fraud and home price depreciation and unfavorable modification of loan principal amount, interest rate and amortization of principal.single-family residential property. The ability of a borrower to repay a mortgage loan secured by a residentialan income-producing property typically is dependent primarily upon the successful operation of such property rather than upon the existence of independent income or assets of the borrower. If the net operating income of the property is reduced, the borrower’s ability to repay the loan may be impaired. Net operating income of an income-producing property can be adversely affected by, among other things:

 

A number of factors may impair borrowers' abilities to repay their loans, including:

·

tenant mix;

 

·

adverse

success of tenant businesses;

·

property management decisions;

·

property location, condition and design;

·

competition from comparable types of properties;

·

changes in national, andregional or local economic and market conditions;conditions and/or specific industry segments;

 

·

changes

declines in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances;regional or local real estate values;

 

·

declines in regional or local rental or occupancy rates;

·

increases in interest rates, real estate tax rates and other operating expenses;

·

costs of remediation and liabilities associated with environmental conditions such as indoor mold;conditions;

 

·

the potential for uninsured or under-insuredunderinsured property losses;

 

·

changes in governmental laws and regulations, including fiscal policies, zoning ordinances and environmental legislation and the related costs of compliance; and

·

acts of God, including earthquakes, floodsterrorism, social unrest and other natural disasters, which may result in uninsured losses; andcivil disturbances.

·acts of war or terrorism, including the consequences of terrorist attacks, such as those that occurred on September 11, 2001.

 

In the event of defaults onany default under a mortgage loan held directly by us, we will bear a risk of loss of principal to the residential mortgage loans that the Company holds, originates or acquires or that underlie its investments in RMBS and the exhaustionextent of any underlying or any additional credit support, the Company may not realize its anticipated return on its investments and the Company may incur a loss on these investments. In addition, the Company's investments in non-Agency RMBS will be backed by residential real property but, in contrast to Agency RMBS, their principal and interest will not be guaranteed by federally chartered entities such as Fannie Mae and Freddie Mac and, in the case of Ginnie Mae, the U.S. Government. The ability of a borrower to repay these loans or other financial assets is dependent upon the income or assets of these borrowers.

Reverse mortgages have payment terms which are different from traditional forward mortgages, and if the actual rate and timing of payoffs of these loans differ significantly from the Company's expectations, the market value of its reverse mortgage loans may be materially adversely affected.

In addition to traditional forward mortgage loans, GMFS also originates and acquires home equity conversion mortgage loans ("HECM loans"), which are reverse mortgage loans that are insured by the FHA. With a reverse mortgage loan, unlike a traditional forward mortgage loan, the borrower does not make ongoing cash payments of principal or interest. Rather, with a reverse mortgage loan, payment of interest and repayment of principal is not triggered until a maturity event—such as death, non-occupancy, sale of the property or other conveyance of title to the property, or a failure to perform certain obligations which remain uncured under the loan. The loan balance of a reverse mortgage loan accrues at a fixed or floating rate of interest and, similar to a traditional forward mortgage loan, the borrower continues to own and live in the home and remains responsible only for maintaining the home in good repair and paying real estate taxes and property insurance premiums for the life of the loan.

HECM loans are generally assignable to the FHA at par when the loan balance reaches 98% of its maximum claim amount. The maximum claim amount is the maximum dollar amount that the FHA will pay on a claim for insurance benefits with respect to a HECM loan or on assignment of a HECM loan to the FHA. This amount is the lowest of the appraised value of the property at the time of loan origination, the sale price of the property being purchased or the national mortgage limit as determined by FHA guidelines, which is currently $625,500.

The timing of any payment of principal and interest is uncertain and will be made in respect of the Company's HECM loans only upon (i) a maturity event, (ii) a borrower voluntary prepayment event which can occur at any time or (iii) the assignment of a HECM loan to the FHA when the loan balance reaches 98% of its maximum claim amount. The rate of principal payments (including prepayments or partial payments) of the HECM loans depends on a variety of economic, social, geographic, demographic, legal and other factors, including changes in home prices, prevailing market interest rates, borrower mortality, and FHA guidelines regarding the HECM loans, and will affect the weighted average lives and the yields the Company realizes on its HECM loans. HECM loans may respond differently than traditional forward mortgage loans to the factors that influence prepayment. There is variability when any amounts might be paid on HECM loans because it is uncertain: (i) when any maturity event might occur, (ii) whether a HECM loan borrower will choose to prepay amounts advanced in whole or in part and (iii) in the case of an adjustable-rate HECM loan, when amounts owed on a HECM loan will equal or exceed 98% of the maximum claim amount. If the actual rate and timing of maturity events, borrower prepayments and assignments to the FHA differ significantly from the Company's expectations, the market value of its HECM loans may be materially adversely affected.

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The Company may be affected by alleged or actual deficiencies in servicing and foreclosure practices of third parties, as well as related delays in the foreclosure process.

Allegations of deficiencies in servicing and foreclosure practices among several large sellers and servicers of residential mortgage loans that surfaced in 2010 raised various concerns relating to such practices, including the improper execution of the documents used in foreclosure proceedings ("robo signing"), inadequate documentation of transfers and registrations of mortgages and assignments of loans, improper modifications of loans, violations of representations and warranties at the date of securitization and failure to enforce put-backs.

As a result of alleged deficiencies in foreclosure practices, a number of servicers temporarily suspended foreclosure proceedings beginning in the second half of 2010 while they evaluated their foreclosure practices. In late 2010, a group of state attorneys general and state bank and mortgage regulators representing nearly all 50 states and the District of Columbia, along with the U.S. Justice Department and HUD, began an investigation into foreclosure practices of banks and servicers. The investigations and lawsuits by several state attorneys general led to a settlement agreement in March 2012 with five of the nation's largest banks, pursuant to which the banks agreed to pay more than $25 billion to settle claims relating to improper foreclosure practices. The settlement does not prohibit the states, the federal government, individuals or investors in RMBS from pursuing additional actions against the banks and servicers in the future.

The integrity of the servicing and foreclosure processes are critical todeficiency between the value of the residential mortgage loanscollateral and the RMBS collateralized by residential mortgage loans in which the Company invests,principal and the Company's financial results could be adversely affected by deficiencies in the conduct of those processes. For example, delays in the foreclosure process that have resulted from investigations into improper servicing practices may adversely affect the values of, and the Company's losses on, the residential mortgage loans and non-Agency RMBS the Company owns or may originate or acquire. Foreclosure delays may also increase the administrative expenses of any securitization trusts that the Company may sponsor for non-Agency RMBS, thereby reducing the amount of funds available for distribution to the Company's stockholders. In addition, the subordinate classes of securities issued by any such securitization trusts may continue to receiveaccrued interest payments while the defaulted loans remain in the trusts, rather than absorbing the default losses. This may reduce the amount of credit support available for the senior classes the Company may own, thus possibly adversely affecting these securities.

In addition, in these circumstances, the Company may be obligated to fund any obligation of the servicer to make advances on behalf of a delinquentmortgage loan, obligor. To the extent that there are significant amounts of advances that need to be funded in respect of loans where the Company owns the servicing right, itwhich could have a material adverse effect on our cash flow from operations and limit amounts available for distribution to our stockholders. In the Company'sevent of the bankruptcy of a mortgage loan borrower, the mortgage loan to such borrower will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the mortgage loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the extent the lien is unenforceable under state law.

Foreclosure can be an expensive and lengthy process, and foreclosing on certain properties where we directly hold the mortgage loan and the borrower’s default under the mortgage loan is continuing could result in actions that could be costly to our operations, in addition to having a substantial negative effect on our anticipated return on the foreclosed mortgage loan.

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Our portfolio of assets may at times be concentrated in certain property types or secured by properties concentrated in a limited number of geographic areas, which increases our exposure to economic downturn with respect to those property types or geographic locations.

We are not required to observe specific diversification criteria. Therefore, our portfolio of assets may, at times, be concentrated in certain property types that are subject to higher risk of foreclosure, or secured by properties concentrated in a limited number of geographic locations.

Our loan portfolio is concentrated in California, Texas, Florida, New York, and Georgia and represents approximately 13.6%, 12.6%, 11.6%, 6.9%, and 6.3%,  respectively, of our total loans as of December 31, 2017. Continued deterioration of economic conditions in these or in any other state in which we have a significant concentration of borrowers could have a material and adverse effect on our business by reducing demand for new financings, limiting the ability of customers to repay existing loans and impairing the value of our real estate collateral and real estate owned properties. For example, the real estate market in South Florida has experienced a significant downturn which has an adverse impact on the collateral securing our loans in these areas.

To the extent that our portfolio is concentrated in any region, or by type of property, downturns relating generally to such region, type of borrower or security may result in defaults on a number of our assets within a short time period, which may reduce our net income and the value of our common stock and accordingly reduce our ability to pay dividends to our stockholders.

Loans to small businesses involve a high degree of business and financial results.risk, which can result in substantial losses that would adversely affect our business, results of operation and financial condition.

 

WhileOur operations and activities include loans to small, privately owned businesses to purchase real estate used in their operations or by investors seeking to acquire small multi-family, office, retail, mixed use or warehouse properties. Additionally, SBC loans are also often accompanied by personal guarantees. Often, there is little or no publicly available information about these businesses. Accordingly, we must rely on our own due diligence to obtain information in connection with our investment decisions. Our borrowers may not meet net income, cash flow and other coverage tests typically imposed by banks. A borrower’s ability to repay its loan may be adversely impacted by numerous factors, including a downturn in its industry or other negative local or more general economic conditions. Deterioration in a borrower’s financial condition and prospects may be accompanied by deterioration in the Company believescollateral for the loan. In addition, small businesses typically depend on the management talents and efforts of one person or a small group of people for their success. The loss of services of one or more of these persons could have a material and adverse impact on the operations of the small business. Small companies are typically more vulnerable to customer preferences, market conditions and economic downturns and often need additional capital to expand or compete. These factors may have an impact on loans involving such businesses. Loans to small businesses, therefore, involve a high degree of business and financial risk, which can result in substantial losses.

Some of the mortgage loans we will originate or acquire are loans made to self-employed borrowers who have a higher risk of delinquency and default, which could have a material and adverse effect on our business, results of operations and financial condition.

Many of our borrowers will be self-employed. Self-employed borrowers may be more likely to default on their mortgage loans than salaried or commissioned borrowers and generally have less predictable income. In addition, many self-employed borrowers are small business owners who may be personally liable for their business debt. Consequently, a higher number of self-employed borrowers may result in increased defaults on the mortgage loans we originate or acquire and, therefore, could have a material and adverse effect on our business, results of operations and financial condition.

Some of the mortgage loans we will originate or acquire are secured by non-owner/user properties that may experience increased frequency of default and, when in default, the sellersowners are more likely to abandon their properties, which could have a material and servicersadverse effect on our business, results of operations and financial condition.

Some of the loans we will originate or acquire have been, and in the future could be, made to borrowers who do not live in or operate a business on the mortgaged properties. These mortgage loans are secured by properties acquired by investors for rental income and capital appreciation and tend to default more than properties regularly occupied or used by the related borrowers. In a default, real property investors not occupying the mortgaged property may be more likely to

48


abandon the related mortgaged property, increasing defaults and, therefore, could have a material and adverse effect on our business, results of operations and financial condition.

We may encounter risks associated with originating or acquiring SBA loans.

We will originate SBA loans and sell the guaranteed portion of such SBA loans into the secondary market. These sales may result in collecting cash premiums, creating a stream of future servicing spread or both. There can be no assurance that we will originate these loans, that a secondary market will exist or that we will realize premiums upon the sale of the guaranteed portion of these loans.

We may acquire SBA loans or originate SBA loans and sell the guaranteed portion of such SBA loans and retain the credit risk on the non-guaranteed portion of such loans. We would then expect to share pro-rata with the SBA in any recoveries. In the event of default on an SBA loan, our pursuit of remedies against a borrower would be subject to SBA rules and in violationsome instances SBA approval. If the SBA establishes that a loss on an SBA guaranteed loan is attributable to significant technical deficiencies in the manner in which the loan was originated, funded or serviced by us, the SBA may seek recovery of their servicing contractsthe principal loss related to the extentdeficiency from us. With respect to the guaranteed portion of SBA loans that they have improperly serviced mortgage loans or improperly executed documents in foreclosure or bankruptcy proceedings, or do not comply with the terms of servicing contracts when deciding whether to apply principal reductions, it may be difficult, expensivesold by us, the SBA would first honor its guarantee and time consumingthen may seek compensation from us in the event that a loss is deemed to be attributable to technical deficiencies. There can be no assurance that we will not experience a loss due to significant deficiencies with our underwriting or servicing of SBA loans.

In certain instances, including liquidation or charge-off of an SBA guaranteed loan, we may have a receivable for the CompanySBA’s guaranteed portion of legal fees, operating expenses, property taxes paid etc. related to enforce its contractual rights.

The Company continues to monitor and review the issues raised by the alleged improper foreclosure practices. While the Company cannot predict exactly how the servicing and foreclosure mattersloan or the resulting litigation or settlement agreements will affect its business,collateral (upon foreclosure). While we may believe expenses incurred were justified and necessary for the care and preservation of the collateral and within the established rules of the SBA, there can be no assurance that these mattersthe SBA will reimburse us. In addition, obtaining reimbursement from the SBA may be a time consuming and lengthy process and the SBA may seek compensation from us related to reimbursement of expenses that it does not have an adverse impact onbelieve were necessary for the Company's consolidated results of operationscare and financial condition.

Homeowner association super priority liens, special assessments and energy efficiency liens may take priority over the mortgage lien.

Homeowner association super priority liens may take priority over the mortgage lien. In some jurisdictions it is possible that the first lienpreservation of a mortgage may be extinguished by super priority liens of homeowners associations ("HOAs"), potentially resulting in a loss of the outstanding principal balance of the mortgage loan. In a number of states, HOAloan or condominium association assessment liens can take priority over first lien mortgages in certain circumstances. The number of these so called superlien jurisdictions has increased in the past few decadesits collateral and may increase further. Recent rulings by the highest courts in Nevada and the District of Columbia have held that the superlien statute provides the HOA or condominium association with a true lien priority rather than a payment priority from the proceeds of the sale, creating the ability to extinguish the existing senior mortgage and greatly increasing the risk of losses on mortgage loans secured by homes whose owners fail to pay HOA or condominium fees. If an HOA, or a purchaser of an HOA superlien, completes a foreclosure in respect of an HOA superlien on a mortgaged property, the related mortgage loan may be extinguished. In those circumstances, a loan owner could suffer a loss of the entire principal balance of such mortgage loan. A servicer might be able to attempt to recover, on an unsecured basis, by suing the related mortgagor personally for the balance, but recovery in these circumstances will be problematic if the related mortgagor has no meaningful assets against which to recover. Special assessments and energy efficiency liens may take priority over the mortgage lien. Mortgaged properties securing mortgage loans may be subject to the lien of special property taxes and/or special assessments. These liens may be superior to the liens securing the mortgage loans, irrespective of the date of the mortgage. In some instances, individual mortgagors may be able to elect to enter into contracts with governmental agencies for property assessed clean energy ("PACE") or similar assessments that are intended to secure the payment of energy and water efficiency and distributed energy generation improvements that are permanently affixed to their properties, possibly without notice to or the consent of the mortgagee. These assessments may also have lien priority over the mortgages securing mortgage loans. No assurance can be given that a mortgaged property so assessedthe SBA will increase in valuenot decline to the extentreimburse us for our portion of material expenses.

A government shutdown or curtailment of the government-guaranteed loan programs could cut off an important segment of our business, and may adversely affect our SBA loan program acquisitions and originations and results of operations.

Although the program has been in existence since 1953, there can be no assurance that the federal government will maintain the SBA program, or that it will continue to guarantee loans at current levels. If we cannot acquire, make or sell government-guaranteed loans, we may generate less interest income, fewer origination fees, and our ability to generate gains on sale of loans may decrease. From time-to-time, the government agencies that guarantee these loans reach their internally budgeted limits and cease to guarantee loans for a stated time period. In addition, these agencies may change their rules for loans. Also, Congress may adopt legislation that could have the effect of discontinuing or changing the programs. Non-governmental programs could replace government programs for some borrowers, but the terms might not be equally acceptable. If these changes occur, the volume of loans to small business and industrial borrowers of the types that now qualify for government-guaranteed loans could decline, as could the profitability of these loans.

Our lending business could be materially and adversely affected by circumstances or events limiting the availability of funds for SBA loan programs. A government shutdown occurred in October 2013 that affected the ability of entities to originate SBA loans because Congress failed to approve a budget which in turn eliminated the availability of funds for these programs. A government shutdown could occur again, which may affect our ability to originate government guaranteed loans and to sell the government guaranteed portions of those loans in the secondary market. A government shutdown may adversely affect our SBA loan program acquisitions and originations and our results of operations.

We are a seller/servicer approved to sell mortgage loans to Freddie Mac and failure to maintain our status as an approved seller/servicer could harm our business.

We are an approved Freddie Mac seller/servicer. As an approved seller/servicer, we are required to conduct certain aspects of our operations in accordance with applicable policies and guidelines published by Freddie Mac and we are required to pledge a certain amount of cash to Freddie Mac to collateralize potential obligations to it. Freddie Mac performed an audit in June 2016.  As a result of that audit, ReadyCap received an overall assessment lien. Additional indebtedness securedof Satisfactory. 

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Failure to maintain our status as an approved seller/servicer would mean we would not be able to sell mortgage loans to Freddie Mac, could result in us being required to re-purchase loans previously sold to Freddie Mac, or could otherwise restrict our business and investment options and could harm our business and expose us to losses or other claims. Freddie Mac may, in the future, require us to hold additional capital or pledge additional cash or assets in order to maintain approved seller/servicer status, which, if required, would adversely impact our financial results. Loans sold to Freddie Mac that may be required to be re-purchased as of December 31, 2017 included 97 loans with a combined unpaid principal balance of $231.5 million.

The diminished level of Freddie Mac participation in, and other changes in the role of Freddie Mac in, the mortgage market may adversely affect our business.

In September 2008, FHFA placed Fannie Mae and Freddie Mac in conservatorship and undertook the extraordinary dual role of supervisor and conservator. Now in their ninth year, FHFA’s conservatorships are of unprecedented scope, scale, and complexity. While in conservatorship, Fannie Mae and Freddie Mac have required $187.5 billion in financial investment from the Treasury to avert insolvency, and, through the start of 2017, have paid to Treasury over $255 billion in dividends. Despite their high leverage, lack of capital, conservatorship status, and uncertain future, the combined Fannie Mae and Freddie Mac have grown in size during conservatorship and, according to FHFA, their combined market share of newly issued MBS is more than 65%. In mid-2017, their combined total assets were approximately $5.3 trillion and their combined debt exceeded $5 trillion. Although market conditions have improved and Fannie Mae and Freddie Mac have returned to profitability, their ability to sustain profitability in the future cannot be assured for a number of reasons: the winding down of their investment portfolios and reduction in net interest income; the level of guarantee fees they will be able to charge and keep; the future performance of their business segments; and the significant uncertainties involving key market drivers such as mortgage rates, homes prices, and credit standards. Fannie Mae and Freddie Mac will also be required to eliminate their capital cushion by the assessment lien would reduceend of 2018 and in any quarter in which they suffer a loss, will have to once again draw funds from Treasury to cover such losses. To address these challenges, a number of reform proposals have been introduced and suggested, but none have passed a congressional vote.

If Freddie Mac participation in the amountmortgage market were reduced or eliminated, or its structures were to change, our ability to originate and service loans under the Freddie Mac program could be adversely affected. These developments could also materially and adversely impact the pricing of our potential future Freddie Mac loan and ABS portfolio. Additionally, the value of a mortgaged property availablecurrent support provided by the Treasury to satisfyFreddie Mac, and any additional support it may provide in the affected mortgage loan. Such actionsfuture, could have a dramatic impactthe effect of lowering the interest rates we expect to receive from such assets, thereby tightening the spread between the interest we earn on the Company's business, results of operations and financial condition,these assets and the cost of complying with any additionalfinancing these assets. Future legislation affecting Freddie Mac may create market uncertainty and have the effect of reducing the actual or perceived credit quality of Freddie Mac and the securities issued or guaranteed by it. As a result, such laws and regulations could have a material adverse effectincrease the risk of loss on our investments related to the Company's business, financial condition, results of operations,Freddie Mac program. It also is possible that such laws could adversely impact the market price of its common stockfor such assets and its ability to pay dividends to its stockholders.the spreads at which they trade.

 

30

The Company'sOur investments may include subordinated tranches of ABS and RMBS, which are subordinate in right of payment to more senior securities.

 

The Company'sOur investments may include subordinated tranches of ABS and RMBS, which are subordinated classes of securities in a structure of securities collateralized by a pool of mortgageassets consisting primarily of SBC loans and, accordingly, are the first or among the first to bear the loss upon a restructuring or liquidation of the underlying collateral and the last to receive payment of interest and principal. Additionally, estimated fair values of these subordinated interests tend to be more sensitive to changes in economic conditions than more senior securities. As a result, such subordinated interests generally are not actively traded and may not provide holders thereof with liquid investments.

 

The Company's MSRs expose it to significant risks.In certain cases we may not control the special servicing of the mortgage loans included in the securities in which we may invest in and, in such cases, the special servicer may take actions that could adversely affect our interests.

 

Fannie Mae and Freddie Mac generally requireWith respect to the SBC ABS in which we expect to invest, overall control over the special servicing of the related underlying mortgage servicers toloans will be paidheld by a minimum servicing fee that significantly exceeds the amount a servicer would charge in an arm's-length transaction. The minimum servicing fee requireddirecting certificate holder, which is appointed by the Agencies is therefore made upholders of the normal arm's-lengthmost subordinate class of securities in such series. When we acquire investment-grade classes of existing series of securities originally rated AAA, we will not have the right to appoint the directing certificate holder. In these cases, in connection with the servicing feeof the specially serviced mortgage loans, the related special servicer may, at the direction of the directing

50


certificate holder, take actions with respect to the specially serviced mortgage loans that could adversely affect our interests.

Any credit ratings assigned to our SBC loans and ABS assets will be subject to ongoing evaluations and revisions and we cannot assure you that those ratings will not be downgraded.

Some of our SBC loan and ABS assets may be rated by Moody’s Investors Service, Standard & Poor’s, or S&P, or Fitch Ratings. Any credit ratings on our SBC loans and ABS assets are subject to ongoing evaluation by credit rating agencies, and we cannot assure you that any such ratings will not be changed or withdrawn by a rating agency in the excess mortgage servicing amount.future if, in its judgment, circumstances warrant. Rating agencies may assign a lower than expected rating or reduce or withdraw, or indicate that they may reduce or withdraw, their ratings of our SBC loans and ABS assets in the future. In addition, we may acquire assets with no rating or with below investment grade ratings. If the rating agencies take adverse action with respect to the rating of our SBC loans and ABS assets or if our unrated assets are illiquid, the value of these SBC loans and ABS assets could significantly decline, which would adversely affect the value of our investment portfolio and could result in losses upon disposition or the failure of borrowers to satisfy their debt service obligations to us.

 

The Company's MSRsreceivables underlying the ABS we may acquire are recorded at fair valuesubject to credit risks, liquidity risks, interest rate risks, market risks, operations risks, structural risks and legal risks, which could result in losses to us.

We may acquire ABS securities, where the underlying pool of assets consists primarily of SBC loans. The structure of an ABS, and the terms of the investors’ interest in the underlying collateral, can vary widely depending on the Company's balance sheet based upon significant estimatestype of collateral, the desires of investors and assumptions,the use of credit enhancements. Individual transactions can differ markedly in both structure and execution. Important determinants of the risk associated with changes in fair value includedissuing or holding ABS include: (i) the relative seniority or subordination of the class of ABS held by an investor, (ii) the relative allocation of principal, and interest payments in the Company's consolidated resultspriorities by which such payments are made under the governing documents, (iii) the effect of operations. Such estimatescredit losses on both the issuing vehicle and assumptions would include, without limitation, estimatesinvestors’ returns, (iv) whether the underlying collateral represents a fixed set of futurespecific assets or accounts, (v) whether the underlying collateral assets are revolving or closed-end, (vi) the terms (including maturity of the ABS) under which any remaining balance in the accounts may revert to the issuing vehicle and (vii) the extent to which the entity that sold the underlying collateral to the issuing vehicle is obligated to provide support to the issuing vehicle or to investors. With respect to some types of ABS, the foregoing risks are more closely correlated with similar risks on corporate bonds of similar terms and maturities than with the performance of a pool of similar assets.

In addition, certain ABS (particularly subordinated ABS) provide that the non-payment of interest thereon in cash will not constitute an event of default in certain circumstances, and the holders of such ABS will not have available to them any associated default remedies. Interest not paid in cash will generally be capitalized and added to the outstanding principal balance of the related security. Deferral of interest through such capitalization will reduce the yield on such ABS.

Holders of ABS bear various risks, including credit risks, liquidity risks, interest rate risks, market risks, operations risks, structural risks and legal risks. Credit risk arises from (i) losses due to defaults by obligors under the underlying collateral and (ii) the issuing vehicle’s or servicer’s failure to perform their respective obligations under the transaction documents governing the ABS. These two risks may be related, as, for example, in the case of a servicer that does not provide adequate credit-review scrutiny to the underlying collateral, leading to a higher incidence of defaults.

Market risk arises from the cash flow characteristics of the ABS, which for most ABS tend to be predictable. The greatest variability in cash flows associatedcome from credit performance, including the presence of wind-down or acceleration features designed to protect the investor in the event that credit losses in the portfolio rise well above expected levels.

Interest rate risk arises for the issuer from (i) the pricing terms on the underlying collateral, (ii) the terms of the interest rate paid to holders of the ABS and (iii) the need to mark to market the excess servicing or spread account proceeds carried on the issuing vehicle’s balance sheet. For the holder of the security, interest rate risk depends on the expected life of the ABS, which may depend on prepayments on the underlying assets or the occurrence of wind-down or termination events. If the servicer becomes subject to financial difficulty or otherwise ceases to be able to carry out its functions, it may be difficult to find other acceptable substitute servicers and cash flow disruptions or losses may occur, particularly with MSRs based upon assumptionsunderlying collateral comprised of non-standard receivables or receivables originated by private retailers who collect many of the payments at their stores.

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Structural and legal risks include the possibility that, in a bankruptcy or similar proceeding involving the originator or the servicer (often the same entity or affiliates), a court having jurisdiction over the proceeding could determine that, because of the degree to which cash flows on the assets of the issuing vehicle may have been commingled with cash flows on the originator’s other assets (or similar reasons), (i) the assets of the issuing vehicle could be treated as never having been truly sold by the originator to the issuing vehicle and could be substantively consolidated with those of the originator, or (ii) the transfer of such assets to the issuer could be voided as a fraudulent transfer. The time and expense related to a challenge of such a determination also could result in losses and/or delayed cash flows.

Increases in interest rates could adversely affect the demand for new SBC loans, the value of our SBC loans and ABS assets and the availability of our target assets, and they could cause our interest expense to increase, which could result in reduced earnings or losses and negatively affect our profitability as well as the prepayment rates, delinquencies and foreclosure rates of the underlying serviced mortgage loans.cash available for distribution to our stockholders.

 

The ultimate realization of the value of MSRs, which are measured at fair value on a recurring basis,We may be materially different than the fair values of such MSRs as may be reflectedinvest in the Company's balance sheet as of any particular date. The use of different estimates or assumptions in connection with the valuation of these assets could produce materially different fair values for such assets, which could have a material adverse effect on the Company's consolidated financial position, results of operationsSBC loans, SBC ABS and cash flows. Accordingly, there may be material uncertainty about the fair value of the Company's MSRs.

Changes in interestother real estate-related investments. Interest rates are a key driver of the performance of MSRs. Historically, the value of MSRs has increased when interest rates risehighly sensitive to many factors, including governmental monetary and decreased when interest rates decline due to the effect those changes in interest rates have on prepayment estimates. The Company may pursue various hedging strategies to seek to reduce its exposure to adverse changes in interest rates. The Company's hedging activity will vary in scope based on the leveltax policies, domestic and volatility of interest rates, the type of assets heldinternational economic and political considerations, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect the Company. To the extent the Company does not utilize derivatives to hedge against changes in the fair value of MSRs, the Company's balance sheet, consolidated results of operations and cash flows would be susceptible to significant volatility due to changes in the fair value of, or cash flows from, MSRs as interest rates change.

Prepayment speeds significantly affect excess mortgage servicing fees. Prepayment speed is the measurement of how quickly borrowers pay down the unpaid principal balance of their loans or how quickly loans are otherwise brought current, modified, liquidated or charged off. The Company will base the price it pays for MSRs and the rate of amortization of those assets on factors such as the Company's projection of the cash flows from the related pool of mortgage loans. The Company's expectation of prepayment speeds will be a significant assumption underlying those cash flow projections. If prepayment speeds are significantly greater than expected, the carrying value of MSRs could exceed their estimated fair value. If the fair value of MSRs decreases, the Company would be required to record a non-cash charge, which would have a negative impact on its financial results. Furthermore, a significant increase in prepayment speeds could materially reduce the ultimate cash flows the Company receives from MSRs, and the Company could ultimately receive substantially less than what it paid for such assets.

Moreover, delinquency rates have a significant impact on the valuation of any excess mortgage servicing fees. An increase in delinquencies will generally result in lower revenue because typically the Company will only collect servicing fees from Agencies or mortgage owners for performing loans. If delinquencies are significantly greater than the Company expects, the estimated fair value of the MSRs could be diminished. When the estimated fair value of MSRs is reduced, the Company could suffer a loss, which could have a negative impact on the Company's financial results.

Furthermore, MSRs are subject to numerous U.S. federal, state and local laws and regulations and may be subject to various judicial and administrative decisions imposing various requirements and restrictions on the Company's business. The Company's failure to comply, or the failure of the servicer to comply, with the laws, rules or regulations to which the Company or the servicer are subject by virtue of ownership of MSRs, whether actual or alleged, could expose the Company to fines, penalties or potential litigation liabilities, including costs, settlements and judgments, any of which could have a material adverse effect on the Company's business, financial condition, consolidated results of operations or cash flows.

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An increase in interest rates may cause a decrease in the volume of certain of the Company's target assets, which could adversely affect its ability to originate or acquire target assets that satisfy its investment objectives and to generate income and make distributions.

beyond our control. Rising interest rates generally reduce the demand for mortgage loans due to the higher cost of borrowing. A reduction in the volume of mortgage loans originated may affect the volume of the Company'sour target assets available to it,us, which could adversely affect the Company'sour ability to originate or acquire assets that satisfy itsour investment objectives. Rising interest rates may also cause the Company'sour target assets that were issued prior to an interest rate increase to provide yields that are below prevailing market interest rates. If rising interest rates cause the Companyus to be unable to originate or acquire a sufficient volume of itsour target assets with a yield that is above the Company'sour borrowing cost, the Company'sour ability to satisfy itsour investment objectives and to generate income and make distributions may be materially and adversely affected.

The relationship between short-term and longer-term interest rates is often referred to as the "yield“yield curve." Ordinarily, short-term interest rates are lower than longer-term interest rates. If short-term interest rates rise disproportionately relative to longer-term interest rates (a flattening of the yield curve), the Company'sour borrowing costs may increase more rapidly than the interest income earned on the Company'sour assets. Because the Company expects its investments, on average,we expect that our SBC loans and ABS assets generally will bear, on average, interest based on longer-term rates than the Company'sour borrowings, a flattening of the yield curve would tend to decrease the Company'sour net income and the fair market value of itsour net assets. Additionally, to the extent cash flows from investmentsSBC loans and ABS assets that return scheduled and unscheduled principal are reinvested, the spread between the yields on the new investmentsSBC loans and ABS assets and available borrowing rates may decline, which would likely decrease the Company'sour net income. It is also possible that short-term interest rates may exceed longer-term interest rates (a yield curve inversion), in which event the Company'sour borrowing costs may exceed itsour interest income and the Companywe could incur operating losses.

Increases in interest rates could adversely affect the value of the Company's investments and cause its interest expense to increase, which could result in reduced earnings or losses and negatively affect the Company's profitability as well as the cash available for distribution to the Company's stockholders.

The Company invests in residential mortgage loans, non-Agency RMBS, MSRs, Agency RMBS and other real estate-related and financial assets, including IOs. In a normal yield curve environment, an investment in such assets will generally decline in value if long-term interest rates increase. Declines in fair market value may ultimately reduce earnings or result in losses to the Company, which may negatively affect cash available for distribution to the Company's stockholders.

A significant risk associated with the Company's target assets is the risk that both long-term and short-term interest rates will increase significantly. If long-term rates increased significantly, the fair market value of these investments would decline, and the duration and weighted average life of the investments would increase. The Company could realize a loss if the investments were sold. At the same time, an increase in short-term interest rates would increase the amount of interest owed on the Company's repurchase agreements.losses.

 

Fair market values of the Company's investmentsour SBC loans and ABS assets may decline without any general increase in interest rates for a number of reasons, such as increases or expected increases in defaults, or increases or expected increases in voluntary prepayments for those investmentsSBC loans and ABS assets that are subject to prepayment risk or widening of credit spreads.

 

In addition, in a period of rising interest rates, the Company'sour operating results will depend in large part on the difference between the income from the Company'sour assets and the Company'sour financing costs. The Company anticipatesWe anticipate that, in most cases, the income from such assets will respond more slowly to interest rate fluctuations than the cost of itsour borrowings. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence the Company'sour net income. Increases in these rates will tend to decrease the Company'sour net income and fair market value of itsour assets.

 

Interest rate fluctuations may adversely affect the level of our net income and the value of our assets and common stock.

Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Interest rate fluctuations present a variety of risks, including the risk of a narrowing of the difference between asset yields and borrowing rates, flattening or inversion of the yield curve and fluctuating prepayment rates, and may adversely affect our income and the value of our assets and common stock.

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Interest rate mismatches between the Company'sour ARMs and RMBS backed by ARMs or hybrid ARMs and the Company'sour borrowings used to fund itsour purchases of these assets may cause itus to suffer losses.

 

The Company funds itsWe will likely fund our residential mortgage loans and RMBS with borrowings that have interest rates that adjust more frequently than the interest rate indices and repricing terms of ARMs and RMBS backed by ARMs or hybrid ARMs. Accordingly, if short-term interest rates increase, the Company'sour borrowing costs may increase faster than the interest rates on itsour ARMs and RMBS backed by ARMs or hybrid ARMs adjust. As a result, in a period of rising interest rates, the Companywe could experience a decrease in net income or a net loss.

 

In most cases, the interest rate indices and repricing terms of ARMs and RMBS backed by ARMs or hybrid ARMs and the Company'sour borrowings are not identical, thereby potentially creating an interest rate mismatch between the Company'sour investments and itsour borrowings. While the historical spread between relevant short-term interest rate indices has been relatively stable, there have been periods when the spread between these indices was volatile. During periods of changing interest rates, these interest rate index mismatches could reduce the Company'sour net income or produce a net loss, and adversely affect the level of the Company'sour dividends and the market price of itsour common stock.

 

In addition, ARMs and RMBS backed by ARMs or hybrid ARMs are typically subject to lifetime interest rate caps that limit the amount an interest rate can increase through the maturity of the ARMs. However, the Company'sour borrowings under repurchase agreements typically are not subject to similar restrictions. Accordingly, in a period of rapidly increasing interest rates, the interest rates paid on the Company'sour borrowings could increase without limitation while caps could limit the interest rates on these types of assets. This problem is magnified for ARMs and RMBS backed by ARMs or hybrid ARMs that are not fully indexed. Further, some ARMs and RMBS backed by ARMs or hybrid ARMs may be subject to periodic payment caps that result in a portion of the interest being deferred and added to the principal outstanding. As a result, the Companywe may receive less cash income on these types of assets than the Company needswe need to pay interest on itsour related borrowings. These factors could reduce the Company'sour net interest income and cause itus to suffer a loss during periods of rising interest rates.

 

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Interest rate fluctuations may adversely affect the level of the Company's net income and the value of the Company's assets and common stock.

Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond the Company's control. Interest rate fluctuations present a variety of risks, including the risk of a narrowing of the difference between asset yields and borrowing rates, flattening or inversion of the yield curve and fluctuating prepayment rates, and may adversely affect the Company's income and the value of its assets and common stock.

Because the Company holdswe hold and may originate additional fixed-rate assets, an increase in interest rates on the Company'sour borrowings may adversely affect itsour book value.

 

Increases in interest rates may negatively affect the fair market value of the Company'sour assets. Any fixed-rate assets the Company holdswe hold or originatesoriginate generally will be more negatively affected by these increases than adjustable-rate assets. In accordance with accounting rules, the Companywe will be required to reduce itsour earnings for any decrease in the fair market value of itsour assets that are accounted for under the fair value option. The CompanyWe will be required to evaluate itsour assets on a quarterly basis to determine their fair value by using third-party bid price indications provided by dealers who make markets in these assets or by third-party pricing services. If the fair value of an asset is not available from a dealer or third-party pricing service, the Companywe will estimate the fair value of the asset using a variety of methods, including discounted cash flow analysis, matrix pricing, option-adjusted spread models and fundamental analysis. Aggregate characteristics taken into consideration include type of collateral, index, margin, periodic cap, lifetime cap, underwriting standards, age and delinquency experience. However, the fair value reflects estimates and may not be indicative of the amounts the Companywe would receive in a current market exchange. If the Company determineswe determine that a security is other-than-temporarily impaired, the Companywe would be required to reduce the value of such security on itsour balance sheet by recording an impairment charge in itsour income statement and its stockholders'our stockholders’ equity would be correspondingly reduced. Reductions in stockholders'stockholders’ equity decrease the amounts the Companywe may borrow to originate or purchase additional target assets, which could restrict the Company'sour ability to increase itsour net income.

 

Because the assets the Company holdswe will hold and expectsexpect to originateacquire may experience periods of illiquidity, the Companywe may lose profits or be prevented from earning capital gains if the Companywe cannot sell mortgage-relatedSBC loans and ABS assets at an opportune time.

 

The Company bearsWe bear the risk of being unable to dispose of itsour assets at advantageous times or in a timely manner because mortgage-relatedSBC loans and ABS assets generally experience periods of illiquidity, including the recent period of delinquencies and defaults with respect to residential mortgage loans. TheAdditionally, we believe that we are currently one of only a handful of active market participants in the secondary SBC loan market and the lack of liquidity may result from the absence of a willing buyer or an established market for these assets, as well as legal or contractual restrictions on resale or the unavailability of financing for these assets. As a result, the Company'sour ability to vary itsour portfolio in response to changes in economic and other conditions may be relatively limited, which may cause itus to incur losses.

 

The Company may experience a decline in the fair market value of its assets.

A decline in the fair market value of the Company's assets and the assets which it intends to originate or acquire may require the Company to recognize an "other-than-temporary" impairment against such assets under accounting principles generally accepted in the United States (“U.S. GAAP”), if the Company were to determine that, with respect to any debt security in unrealized loss positions, the Company does not have the ability and intent to hold such assets to maturity or for a period of time sufficient to allow for recovery to the amortized cost of such assets. If such a determination were to be made, the Company would recognize realized losses through earnings and write down the amortized cost of such assets to a new cost basis, based on the fair market value of such assets on the date they are considered to be other-than-temporarily impaired. Such impairment charges reflect non-cash losses at the time of recognition; subsequent disposition or sale of such assets could further affect the Company's future losses or gains, as they are based on the difference between the sale price received and the adjusted amortized cost of such assets at the time of sale. In addition, the Company has elected the fair value option for its residential mortgage loans and RMBS and future mortgage related assets may also be carried at fair value. Accordingly, declines in the fair value of these assets will also be recognized as unrealized losses through earnings and will adversely impact the results of its operations for the period in which such change in value occurs.

Goodwill and other intangible assets are also measured for impairment. If the Company determines that it is more likely than not that the carrying amount of these assets are not recoverable and the carrying amount of the assets are less than their fair value, an impairment loss will be recorded by the Company under U.S. GAAP. The impairment is recognized as an expense in the period in which it occurs and would adversely impact the results of operations for such period.

Many of the assets in the Company's portfolio will be recorded at fair value and, as a result, there will be uncertainty as to the value of these assets.

Many of the assets in the Company's portfolio are and will likely be in the form of assets that are not publicly traded. The fair value of residential mortgage loans, RMBS and other mortgage-related assets that are not publicly traded may not be readily determinable. The Company values these assets quarterly at fair value, as determined in accordance with applicable accounting standards, which may include unobservable inputs. Because such valuations are subjective, the fair value of certain of the Company's assets may fluctuate over short periods of time and the Company's determinations of fair value may differ materially from the values that would have been used if a ready market for these assets existed. The value of the Company's common stock could be adversely affected if its determinations regarding the fair value of these assets were materially higher than the values that the Company ultimately realizes upon their disposal.

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Prepayment ratesRecent market conditions may adversely affect the value of the Company'smake it more difficult for us to analyze potential investment opportunities for our portfolio of assets.

 

There are seldom any restrictions on borrowers' abilities to prepay their residential mortgage loans. Declines in interest rates may cause an increase in prepayment rates of mortgage loans. In addition, both HARP and actions by the U.S. Federal Reserve intended to lower interest rates may also cause an increase in prepayment rates. The Company generally receives distributions from principal payments that are made on these underlying mortgage loans. When borrowers prepay their mortgage loans faster than expected, this results in prepayments that are faster than expected on the RMBS. Faster than expected prepayments could adversely affect the Company's profitability, including in the following ways:

·The Company may purchase residential mortgage loans and RMBS that have a higher interest rate than the market interest rate at the time. In exchange for this higher interest rate, the Company may pay a premium over the par value to acquire the asset. In accordance with U.S. GAAP, the Company may amortize this premium over the estimated term of the residential mortgage loans or RMBS. If the asset is prepaid in whole or in part prior to its maturity date, however, the Company may be required to expense the premium that was prepaid at the time of the prepayment.

·The Company also may acquire residential mortgage loans and RMBS at a lower interest rate than the market interest rate at the time. This would adversely affect the Company's profitability.

·Slower-than-expected prepayments may also adversely affect the fair market value of discounted residential mortgage loans and RMBS.

·The Company anticipates that a substantial portion of its ARMs and adjustable-rate RMBS may bear interest rates that are lower than their fully indexed rates, which are equivalent to the applicable index rate plus a margin. If an ARM or adjustable-rate RMBS is prepaid prior to or soon after the time of adjustment to a fully-indexed rate, the Company will have held that ARM or RMBS while it was least profitable and lost the opportunity to receive interest at the fully indexed rate over the remainder of its expected life.

·If the Company is unable to originate new residential mortgage loans similar to the prepaid assets, the Company's financial condition, results of operation and cash flow would suffer. Prepayment rates generally increase when interest rates fall and decrease when interest rates rise, but changes in prepayment rates are difficult to predict. Prepayment rates also may be affected by conditions in the housing and financial markets, general economic conditions, the relative interest rates on fixed-rate mortgages and ARMs, the credit rating of the borrower, the rate of home price appreciation or depreciation, and foreclosures and lender competition.

While the CompanyOur success will seek to minimize prepayment risk to the extent practical, it must balance prepayment risk against other risks and the potential returns of each asset. No strategy can completely insulate the Company from prepayment risk.

Recent market conditions may upset the historical relationship between interest rate changes and prepayment trends, which would make it more difficult for the Company to analyze its portfolio of assets. The Company is vulnerable to loss from prepayments if it purchased assets above par, especially in the event of additional mortgage loan modification and refinance programs or similar future legislative action.

The Company's success dependsdepend, in part, on itsour ability to effectively analyze potential acquisition and origination opportunities in order to assess the relationshiplevel of changing interest ratesrisk-adjusted returns that we should expect from any particular investment. To estimate the value of a particular asset, we may use historical assumptions that may or may not be appropriate during the recent unprecedented downturn in the real estate market and general economy. To the extent that we use historical assumptions that are inappropriate under current market conditions, we may overpay for an asset or acquire an asset that it otherwise might not acquire, which could have a material and adverse effect on prepaymentsour results of mortgage loans. Changes in interest ratesoperations and prepayments affect the market price of the residential mortgage loans and RMBS that the Company intendsour ability to originate or purchase and any residential mortgage loans and RMBS that the Company holds at a given time. Asmake distributions to our stockholders.

In addition, as part of the Company'sour overall portfolio risk management, the Companywe will analyze interest rate changes and prepayment trends separately and collectively to assess their effects on the Company'sour portfolio of assets. In conducting thisour analysis, the Companywe will depend on certain assumptions based upon historical trends with respect to the relationship between interest rates and prepayments under normal market conditions. IfRecent dislocations in the residential mortgage market or other developments may change the way that prepayment trends have historically respondedrespond to interest rate changes, the Company'swhich may adversely affect our ability to (i) assess the fair market value of itsour portfolio of assets, (ii) implement itsour hedging strategies and (iii)or implement techniques to reduce itsour prepayment rate volatility wouldvolatility. If our estimates prove to be significantly affected, whichincorrect or our hedges do not adequately mitigate the impact of changes in interest rates or prepayments, we may incur losses that could materially and adversely affect the Company'sour financial position and consolidated results of operations. In particular, despite the historically low interest rates, recent dislocations, including home price depreciation resulting in many borrowers owing more on their mortgage than the values of their homes, have prevented many such borrowers from refinancing their mortgage loans, which has impacted prepayment rates and the value of residential mortgage loans and RMBS assets. However, mortgage loan modification and refinance programs or future legislative action may make refinancing mortgage loans more accessible or attractive to such borrowers, which could cause the rate of prepayments on residential mortgage loans and RMBS assets to accelerate. For residential mortgage loans and RMBS assets, including some of the Company's RMBS assets, that were purchased or are trading at premium to their par value, higher prepayment rates would adversely affect the value of such assets or cause the holder to incur losses with respect to such assets.

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Risks Related to Owning the Company's Common Stock

Common stock and preferred stock eligible for future sale may have adverse effects on the Company's share price.

Subject to applicable law, the Company's board of directors has the authority, without further stockholder approval, to authorize the Company to issue additional authorized shares of common stock and preferred stock on the terms and for the consideration it deems appropriate, including shares of common stock issuable upon exchange of the Exchangeable Senior Notes. The Company cannot predict the effect, if any, of future sales of its common stock, or the availability of shares for future sales, on the market price of its common stock. As of March 8, 2016, the Company had 8,897,800 shares of common stock outstanding which are comprised of (i) 7,970,886 shares of common stock, and (ii) 926,914 Operating Partnership units ("OP Units"), which are exchangeable, on a one-for-one basis, into cash or, at the Company's option, for shares of the Company's common stock. In addition, 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 an exchange rate of 54.3103 shares of common stock for each $1,000 aggregate principal amount of the Exchangeable Senior Notes, subject to adjustment and other limitations under certain circumstances. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources" of this annual report on Form 10-K, for a discussion of the terms of the Exchangeable Senior Notes. Sales of substantial amounts of common stock or the perception that such sales could occur may adversely affect the prevailing market price for the Company's common stock.

For as long as the Company is an emerging growth company, the Company will not be required to comply with certain reporting requirements, including those relating to accounting standards and disclosure about the Company's executive compensation, that apply to other public companies.

Upon the completion of its initial public offering (“IPO”), the Company became subject to reporting and other obligations under the Exchange Act. In April 2012, the Jumpstart Our Business Startups Act (the "JOBS Act") was enacted into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for "emerging growth companies," including certain requirements relating to accounting standards and compensation disclosure. The Company is an "emerging growth company" as defined in the JOBS Act and may remain an emerging growth company for up to five full fiscal years. Unlike public companies that are not "emerging growth companies," for as long as the Company is an emerging growth company, the Company will not be required to (i) provide an auditor's attestation report on internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act"), (ii) comply with any new requirements adopted by the Public Company Accounting Oversight Board ("PCAOB") requiring mandatory audit firm rotation or a supplement to the auditor's report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer, (iii) comply with any new audit rules adopted by the PCAOB after April 5, 2012 unless the SEC determines otherwise, (iv) provide certain disclosure regarding executive compensation required of larger public companies or (v) hold shareholder advisory votes on executive compensation. The Company cannot predict if investors will find its shares of common stock less attractive if the Company chooses to rely on these exemptions.

Future offerings of debt or equity securities or notes exchangeable for shares of common stock, which may rank senior to the Company's common stock, may adversely affect the market price of the Company's common stock.

If the Company issues debt securities, including issuances of notes by the Operating Partnership which are exchangeable for shares of common stock of the Company, which rank senior to the Company's common stock, it is likely that they will be governed by an indenture or other instrument containing covenants restricting the Company's operating flexibility. Additionally, any equity securities or convertible or exchangeable securities that the Company issues in the future may have rights, preferences and privileges more favorable than those of the Company's common stock and may result in dilution to owners of the Company's common stock. The Company and, indirectly, the Company's stockholders, will bear the cost of issuing and servicing such securities. Because the Company's decision to issue debt, exchangeable notes or equity securities in any future offering will depend on market conditions and other factors beyond the Company's control, the Company cannot predict or estimate the amount, timing or nature of the Company's future offerings. Thus, holders of the Company's common stock will bear the risk of the Company's future offerings, reducing the market price of the Company's common stock and diluting the value of their stock holdings in the Company.

The Company has not established a minimum distribution payment level and the Company cannot assure stockholders of its ability to pay distributions in the future.

The Company's current policy is to pay distributions which will allow the Company to satisfy the requirements to qualify as a REIT and generally not be subject to U.S. federal income tax on its undistributed income. The Company has not, however, established a minimum distribution payment level and the Company's ability to pay distributions may be adversely affected by a number of factors, including the risk factors described in this annual report on Form 10-K. All distributions will be made at the discretion of the Company's board of directors and will depend on the Company's earnings, its financial condition, any debt covenants, maintenance of the Company's REIT qualification, restrictions on making distributions under Maryland law and other factors as the Company's board of directors may deem relevant from time to time. The Company may not be able to make distributions in the future and the Company's board of directors may change the Company's distribution policy in the future. The Company believes that a change in any one of the following factors, among others, could adversely affect its consolidated results of operations and impair the Company'sour ability to paymake distributions to its stockholders:

·the profitability of the assets the Company holds, originates or acquires;

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·the Company's ability to make profitable acquisitions;

·margin calls or other expenses that reduce the Company's cash flow;

·defaults in the Company's asset portfolio or decreases in the value of the Company's portfolio; and

·the fact that anticipated operating expense levels may not prove accurate, as actual results may vary from estimates.

The Company cannot provide any assurance that it will achieve results that will allow it to make a specified level of cash distributions or year-to-year increases in cash distributions in the future. In addition, some of the Company's distributions may include a return of capital.

As discussed elsewhere in this annual report on Form 10-K, in light of the strategic review and in order to reduce current market risk in its investment portfolio,the Company has recently begun the process of selling its seasoned, re-performing mortgage loans from its residential mortgage investments segment. A sale of these assets is expected to be completed early in the second quarter of 2016. Additionally, as part of the strategic review, the Company has made the decision to cease the purchase of newly originated residential mortgage loans as part of its mortgage conduit program and will begin the unwinding of the Company’s mortgage conduit business. These transactions are likely to result in a reduction of the Company’s investment income and may therefore result in a decision to curtail distributions in the future. If the Company is unable to close any such sale or similar transaction, the Company may not be able to re-establish a mortgage related portfolio in its residential mortgage investments segment which could impair the Company's ability to pay distributions to itsour stockholders.

 

Risks Related to the Company's Organization and StructureAny mezzanine loan assets we may purchase or originate may involve greater risks of loss than senior loans secured by income-producing properties.

 

ConflictsWe may originate or acquire mezzanine loans, which take the form of subordinated loans secured by second mortgages on the underlying property or loans secured by a pledge of the ownership interests of either the entity owning the property or a pledge of the ownership interests of the entity that owns the interest could arisein the entity owning the property. These types of assets involve a higher degree of risk than long-term senior mortgage lending secured by income producing real property, because the loan may become unsecured as a result of foreclosure by the Company's UpREIT structure.

Conflictssenior lender. In the event of interest could arise in the future as a resultbankruptcy of the relationships betweenentity providing the Company andpledge of its affiliates, on the one hand, and the Operating Partnership or any partner thereof, on the other. The Company's directors and officersownership interests as security, we may not have dutiesfull recourse to the Company under applicable Maryland law in connection with their managementassets of such entity, or the assets of the Company. At the same time, the Company, through the Operating Partnership subsidiary, has fiduciary duties, as a general partner, to the Operating Partnership and to the limited partners under Delaware law in connection with the management of the Operating Partnership. The Company's duties, through the Operating Partnership subsidiary, as a general partner to the Operating Partnership and its partners may come into conflict with the duties of the Company's directors and officers.

Certain provisions of Maryland law could inhibit changes in control and prevent the Company's stockholders from realizing a premium over the then-prevailing market price of the Company's common stock.

Certain provisions of the Maryland General Corporation Law ("MGCL") may have the effect of deterring a third party from making a proposal to acquire the Company or of impeding a change in control under circumstances that otherwise could provide the holders of shares of the Company's common stock with the opportunity to realize a premium over the then-prevailing market price of such shares.

The Company is subject to the "business combination" provisions of the MGCL that, subject to limitations, prohibit certain business combinations (including, generally, a merger, consolidation, share exchange, or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities) between the Company and an "interested stockholder" (defined generally as any person who beneficially owns 10% or more of the voting power of the Company's outstanding voting stock or an affiliate or associate of the Company who, at any time within the two-year period immediately prior to the date in question, was the beneficial owner of 10% or more of the voting power of the Company's outstanding stock) or an affiliate thereof for five years after the most recent date on which the stockholder becomes an interested stockholder. After the five-year prohibition, any business combination between the Company and an interested stockholder generally must be recommended by the Company's board of directors and approved by the affirmative vote of at least (i) eighty percent of the votes entitled to be cast by holders of outstanding shares of the Company's voting stock; and (ii) two-thirds of the votes entitled to be cast by holders of voting stock of the corporation other than shares held by the interested stockholder with whom or with whose affiliate the business combination is to be effected or held by an affiliate or associate of the interested stockholder. These super-majority vote requirements do not apply if the Company's common stockholders receive a minimum price, as defined under Maryland law, for their shares in the form of cash or other consideration in the same form as previously paid by the interested stockholder for its shares. These provisions of the MGCL do not apply, however, to business combinations that are approved or exempted by a board of directors prior to the time that the stockholder would otherwise have become an interested stockholder. Pursuant to the statute, the Company's board of directors will by resolution exempt business combinations (i) between the Company and ZAIS or its affiliates and (ii) between the Company and any person, provided that such business combination is first approved by the Company's board of directors (including a majority of the Company's directors who are not affiliates or associates of such person). Consequently, the five-year prohibition and the super-majority vote requirements will not apply to business combinations between the Company and any of them. As a result, any person described above may be able to enter into business combinations with the Company thatentity may not be in the best interest of the Company's stockholders, without compliance with the super-majority vote requirements and the other provisions of the statute.

The "control share" provisions of the MGCL provide thatsufficient to satisfy its mezzanine loan. If a holder of "control shares" of a Maryland corporation (defined as voting shares of stock which, when aggregated with all other shares of stock owned by the stockholderborrower defaults on any mezzanine loan we may purchase or in respect of which the stockholder is ableoriginate, or debt senior to exerciseany such loan, or direct the exercise of voting power (except solely by virtue of a revocable proxy), would entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a "control share acquisition" (defined as the direct or indirect acquisition of ownership of or the power to direct the exercise of voting power with respect to "control shares," subject to certain exceptions) have no voting rights except to the extent approved by the Company's stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding votes entitled to be cast by the acquirer of control shares, the Company's officers and employees who are also the Company's directors. The Company's bylaws contain a provision exempting from the control share acquisition statute any and all acquisitions by any person of shares of the Company's stock. There can be no assurance that this provision will not be amended or eliminated at any time in the future.

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The Company's ability to issue additional shares of common and preferred stock may prevent a change in the Company's control.

The Company's charter authorizes it to issue additional authorized but unissued shares of common or preferred stock. In addition, the Company's board of directors may, without stockholder approval, amend the Company's charter to increase or decrease the aggregate number of shares of the Company's stock or the number of shares of stock of any class or series that the Company has the authority to issue. As a result, the Company's board may establish a series of shares of common or preferred stock that could delay or prevent a transaction or a change in control that might involve a premium price for shares of the Company's common stock or otherwise be in the best interest of the Company's stockholders.

The Company's rights and the Company's stockholders' rights to take action against the Company's directors and officers are limited, which could limit the Company's stockholders' recourse in the event of actionsa borrower bankruptcy, such mezzanine loan will be satisfied only after the senior debt. As a result, we may not recover some or all of our initial expenditure. In addition, mezzanine loans may have higher LTVs than conventional mortgage loans, resulting in less equity in the Company's stockholders' best interests.

As permitted by Maryland law,property and increasing the Company's charter limits the liabilityrisk of its directors and officers to the Company and its stockholders for money damages, except for liability resulting from:

·actual receipt of an improper benefit or profit in money, property or services; or

·a final judgment based upon a finding of active and deliberate dishonesty by the director or officer that was material to the cause of action adjudicated.

In addition, the Company's charter authorizes it, to the maximum extent permitted by Maryland law, to obligate the Company to indemnify any present or former director or officer or any individual who, while a director or officerloss of the Company and at its request, serves or has served another corporation, real estate investment trust, limited liability company, partnership, joint venture, trust, employee benefit plan or other enterprise as a director, officer, partner, trustee, member or manager from and against any claim or liability to which that individual may become subject or which that individual may incur by reason of his or her service in any of the foregoing capacities and to pay or reimburse his or her reasonable expenses in advance of final disposition of a proceeding. The Company's bylaws obligate it, to the maximum extent permitted by Maryland law, to indemnify any present or former director or officer or any individual who, while a director or officer of the Company and at its request, serves or has served another corporation, real estate investment trust, limited liability company, partnership, joint venture, trust, employee benefit plan or other enterprise as a director, officer, partner, trustee, member or manager and who is made or threatened to be made a party to the proceeding by reason of his or her service in that capacity from and against any claim or liability to which that individual may become subject or which that individual may incur by reason of his or her service in any of the foregoing capacities and to pay or reimburse his or her reasonable expenses in advance of final disposition of a proceeding. The Company's charter and bylaws also permit it to indemnify and advance expensesprincipal. Significant losses related to any individual who served a predecessor of the Companymezzanine loans we may purchase or originate would result in any of the capacities described aboveoperating losses for us and any employee or agent of the Company or a predecessor of the Company.

The Company's amended and restated bylaws designates the Circuit Court for Baltimore City, Maryland as the sole and exclusive forum for some litigation, which could limit the ability of stockholders of the Company to obtain a favorable judicial forum for disputes with the Company.

On March 11, 2014, the board of directors of the Company approved an amendment to its bylaws which, unless the Company consents in writing to the selection of an alternative forum, makes the Circuit Court for Baltimore City, Maryland, or, if that Court does not have jurisdiction, the United States District Court for the District of Maryland, Baltimore Division the sole and exclusive forum for (i) any derivative action or proceeding brought on behalf of the Company, (ii) any action asserting a claim of breach of any duty owed by any director or officer or other employee of the Company to the Company or to the stockholders of the Company, (iii) any action asserting a claim against the Company or any director or officer or other employee of the Company arising pursuant to any provision of the MGCL or the Company's charter or bylaws, or (iv) any action asserting a claim against the Company or any director or officer or other employee of the Company that is governed by the internal affairs doctrine. Any person or entity purchasing or otherwise acquiring any interest in shares of the Company's capital stock shall be deemed to have notice of and to have consented to the provisions described above. This forum selection provision may limit theour ability of stockholders of the Company to obtain a judicial forum that they find favorable for disputes with the Company or its directors, officers, employees, if any, or othermake distributions to our stockholders.

 

Maintenance of the Company'sour 1940 Act exemptionexception imposes limits on the Company'sour operations.

 

The Company conducts, and intends to continueWe intend to conduct itsour operations so as notthat neither we nor our subsidiaries are required to become regulatedregister as an investment company under the 1940 Act. Because the Company is a holding company and conducts its businesses primarily through wholly-owned or majority-owned subsidiaries, the securities issued by these subsidiaries that are excepted from the definition of "investment company" under Section 3(c)3(a)(1) or Section 3(c)(7)(A) of the 1940 Act together withdefines an investment company as any otherissuer that is or holds itself out as being engaged primarily in the business of investing, reinvesting or trading in securities. Section 3(a)(1)(C) of the 1940 Act defines an investment company as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire investment securities the Company may own, may not havehaving a combined value in excess ofexceeding 40% of the value of the Company'sissuer’s total assets (exclusive of U.S. Government securities and cash items) on an unconsolidated basis. Excluded from the term “investment securities,” among other things, are U.S. Government securities and securities issued by majority-owned subsidiaries that are not themselves investment companies and are not relying on the exception from the definition of investment company set forth in Section 3(c)(1) or Section 3(c)(7) of the 1940 Act.

We intend to conduct our operations so that we do not come within the definition of an investment company under Section 3(a)(1)(C) of the 1940 Act because fewer than 40% of our total assets on an unconsolidated basis whichwill consist of “investment securities.” The securities issued to us by any wholly-owned or majority-owned subsidiary that we currently own or may form in the Company refersfuture that is excluded from the definition of “Investment Company” by Section 3(c)(1) or 3(c)(7) of the 1940 Act, together with any other investment securities we may own, may not have a value in excess of 40% of the value of our total assets on an unconsolidated basis. We will monitor our holdings to ensure continuing and ongoing compliance with this test. However, qualification for exclusion from registration under the 1940 Act will limit our ability

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to make certain investments. In addition, we believe that we will not be considered an investment company under Section 3(a)(1)(A) of the 1940 Act because we will not engage primarily or hold ourselves out as being engaged primarily in the 40% test. This requirement limitsbusiness of investing, reinvesting or trading in securities. Rather, we will be primarily engaged in the typesnon-investment company businesses of our subsidiaries, and thus the type of businesses in which the Companywe may engage through its subsidiaries.our subsidiaries is limited.

 

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TheIn connection with the Section 3(a)(1)(c) analysis, the determination of whether an entity is a majority-owned subsidiary of theour Company is made by the Company.us. The 1940 Act defines a majority-owned subsidiary of a person as a company 50% or more of the outstanding voting securities of which are owned by such person, or by another company which is a majority-owned subsidiary of such person. The 1940 Act further defines voting securities as any security presently entitling the owner or holder thereof to vote for the election of directors of a company. The Company treatsWe will treat companies in which it ownswe own at least a majority of the outstanding voting securities as majority-owned subsidiaries for purposes of the 40% test. The Company hasWe will also treat securitization trusts as majority-owned subsidiaries for purposes of this analysis even where the securities issued by such trusts do not meet the definition of voting securities under the 1940 Act only in cases where this conclusion is supported by an opinion of counsel that the trust certificates or other interests issued by such securitization trusts are the functional equivalent of voting securities and that, in any event, such securitization trusts should be considered to be majority-owned subsidiaries for purposes of this analysis. We have not requested the SEC, or its staff, to concur or approve the Company'sour treatment of any securitization trust or other company as a majority-owned subsidiary and neither the SEC nor its staff has done so. If the SEC, or its staff, were to disagree with the Company'sour treatment of one of more companies as majority-owned subsidiaries, the Companywe would need to adjust itsour strategy and itsour assets in order to continue to pass the 40% test. Any such adjustment in the Company'sour strategy could have a material adverse effect on it.

us.

 

The Company believesWe believe that certain of itsour subsidiaries qualify to be excluded from the definition of investment company under the 1940 Act pursuant to Section 3(c)(5)(C) of the 1940 Act, which is available for entities "primarily“primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate." This exception generally requires that at least 55% of such subsidiaries'subsidiaries’ assets must be comprised of qualifying assets and at least 80% of their total assets must be comprised of qualifying assets and real estate-related assets under the 1940 Act. The CompanyWe will treat as qualifying assets for this purpose mortgageSBC loans Agency RMBS in which it holds all the certificates issued by the pool and other interests in real estate,mortgages, in each case meeting certain other qualifications based upon SEC staff no-action letters. Although SEC staff no-action letters have not specifically addressed the categorization of these types of assets, the Companywe will also treat as qualifying assets for this purpose bridgetransitional loans wholly securedwholly-secured by first priority liens on real estate that provide interim financing to borrowers seeking short-term capital (with terms of generally up to three years), non-Agency RMBSMBS representing ownership of an entire pool of mortgage loans, and real estate owned properties. The Company expectsestate-owned properties that may be acquired in connection with mortgage loan foreclosures. We expect each of itsour subsidiaries relying on Section 3(c)(5)(C) to treat as real estate-relatedmay invest an additional 25% of its assets in either qualifying assets or in other types of RMBS, CMBS,mortgages, interests in MBS or other securitizations, securities of REITs, and other real estate-related assets. The Company expectsWe expect each of itsour subsidiaries relying on Section 3(c)(5)(C) to rely on guidance published by the SEC, or its staff, or if such guidance has not been published, on the Company'sour own analyses of guidance published with respect to other types of assets to determine which assets are qualifying real estate assets and real estate-related assets. However, neither the SEC nor its staff has published guidance with respect to the treatment of some of these assets under Section 3(c)(5)(C). To the extent that the SEC, or its staff, publishes new or different guidance with respect to these matters, the Companywe may be required to adjust itsour strategy accordingly. Although the Company intendswe intend to monitor itsour portfolio periodically and prior to each investment acquisition, there can be no assurance that the Companywe will be able to maintain an exclusion for these subsidiaries. In addition, the Companywe may be limited in itsour ability to make certain investments and these limitations could result in the subsidiary holding assets the Companywe might wish to sell or selling assets itwe might wish to hold.

 

In 2011, the SEC solicited public comment on a wide range of issues relating to Section 3(c)(5)(C) of the 1940 Act, including the nature of the assets that qualify for purposes of the exclusion and whether mortgage REITs should be regulated in a manner similar to registered investment companies. There can be no assurance that the laws and regulations orgoverning the interpretation1940 Act status of such laws or regulations byREITs, including the SEC, or its staff, providing more specific or different guidance regarding this exclusion, will not change in a manner that adversely affects the Company'sour operations. If theour Company or itsour subsidiaries fail to maintain an exception or exclusionexemption from the 1940 Act, the Companywe could, among other things, be required either to (i) change the manner in which it conducts itswe conduct our operations to avoid being required to register as an investment company, (ii) effect sales of itsour assets in a manner that, or at a time when, itwe would not otherwise choose to do so, or (iii) register as an investment company, any of which would negatively affect the value of itsour shares of common stock, the sustainability of itsour business model, and itsour ability to make distributions which would have an adverse effect on itsour business and the value of itsour shares of common stock.

 

Qualification for exemption from registration under the 1940 Act will limit the Company's ability to make certain investments. For example, these restrictions will limit the ability of the Company's subsidiaries to invest directly in mortgage back securities that represent less than the entire ownership in a pool of mortgage loans, debt and equity tranches of securitizations and ABS, and real estate companies or in assets not related to real estate.

Certain of the Company'sour subsidiaries may rely on the exclusion from the definition of investment company provided by Section 3(c)(6) to the extent that they hold mortgage assets through majority-owned subsidiaries that rely on Section 3(c)(5)(C). The

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Little interpretive guidance has been issued by the SEC, has issued little interpretive guidanceor its staff, with respect to Section 3(c)(6) and any guidance published by the SEC, or its staff, could require the Companyus to adjust itsour strategy accordingly. Although little interpretive guidance has been issued with respect to Section 3(c)(6), we believe that each of our subsidiaries may rely on Section 3(c)(6) if, among other things, 55% of the assets of such subsidiaries consist of, and at least 55% of the income of such subsidiaries are derived from, qualifying real estate investment assets owned by wholly-owned or majority-owned subsidiaries of such subsidiaries.

Qualification for exemption from registration under the 1940 Act will limit our ability to make certain investments. For example, these restrictions will limit the ability of our subsidiaries to invest directly in MBS that represent less than the entire ownership in a pool of mortgage loans, debt and equity tranches of securitizations and MBS, and real estate companies or in assets not related to real estate.

 

No assurance can be given that the SEC, or its staff, will concur with the Company'sour classification of the Company'sour Company or the Company's subsidiaries'our subsidiaries’ assets or that the SEC, or its staff, will not, in the future, issue further guidance that may require itus to reclassify those assets for purposes of qualifying for an exception to the definition of investment company or an exclusion from regulation under the 1940 Act. To the extent that the SEC or its staff provides more specific guidance regarding any of the matters bearing upon the definition of investment company and the exceptions to that definition, the Companywe may be required to adjust itsour investment strategy accordingly. Additional guidance from the SEC, or its staff, could provide additional flexibility to the Company,us, or it could further inhibit the Company'sour ability to pursue the investment strategy it haswe have chosen. If the SEC, or its staff takes a position contrary to the Company'sour analysis with respect to the characterization of any of the assets or securities the Company investswe invest in, the Companywe may be deemed an unregistered investment company. Therefore, in order not to be required to register as an investment company, the Companywe may need to dispose of a significant portion of itsour assets or securities or originate or acquire significant other additional assets which may have lower returns than itsour expected portfolio, or the Companywe may need to modify itsour business plan to register as an investment company, which would result in significantly increased operating expenses and would likely entail significantly reducing the Company'sour indebtedness, which could also require the Companyus to sell a significant portion of itsour assets. The CompanyWe cannot provide assuranceassure you that itwe would be able to complete these dispositions or acquisitions of assets, or deleveraging, on favorable terms, or at all. Consequently, any modification of itsour business plan could have a material adverse effect on the Company.us. Further, if the SEC determined that the Companywe were an unregistered investment company, the Companywe would be subject to monetary penalties and injunctive relief in an action brought by the SEC, the Companywe would potentially be unable to enforce contracts with third parties and third parties could seek to obtain rescission of transactions undertaken during the period for which it was established that the Company waswe were an unregistered investment company. Any of these results would have a material adverse effect on the Company.us.

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Since the Company willwe are not expected to be registered as an investment company undersubject to the 1940 Act, the Companywe will not be subject to its substantive provisions, including provisions requiring diversification of investments, limiting leverage and restricting investments in illiquid assets.

 

Rapid changes in the values of the Company'sour target assets may make it more difficult for the Companyus to maintain itsour qualification as a REIT or the Company's exemptionour exclusion from the 1940 Act.

 

If the fair market value or income potential of the Company'sour target assets declines as a result of increased interest rates, prepayment rates, general market conditions, government actions or other factors, the Companywe may need to increase itsour real estate assets and income or liquidate itsour non-qualifying assets to maintain itsour REIT qualification or its exemptionour exclusion from the 1940 Act. If the decline in real estate asset values or income occurs quickly, this may be especially difficult to accomplish. The CompanyWe may have to make decisions that itwe otherwise would not make absent the REIT and 1940 Act considerations.

 

Risks Relating to an Investment in Our Common Stock

Future offerings of debt or equity securities, which may rank senior to our common stock, may adversely affect the market price of the common stock.

If we decide to issue additional debt securities in the future, which would rank senior to our common stock, it is likely that they will be governed by an indenture or other instrument containing covenants restricting our operating flexibility. Additionally, any equity securities or convertible or exchangeable securities that we issue in the future may have rights, preferences and privileges more favorable than those of our common stock and may result in dilution to owners of our common stock. We and, indirectly, our stockholders, will bear the cost of issuing and servicing such securities. Because our decision to issue debt or equity securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Thus, holders of

56


our common stock will bear the risk of our future offerings reducing the market price of our common stock and diluting the value of their stock holdings in the Company.

We cannot assure you of our ability to pay distributions in the future.

To maintain our qualification as a REIT and generally not be subject to U.S. federal income tax, we intend to make regular quarterly distributions to holders of our common stock out of legally available funds. Our current policy is to distribute our net taxable income to our stockholders in a manner intended to satisfy the 90% distribution requirement and to avoid corporate income tax. We expect to continue our current distribution practices following the ZAIS Financial merger, but our ability to pay distributions may be adversely affected by a number of factors, including the risk factors described in this annual report on Form 10-K. All distributions will be made at the discretion of our board of directors and will depend on our earnings, financial condition, debt covenants, maintenance of our REIT qualification, restrictions on making distributions under Maryland law and other factors as our board of directors may deem relevant from time to time. We may not be able to make distributions in the future, and our board of directors may change our distribution policy in the future. We believe that a change in any one of the following factors, among others, could adversely affect our results of operations and impair our ability to pay distributions to our stockholders:

·

the profitability of the assets we hold or acquire;

·

our ability to make profitable acquisitions;

·

margin calls or other expenses that reduce our cash flow;

·

defaults in our asset portfolio or decreases in the value of our portfolio; and

·

the fact that anticipated operating expense levels may not prove accurate, as actual results may vary from estimates.

We cannot assure you that we will achieve results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions in the future. In addition, some of our distributions may include a return of capital.

Tax Risks

 

The Company's taxable income is calculated differently than net income based on U.S. GAAP.

The Company's taxable income may substantially differ from its net income based on U.S. GAAP. For example, interest income on the Company's mortgage loans and other mortgage related assets does not necessarily accrue under an identical schedule for U.S. federal income tax purposes as for accounting purposes.

For U.S. GAAP purposes, interest income on the Company's mortgage related securities is accrued based on the actual coupon rate and the outstanding principal amount of the underlying mortgages. Premiums and discounts are amortized or accreted into interest income over the estimated lives of the securities using the effective yield method adjusted for the effects of estimated prepayments. Adjustments are made using the retrospective method to the effective interest computation each reporting period based on the actual prepayment experiences to date, and the present expectation of future prepayments of the underlying mortgages. If the Company's estimate of prepayments is incorrect, the Company is required to make an adjustment to the amortization or accretion of premiums and discounts that would have an impact on future income.

Management will estimate, at the time of purchase, the future expected cash flows and determine the effective interest rate based on these estimated cash flows and the Company's purchase price. As needed, these estimated cash flows will be updated and a revised yield computed based on the current amortized cost of the investment. In estimating these cash flows, the Company will have to make assumptions regarding the rate and timing of principal payments and coupon rates. These uncertainties and contingencies are difficult to predict and are subject to future events that may impact management's estimates and the Company's interest income.

In particular, interest income on mortgage related securities that were purchased at a discount to par value will be recognized based on the security's effective interest rate. The effective interest rate on these securities will be based on the projected cash flows from each security, which will be estimated based on the Company's observation of current information and events and include assumptions related to interest rates, prepayment rates and the timing and amount of credit losses. Based on the projected cash flows from the Company's mortgage related securities purchased at a discount to par value, a portion of the purchase discount may be designated as credit protection against future credit losses and, therefore, may not be accreted into interest income. The amount designated as credit discount may be adjusted over time, based on the actual performance of the security, its underlying collateral, actual and projected cash flow from such collateral, economic conditions and other factors. If the performance of a security with a credit discount is more favorable than forecasted, a portion of the amount designated as credit discount may be accreted into interest income over time. Conversely, if the performance of a security with a credit discount is less favorable than forecasted, additional amounts of the purchase discount may be designated as credit discount, or impairment charges and write-downs of such securities to a new cost basis could result.

When the Company purchases mortgage loans that have shown evidence of credit deterioration since origination and management determines that it is probable the Company will not collect all contractual cash flows on those assets, the Company will apply the guidance that addresses accounting for differences between contractual cash flows and cash flows expected to be collected if those differences are attributable to, at least in part, credit quality. Interest income will be recognized on a level-yield basis over the life of the loan as long as cash flows can be reasonably estimated. The level-yield is determined by the excess of the Company's initial estimate of undiscounted expected principal, interest, and other cash flows (cash flows expected at acquisition to be collected) over the Company's initial investment in the mortgage loan (accretable yield). The amount of interest income to be recognized cannot result in a carrying amount that exceeds the payoff amount of the loan. The excess of contractual cash flows over cash flows expected to be collected (nonaccretable difference) will not be recognized as an adjustment of yield.

39

For U.S. federal income tax purposes, if a debt instrument pays interest currently, the Company is generally required to treat all such interest as interest income. In addition, if the Company acquires mortgage loans, RMBS or other debt instruments at a discount in the secondary market, the discount at which such debt instruments are acquired will generally be treated as "market discount" for U.S. federal income tax purposes and will accrue over the term of the debt instrument. Accrued market discount is reported as income when, and to the extent that, the Company receives any payment of principal on the debt instrument, unless the Company elects to include accrued market discount in incomes as it accrues. As a result, the Company will be required to treat principal payments on such a debt instrument as ordinary income for U.S. federal income tax purposes to the extent of any accrued market discount regardless of the Company's expected return on its investment in the debt instrument. In particular, payments on residential mortgage loans are ordinarily made monthly, and consequently accrued market discount may have to be included in income each month as if the debt instrument were assured of ultimately being collected in full. Similarly, if the Company acquires a debt instrument that is issued with original issue discount ("OID"), the Company will generally be required to accrue such OID regardless of whether the Company expects to receive the full face amount of the debt instrument on its maturity. If the Company collects less on a debt instrument than the Company's purchase price plus any market discount it had previously reported as income, the Company may not be able to benefit from any offsetting loss deductions in subsequent years. In certain cases, the Company may be able to cease accruing interest income with respect to a debt instrument, to the extent there is reasonable doubt as to the Company's ability to collect such interest income. However, if the Company recognizes insufficient interest income with respect to certain debt instruments that the Company acquires, and the Internal Revenue Service ("IRS") were to successfully assert that the Company did not accrue the appropriate amount of income with respect to such a debt instrument in a given taxable year, the Company may be required to increase its taxable income with respect to such year, which could cause it to be required to pay a deficiency dividend or a tax on undistributed income, or failOur failure to qualify as a REIT.

Investment in the Company's common stock has various tax risks.

This summary of certain tax risks is limited to the U.S. federal income tax risks addressed below. Additional risks or issues may exist that are not addressed in this annual report on Form 10-K and that could affect the U.S. federal income tax treatment of the Company, the Operating PartnershipREIT, or the Company's stockholders.

The Company's failure of our predecessor to qualify as a REIT, would subject itus to U.S. federal income tax and applicable state and local taxes, which would reduce the amount of cash available for distribution to the Company'sour stockholders.

 

The Company isWe have been organized operates (commencing with the Company's taxable year ended December 31, 2011), and intendsoperated and intend to continue to be organized and to operate in a manner that will allow itenable us to qualify as a REIT for U.S. federal income tax purposes. The Company haspurposes commencing with our taxable year ended December 31, 2011. We have not requested and doesdo not intend to request a ruling from the IRSInternal Revenue Service (the “IRS”), that the Company qualifieswe qualify as a REIT. The U.S. federal income tax laws governing REITs are complex, and judicial and administrative interpretations of the U.S. federal income tax laws governing REIT qualification are limited. The complexity of these provisions and of applicable regulations promulgated by the U.S. Department of the Treasury ("Treasury Regulations")Regulations is greater in the case of a REIT that, like the Company,us, holds itsour assets through a partnership. To qualify as a REIT, the Companywe must meet, on an ongoing basis, various tests regarding the nature of itsour assets and itsour income, the ownership of itsour outstanding shares, and the amount of itsour distributions. The Company'sOur ability to satisfy the asset tests depends on itsour analysis of the characterization and fair market values of itsour assets, some of which are not susceptible to a precise determination, and for which the Companywe may not obtain independent appraisals. Moreover, new legislation, court decisions or administrative guidance, in each case possibly with retroactive effect, may make it more difficult or impossible for the Companyus to qualify as a REIT. In addition, the Company'sour ability to satisfy the requirements to qualify as a REIT depends in part on the actions of third parties over which the Company haswe have no control or only limited influence, including in cases where the Company ownswe own an equity interest in an entity that is classified as a partnership for U.S. federal income tax purposes. Furthermore, we hold certain assets through our ownership interest in Ready Capital Subsidiary REIT I, LLC, which we refer to as our subsidiary REIT. Our ability to qualify as a REIT is dependent in part on the REIT qualification of our subsidiary REIT, which is required to separately satisfy each of the REIT requirements in order to qualify as a REIT. Thus, while the Company believes that it has operated and intends to continuewe intend to operate so that the Companywe will qualify as a REIT, given the highly complex nature of the rules governing REITs, the ongoing importance of factual

57


determinations, and the possibility of future changes in the Company'sour circumstances, no assurance can be given that the Company has qualified orwe will so qualify for any particular year. These considerations also might restrict the types of assets that the Companywe can acquire in the future.

 

If the Company failswe fail to qualify as a REIT in any taxable year, and doesdo not qualify for certain statutory relief provisions, the Companywe would be required to pay U.S. federal income tax on itsour taxable income, and distributions to itsour stockholders would not be deductible by the Companyus in determining itsour taxable income. In such a case, the Companywe might need to borrow money or sell assets in order to pay the Company'sour taxes. The Company'sOur payment of income tax would decrease the amount of itsour income available for distribution to itsour stockholders. Furthermore, if the Company failswe fail to maintain itsour qualification as a REIT, the Companywe no longer would be required to distribute substantially all of itsour net taxable income to itsour stockholders. In addition, unless the Companywe were eligible for certain statutory relief provisions, the Companywe could not re-elect to qualify as a REIT until the fifth calendar year following the year in which itwe failed to qualify.

 

InAs further described above, on October 31, 2016, our predecessor entity merged with and into a subsidiary of ZAIS Financial, with ZAIS Financial surviving the contextmerger and changing its name to Sutherland Asset Management Corporation.  If prior to the merger our predecessor (“Pre-Merger Sutherland”) failed to qualify as a REIT, we could fail to qualify as a REIT as a result.  Even if we retained our REIT qualification, if Pre-Merger Sutherland failed to qualify as a REIT for any taxable year prior to the merger, we would face serious tax consequences that could substantially reduce the cash available for distribution to our stockholders because (i) we, as successor to Pre-Merger Sutherland in the merger, generally inherited any corporate income, excise and other tax liabilities of Pre-Merger Sutherland, including penalties and interest; (ii) we would be subject to tax on the built-in gain on each asset of Pre-Merger Sutherland existing at the time of the on-going strategic review discussed elsewheremerger; and (iii) we could be required to employ applicable deficiency dividend procedures (which would include the payment of penalties and interest to the IRS) to eliminate any earnings and profits accumulated by Pre-Merger Sutherland for taxable periods that it did not qualify as a REIT. As a result, any failure by Pre-Merger Sutherland to qualify as a REIT could impair our ability to expand our business and raise capital, and could materially adversely affect the value of our common stock.

The percentage of our assets represented by TRSs and the amount of our income that we can receive in the form of TRS dividends and interest are subject to statutory limitations that could jeopardize our REIT qualification and could limit our ability to acquire or force us to liquidate otherwise attractive investments.

A REIT may own up to 100% of the stock of one or more TRSs. A TRS may earn income that would not be qualifying income if earned directly by the parent REIT. In order to treat a subsidiary of the REIT as a TRS, both the subsidiary and the REIT must jointly elect to treat the subsidiary as a TRS. In order to qualify as a REIT, no more than 20% of the value of our gross assets at the end of each calendar quarter may consist of securities of one or more TRSs. A significant portion of our activities are conducted through our TRSs, and we expect that such TRSs will from time to time hold significant assets.

We have elected, together with each of ReadyCap Holdings and Ready Capital TRS I, LLC, for each such entity to be treated as a TRS, and we may make TRS elections with respect to certain other entities we may form in the future (collectively referred to herein as "our TRSs"). While we intend to manage our affairs so as to satisfy the TRS limitation, there can be no assurance that we will be able to do so in all market circumstances.

In order to satisfy the TRS limitation, we have been required to and may in the future be required to acquire assets that we otherwise would not acquire, liquidate or restructure assets that we hold through ReadyCap Holdings or any of our TRSs, or otherwise engage in transactions that we would not otherwise undertake absent the requirements for REIT qualifications. Each of these actions could reduce the distributions available to our stockholders. In addition, we and our subsidiary REIT have made loans to our TRSs that meet the requirements to be treated as qualifying investments of new capital, which is generally treated as a real estate asset under the Code. Because such loans are treated as real estate assets for purposes of the REIT requirements, we do not treat these loans as TRS securities for purposes of the TRS asset limitation, which is consistent with private rulings issues by the IRS. However, no assurance can be provided that the IRS may not successfully assert that such loans should be treated as securities of our TRSs or our subsidiary REIT's TRSs, which could adversely impact our qualification as a REIT. In addition, our TRSs have obtained financing in transactions in which we and our other subsidiaries have provided guaranties and similar credit support. Although we believe that these financings are properly treated as financings of our TRSs for U.S. federal income tax purposes, no assurance can be provided that the IRS would not assert that such financings should be treated as issued by other entities in our structure, which could impact our compliance with the TRS limitation and the other REIT requirements. Moreover, no assurance

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can be provided that we will be able to successfully manage our asset composition in a manner that causes us to satisfy the TRS limitation each quarter, and our failure to satisfy this Form 10-K, the Company may liquidate its assets. The results of any such sale or liquidationlimitation could cause the Company to failresult in our failure to qualify as a REIT.

 

Any distributions we receive from our TRSs are classified as dividend income to the extent of the earnings and profits of the distributing corporation. Any of our TRSs may from time to time need to make such distributions in order to keep the value of our TRSs below 20% of our total assets. However, TRS dividends will generally not constitute qualifying income for purposes of one of the tests we must satisfy to qualify as a REIT, namely, that at least 75% of our gross income must in each taxable year generally be from real estate assets. While we will continue to monitor our compliance with both this income test and the limitation on the percentage of our assets represented by securities of our TRSs, and intend to conduct our affairs so as to comply with both, the two may at times be in conflict with one another. As an example, it is possible that we may wish to distribute a dividend from a TRS in order to reduce the value of our TRSs below the required threshold of our assets, but be unable to do so without violating the requirement that 75% of our gross income in the taxable year be derived from real estate assets. Although there are other measures we can take in such circumstances in order to remain in compliance, there can be no assurance that we will be able to comply with both of these tests in all market conditions.

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Complying with REIT requirements may force the Companyus to liquidate or forego otherwise attractive investments, which could reduce returns on the Company'sour assets and adversely affect returns to the Company'sour stockholders.

 

To qualify as a REIT, the Companywe must generally ensure that at least 75% of our gross income for each taxable year, excluding certain amounts, is derived from certain real property‑related sources, and at least 95% of our gross income for each taxable year, excluding certain amounts, is derived from certain real property‑related sources and passive income such as dividends and interest. In addition, we generally must ensure that at the end of each calendar quarter at least 75% of the value of itsour total assets consists of cash, cash items, government securities and qualified REIT real estate assets, including certain mortgage loans and RMBS. The remainder of the Company'sour investment in securities (other than government securities and qualifying real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of the Company'sour assets (other than government securities and qualifying real estate assets) can consist of the securities of any one issuer, and no more than 25% (20% beginning in 2018)20% of the value of the Company'sour total assets can be represented by stock and securities of one or more TRSs.TRSs and no more than 25% of the value of our assets may consist of “nonqualified publicly offered REIT debt instruments.” If the Company failswe fail to comply with these requirements at the end of any quarter, the Companywe must correct the failure within 30 days after the end of such calendar quarter or qualify for certain statutory relief provisions to avoid losing itsour REIT qualification and suffering adverse tax consequences. As a result, the Companywe may be required to liquidate from its portfolio otherwise attractive investments.investments from our portfolio. These actions could have the effect of reducing the Company'sour income and amounts available for distribution to itsour stockholders. In addition, if the Company iswe are compelled to liquidate itsour investments to repay obligations to itsour lenders, the Companywe may be unable to comply with these requirements, ultimately jeopardizing itsour qualification as a REIT. The REIT requirements described above may also restrict the Company’sour ability to sell REIT-qualifying assets, including asset sales made in connection with a disposition of certain segments of the Company’sour business or in connection with a liquidation of the Company,us, without adversely impacting the Company’sour qualifications as a REIT. Furthermore, the Companywe may be required to make distributions to stockholders at disadvantageous times or when it doeswe do not have funds readily available for distribution, and may be unable to pursue investments that would be otherwise advantageous to the Companyus in order to satisfy the source of income or asset diversification requirements for qualifying as a REIT.

 

In addition, certain assets that we hold or intend to hold, including unsecured loans, loans secured by both real property and personal property where the fair market value of the personal property exceeds 15% of the total fair market value of all of the property securing the loan, and interests in ABS secured by assets other than real property or mortgages on real property or on interests in real property, are not qualified and will not be qualified real estate assets for purposes of the REIT asset tests. Accordingly, our ability to invest in such assets will be limited, and our investment in such assets could cause us to fail to qualify as a REIT if our holdings in such assets do not satisfy such limitations.

Distributions from the Companyus or gain on the sale of itsour common stock may be treated as unrelated business taxable income, ("UBTI")or “UBTI”, to U.S. tax exempttax-exempt holders of common stock.

 

If (i) all or a portion of the Company'sour assets are subject to the rules relating to taxable mortgage pools, (ii) a tax exempttax-exempt U.S. person has incurred debt to purchase or hold the Company'sour common stock, (iii) the Company purchases residualwe purchase real estate mortgage investment conduit ("REMIC"(“REMIC”) residual interests that generate "excess“excess inclusion income," or (iv) the Company iswe are a "pension“pension held REIT," then a portion

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of the distributions with respect to itsour common stock and, in the case of a U.S. person described in clause (ii), gains realized on the sale of such common stock by such U.S. person, may be subject to U.S. federal income tax as UBTI under the Internal Revenue CodeCode. We have engaged in certain securitization transactions that are treated as taxable mortgage pools for U.S. federal income tax purposes. Although we believe that such transactions are structured in a manner so that they should not cause any portion of 1986,the distributions in our shares to be treated as amended (the "Internal Revenue Code").excess inclusion income, no assurance can be provided that the IRS would not assert a contrary position.

 

The CompanyWe may lose itsour REIT qualification or be subject to a penalty tax if it earnswe earn, and the IRS successfully challenges the Company'sour characterization of, income from foreign TRSs or other non-U.S. corporations in which the Company holdswe hold an equity interest.

 

The CompanyWe may make investments in non-U.S. corporations some of which may, together with the Company,us, make a TRS election. The CompanyWe likely will be required to include in itsour income, even without the receipt of actual distributions, earnings from any such foreign TRSs or other non-U.S. corporations in which the Company holdswe hold an equity interest. Income inclusions from equity investments in certain foreign corporations are technically neither dividends nor any of the other enumerated categories of income specified in the 95% gross income test for U.S. federal income taxREIT qualification purposes. However, in recent private letter rulings, the IRS exercised its authority under Internal Revenue Code sectionSection 856(c)(5)(J)(ii) to treat such income as qualifying income for purposes of the 95% gross income test, notwithstanding the fact that the income is not included in the enumerated categories of income qualifying for the 95% gross income test. A private letter ruling may be relied upon only by the taxpayer to whom it is issued, and the IRS may revoke a private letter ruling. Consistent with the position adopted by the IRS in those private letter rulings and based on advice of counsel concerning the classification of such income inclusions for purposes of the REIT income tests, the Company intendswe intend to treat such income inclusions that meet certain requirements as qualifying income for purposes of the 95% gross income test. Notwithstanding the IRS'sIRS’s determination in the private letter rulingrulings described above, it is possible that the IRS could successfully assert that such income does not qualify for purposes of the 95% gross income test, which, if such income together with other income the Company earnswe earn that does not qualify for the 95% gross income test exceeded 5% of the Company'sour gross income, could cause the Companyus to be subject to a penalty tax and could impact the Company'sour ability to qualify as a REIT.

 

The REIT distribution requirements could adversely affect the Company'sour ability to execute itsour business plan and may require itus to incur debt, sell assets or take other actions to make such distributions.

 

To qualify as a REIT, the Companywe must distribute to itsour stockholders each calendar year at least 90% of itsour REIT taxable income (including certain items of non-cash income), determined without regard to the deduction for dividends paid and excluding net capital gain. To the extent that the Company satisfieswe satisfy the 90% distribution requirement, but distributesdistribute less than 100% of itsour taxable income, the Companywe will be subject to U.S. federal corporate income tax on itsour undistributed income. In addition, the Companywe will incur a 4% nondeductible excise tax on the amount, if any, by which the Company'sour distributions in any calendar year are less than a minimum amount specified under U.S. federal income tax laws. The Company'sOur current policy is to pay distributions which will allow the Companyus to satisfy the requirements to qualify as a REIT and generally not be subject to U.S. federal income tax on itsour undistributed income.

 

The Company'sOur taxable income may substantially exceed itsour net income as determined based onunder U.S. GAAP, or differences in timing between the recognition of taxable income and the actual receipt of cash may occur. For example, it is likely that the Companywe will acquire assets, including RMBS requiring itus to accrue OIDoriginal issue discount (“OID”) or recognize market discount income, that generate taxable income in excess of economic income or in advance of the corresponding cash flow from the assets referredassets. Under the recently enacted Tax Cuts and Jobs Act ("TCJA"), we generally will be required to recognize certain amounts in income no later than the time such amounts are reflected on our financial statements.  The application of this rule may require the accrual of income with respect to our loans, such as "phantom income."original issue discount or market discount, earlier than would be the case under the otherwise applicable tax rules, although the precise application of this rule is unclear at this time.  This rule generally will be effective for tax years beginning after December 31, 2017 but, for debt instruments issued with original issue discount, for tax years beginning after December 31, 2018. Also, in certain circumstances our ability to deduct interest expenses for U.S. federal income tax purposes may be limited. We may also acquire distressed debt investments that are subsequently modified by agreement with the borrower. If the amendments to the outstanding debt are “significant modifications” under the applicable Treasury Regulations, the modified debt may be considered to have been reissued to us at a gain in a debt-for-debt exchange with the borrower, with gain recognized by us to the extent that the principal amount of the modified debt exceeds our cost of purchasing it prior to modification.  Finally, the Companywe may be required under the terms of the indebtedness that it incurswe incur to use cash received from interest payments to make principal payments on that indebtedness, with the effect that the Companywe will recognize income but will not have a corresponding amount of cash available for distribution to itsour stockholders.

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As a result of the foregoing, the Companywe may generate less cash flow than taxable income in a particular year and find it difficult or impossible to meet the REIT distribution requirements in certain circumstances. In such circumstances, the Companywe may be required to (i) sell assets in adverse market conditions, (ii) borrow on unfavorable terms, (iii) distribute amounts that would otherwise be used for future investment or used to repay debt, or (iv) make a taxable distribution of shares of common stock as part of a distribution in which stockholders may elect to receive shares of common stock or (subject to a limit measured as a percentage of the total distribution) cash, in order to comply with the REIT distribution requirements. Thus, compliance with the REIT distribution requirements may hinder the Company'sour ability to grow, which could adversely affect the value of itsour common stock.

 

The CompanyWe may be required to report taxable income with respect to certain of the Company'sour investments in excess of the economic income the Companywe ultimately realizesrealize from them.

The CompanyWe may acquire mortgage loans, RMBS or other debt instruments in the secondary market for less than their face amount. The discount at which such securities are acquired may reflect doubts about their ultimate collectability rather than current market interest rates. The amount of such discount will nevertheless generally be treated as "market discount"“market discount” for U.S. federal income tax purposes. Market discount generally accrues on the basis of the constant yield to maturity of the debt instrument based generally on the assumption that all future payments on the debt instrument will be made. Accrued market discount is reported as income when, and to the extent that, any payment of principal of the debt instrument is made. In particular, payments on residential mortgage loans are ordinarily made monthly, and consequently accrued market discount may have to be included in income each month as if the debt instrument were assured of ultimately being collected in full. If the Company collectswe collect less on a debt instrument than the Company'sour purchase price plus the market discount the Companywe had previously reported as income, the Companywe may not be able to benefit from any offsetting loss deduction in a subsequent taxable year. In addition, the Companywe may acquire distressed debt investments that are subsequently modified by agreement with the borrower. If the amendments to the outstanding debt are "significant modifications"“significant modifications” under applicable Treasury regulations,Regulations, the modified debt may be considered to have been reissued to the Companyus at a gain in a debt-for-debt exchange with the borrower. In that event, the Companywe may be required to recognize taxable gain to the extent the principal amount of the modified debt exceeds the Company'sour adjusted tax basis in the unmodified debt, even if the value of the debt or the payment expectations have not changed.

 

Similarly, some of the RMBS that the Company purchaseswe purchase will likely have been issued with OID. The CompanyWe will generally be required to report such OID based on a constant yield method and income will accrue based on the assumption that all future projected payments due on such mortgage backed securities ("MBSs")MBSs will be made. If such MBSs turn out not to be fully collectible, an offsetting loss deduction will become available only in the later year in which uncollectability is provable. Finally, in the event that any mortgage loans, RMBS or other debt instruments acquired by the Companyus are delinquent as to mandatory principal and interest payments, or in the event a borrower with respect to a particular debt instrument acquired by the Companyus encounters financial difficulty rendering it unable to pay stated interest as due, the Companywe may nonetheless be required to continue to recognize the unpaid interest as taxable income as it accrues, despite doubt as to its ultimate collectability. Similarly, the Companywe may be required to accrue interest income with respect to subordinate RMBS at their stated rate regardless of whether corresponding cash payments are received or are ultimately collectible. In each case, while the Companywe would in general ultimately have an offsetting loss deduction available to itus when such interest was determined to be uncollectible, the loss would likely be treated as a capital loss, and the utility of that loss would therefore depend on the Company'sour having capital gain in that later year or thereafter.

 

The CompanyWe may acquirehold excess MSRs, which means the portion of an MSR that exceeds the arm's-lengtharm’s-length fee for services performed by the mortgage servicer. Based on IRS guidance concerning the classification of MSRs, the Company intendswe intend to treat any excess MSRs the Company acquireswe acquire as ownership interests in the interest payments made on the underlying mortgage loans, akin to an "interest only"“interest only” strip. Under this treatment, for purposes of determining the amount and timing of taxable income, each excess MSR is treated as a bond that was issued with OID on the date the Companywe acquired such excess MSR. In general, the Companywe will be required to accrue OID based on the constant yield to maturity of each excess MSR, and to treat such OID as taxable income in accordance with the applicable U.S. federal income tax rules. The constant yield of an excess MSR will be determined, and the Companywe will be taxed, based on a prepayment assumption regarding future payments due on the mortgage loans underlying the excess MSR. If the mortgage loans underlying an excess MSR prepay at a rate different than that under the prepayment assumption, the Company'sour recognition of OID will be either increased or decreased depending on the circumstances. Thus, in a particular taxable year, the Companywe may be required to accrue an amount of income in respect of an excess MSR that exceeds the amount of cash collected in respect of that excess MSR. Furthermore, it is possible that, over the life of the investment in an excess MSR, the total amount the Company payswe pay for, and accrues with respect to, the excess MSR may exceed the total amount the Company collectswe collect on such excess MSR. No assurance can be given that the Companywe will be entitled to a deduction for such excess, meaning that the Companywe may be required to recognize phantom income over the life of an excess MSR.

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The interest apportionment rules may affect the Company'sour ability to comply with the REIT asset and gross income tests.

 

The interest apportionment rules under Treasury Regulation Section 1.856-5(c) provide that, if a mortgage is secured by both real property and other property, a REIT is required to apportion its annual interest income to the real property security based on a fraction, the numerator of which is the value of the real property securing the loan, determined when the REIT commits to acquire the loan, and the denominator of which is the highest "principal amount"“principal amount” of the loan during the year. Beginning in 2016, ifIf a mortgage is secured by both real property and personal property and the value of the personal property does not exceed 15% of the aggregate value of the property securing the mortgage, the mortgage is treated as secured solely by real property for this purpose. IRS Revenue procedureProcedure 2014-51 interprets the "principal amount"“principal amount” of the loan to be the face amount of the loan, despite the Code'sCode’s requirement that taxpayers treat any market discount, which is the difference between the purchase price of the loan and its face amount, for all purposes (other than certain withholding and information reporting purposes) as interest rather than principal.

 

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The interest apportionment regulations apply only ifTo the mortgageextent the face amount of any loan in questionthat we hold that is secured by both real property and other property and, beginning in 2016,exceeds the value of the real property securing such loan, the interest apportionment rules described above may apply to certain of our loan assets unless the loan is secured solely by real property and personal property securingand the mortgage exceedsvalue of the personal property does not exceed 15% of the aggregate value of the property securing the mortgage. The Company expects that all or most of the mortgage loans that the Company acquires will be secured only by real property and no other property value is taken into account in the Company's underwriting process. Accordingly, it is not contemplated that the Company will regularly invest in mortgage loans to which the interest apportionment rules described above would apply. Nevertheless, if the IRS were to assert successfully that the Company's mortgage loans were secured by property other than real estate, that the interest apportionment rules applied for purposes of the Company's REIT testing, and that the position taken in IRS Revenue Procedure 2014-51 should be applied to certain mortgage loans in the Company's portfolio, thenloan. Thus, depending upon the value of the real property securing the Company'sour mortgage loans and their face amount, and the other sources of the Company'sour gross income generally, the Companywe may fail to meet the 75% REIT gross income test. In addition, although we will endeavor to accurately determine the values of the real property securing our loans at the time we acquire or commit to acquire such loans, such values may not be susceptible to a precise determination and will be determined based on the information available to us at such time. If the Company doesIRS were to successfully challenge our valuations of such assets and such revaluations resulted in a higher portion of our interest income being apportioned to property other than real property, we could fail to meet the 75% REIT gross income test. If we do not meet this test, the Companywe could potentially lose itsour REIT qualification or be required to pay a penalty tax to the IRS. Furthermore, prior to 2016, the apportionment rules described above applied to any debt instrument that was secured by real and personal property if the principal amount of the loan exceeded the value of the real property securing the loan. As a result, prior to 2016, these apportionment rules applied to mortgage loans held by us even if the personal property securing the loan did not exceed 15% of the total property securing the loan. We and our predecessor have held significant mortgage loans that are secured by both real property and personal property. If the IRS were to successfully challenge the application of these rules to us, we could fail to meet the 75% REIT gross income test and potentially lose our REIT qualification or be required to pay a penalty tax to the IRS.

 

In addition, the Code provides that a regular or a residual interest in a REMIC is generally treated as a real estate asset for the purposes of the REIT asset tests, and any amount includible in the Company'sour gross income with respect to such an interest is generally treated as interest on an obligation secured by a mortgage on real property for the purposes of the REIT gross income tests. If, however, less than 95% of the assets of a REMIC in which the Company holdswe hold an interest consistconsists of real estate assets (determined as if the Companywe held such assets), the Companywe will be treated as holding itsour proportionate share of the assets of the REMIC for the purpose of the REIT asset tests and receiving directly itsour proportionate share of the income of the REMIC for the purpose of determining the amount of income from the REMIC that is treated as interest on an obligation secured by a mortgage on real property. In connection with the recently expanded HARP program, the IRS recently issued guidance providing that, among other things, if a REIT holds a regular interest in an "eligible“eligible REMIC," or a residual interest in an "eligible REMIC"“eligible REMIC” that informs the REIT that at least 80% of the REMIC'sREMIC’s assets constitute real estate assets, then (i) the REIT may treat 80% of the value of the interest in the REMIC as a real estate asset for the purpose of the REIT asset tests and (ii) the REIT may treat 80% of the gross income received with respect to the interest in the REMIC as interest on an obligation secured by a mortgage on real property for the purpose of the 75% REIT gross income test. For this purpose, a REMIC is an "eligible REMIC"“eligible REMIC” if (i) the REMIC has received a guarantee from Fannie Mae or Freddie Mac that will allow the REMIC to make any principal and interest payments on its regular and residual interests and (ii) all of the REMIC'sREMIC’s mortgages and pass-through certificates are secured by interests in single-family dwellings. If the Companywe were to acquire an interest in an eligible REMIC less than 95% of the assets of which constitute real estate assets, the IRS guidance described above may generally allow the Companyus to treat 80% of itsour interest in such a REMIC as a qualifying real estate asset for the purpose of the REIT asset tests and 80% of the gross income derived from the interest as qualifying income for the purpose of the 75% REIT gross income test. Although the portion of the income from such a REMIC interest that does not qualify for the 75% REIT gross income test would likely be qualifying income for the purpose of the 95% REIT gross income test, the remaining 20% of the REMIC interest generally would not qualify as a real estate asset, which could adversely affect the Company'sour ability to satisfy the REIT asset tests. Accordingly, owning such a REMIC interest could adversely affect the Company'sour ability to qualify as a REIT.

 

The Company's

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Our ownership of and relationship with any TRS which the Companywe may form or acquire will be limited, and a failure to comply with the limits would jeopardize the Company'sour REIT qualification and the Company'sour transactions with itsour TRSs may result in the application of a 100% excise tax if such transactions are not conducted on arm's-lengtharm’s-length terms.

 

A REIT may own up to 100% of the stock of one or more TRSs. A TRS may earn income that would not be qualifying income if earned directly by a REIT. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a TRS. Overall, no more than 25% (20% beginning in 2018)20% of the value of a REIT'sREIT’s assets may consist of stock and securities of one or more TRSs. A domestic TRS will pay U.S. federal, state and local income tax at regular corporate rates on any income that it earns. In addition, the TRS rules impose a 100% excise tax on certain transactions between a TRS and its parent REIT that are not conducted on an arm's-lengtharm’s-length basis.

 

The Company hasWe have elected together with ZFC Funding Inc. ("ZFC Funding TRS") (formerly knownand will elect to treat certain subsidiaries as ZAIS I TRS, Inc.), for ZFC Funding TRS to be treated as a TRS, the Company has elected, together with ZFC Trust TRS I, LLC ("ZFC Trust TRS") for ZFC Trust TRS to be treated as a TRS, and the Company has elected, together with ZFC Honeybee TRS, LLC ("Honeybee TRS"), for Honeybee TRS to be treated as a TRS. ZFC Funding TRS, ZFC Trust TRS, HoneybeeTRSs. Any such TRS and any other domestic TRS that the Companywe may form would therefore be required to pay U.S. federal, state and local income tax on itstheir taxable income, and its after taxtheir after-tax net income would be available for distribution to the Companyus but would not be required to be distributed to itus by such domestic TRS. The Company anticipatesWe anticipate that the aggregate value of the TRS stock and securities owned by itus will be less than 25% (20% beginning in 2018)20% of the value of itsour total assets (including the TRS stock and securities). Furthermore, the Companywe will monitor the value of itsour investments in itsour TRSs to ensure compliance with the rule that no more than 25% (20% beginning in 2018)20% of the value of itsour assets may consist of TRS stock and securities (which is applied at the end of each calendar quarter). In addition, the Companywe will scrutinize all of the Company'sour transactions with TRSs to ensure that they are entered into on arm's-lengtharm’s-length terms to avoid incurring the 100% excise tax described above. There can be no assurance, however, that the Companywe will be able to comply with the TRS limitations or to avoid application of the 100% excise tax discussed above.

 

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The ownership limits that apply to REITs, as prescribed by the Internal Revenue Code and by the Company'sour charter, may inhibit market activity in shares of the Company'sour common stock and restrict itsour business combination opportunities.

 

In order for the Companyus to qualify as a REIT, not more than 50% in value of itsour outstanding shares of stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the Internal Revenue Code to include certain entities) at any time during the last half of each taxable year after the first year for which the Company electswe elect to qualify as a REIT. Additionally, at least 100 persons must beneficially own the Company'sour stock during at least 335 days of a taxable year or during a proportionate part of a taxable year of less than twelve months (other than the first taxable year for which the Company electswe elect to be taxed as a REIT). The Company'sOur charter, with certain exceptions, authorizes the Company'sour directors to take such actions as are necessary and desirableor appropriate to preserve itsour qualification as a REIT. The Company'sOur charter also provides that, unless exempted by the Company'sour board of directors, no person may own more than 9.8% in value or in number, whichever is more restrictive, of the outstanding shares of itsour common stock, or 9.8% in value or in number, whichever is more restrictive, of the outstanding shares of all classes and series of itsour capital stock. The Company'sOur board of directors may, in its sole discretion, subject to such conditions as it may determine and the receipt of certain representations and undertakings, prospectively or retroactively, waive the ownership limitlimits or establish a different limit on ownership, or excepted holder limit, for a particular stockholder if the stockholder'sstockholder’s ownership in excess of the ownership limitlimits would not result in the Companyus being "closely held"“closely held” under Section 856(h) of the Internal Revenue Code or otherwise failing to qualify as a REIT. These ownership limits could delay or prevent a transaction or a change in control of the Companyus that might involve a premium price for shares of itsour common stock or otherwise be in the best interest of itsour stockholders.

 

Certain financing activities may subject the Companyus to U.S. federal income tax and increase the tax liability of itsour stockholders.

 

The CompanyWe may enter into transactions that could result in it,us, the Operating Partnershipoperating partnership or a portion of the Operating Partnership'soperating partnership’s assets being treated as a "taxable“taxable mortgage pool"pool” for U.S. federal income tax purposes. Specifically, the Companywe may securitize residential or commercial real estate loans that the Company originateswe originate or acquiresacquire and such securitizations, to the extent structured in a manner other than a REMIC, would likely result in the Companyus owning interests in a taxable“taxable mortgage pool. The Companypool”. We would be precluded from holding equity interests in such a taxable mortgage pool securitization through the Operating Partnership.operating partnership. Accordingly, the Companywe would likely enter into such transactions through a qualified REIT subsidiary of one or more subsidiary REITs formed by the Operating Partnership,operating partnership, and will be precluded from selling to outside investors equity interests in such securitizations or from selling any debt securities issued in connection with such securitizations that might be considered equity for U.S. federal income tax purposes. The CompanyWe will be taxed at the highest U.S. federal corporate income tax rate on any "excess“excess inclusion income"income” arising from a taxable mortgage pool that is allocable to the percentage of the Company'sour shares held in record name by "disqualified“disqualified organizations," which are generally certain cooperatives, governmental entities and tax-exempt organizations that are exempt from tax on unrelated business taxable income. To the extent that common stock owned by "disqualified organizations"“disqualified organizations” is held in record name by a broker/dealer or other nominee, the broker/dealer or other nominee would be liable for the U.S. federal corporate income tax on the portion of the Company'sour excess inclusion income

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allocable to the common stock held by the broker/dealer or other nominee on behalf of the disqualified organizations. Disqualified organizations may own the Company'sour stock. Because this tax would be imposed on the Company,us, all of the Company'sour investors, including investors that are not disqualified organizations, will bear a portion of the tax cost associated with the classification of the Companyus or a portion of itsour assets as a taxable mortgage pool. A regulated investment company, ("RIC")or “RIC”, or other pass-through entity owning the Company'sour common stock in record name will be subject to tax at the highest corporate tax rate on any excess inclusion income allocated to their owners that are disqualified organizations. We have engaged in certain securitization transactions that are treated as taxable mortgage pools for U.S. federal income tax purposes. Although we believe that such transactions are structured in a manner so that they should not cause any portion of the distributions in our shares to be treated as excess inclusion income, no assurance can be provided that the IRS would not assert a contrary position.

 

In addition, if the Company realizeswe realize excess inclusion income and allocatesallocate it to itsour stockholders, this income cannot be offset by net operating losses of itsour stockholders. If the stockholder is a tax-exempt entity and not a disqualified organization, then this income is fully taxable as unrelated business taxable income under Section 512 of the Internal Revenue Code. If the stockholder is a foreignnon-U.S. person, it would be subject to U.S. federal income tax withholding on this income without reduction or exemption pursuant to any otherwise applicable income tax treaty. If the stockholder is a REIT, a RIC,Registered Investment Company, common trust fund or other pass-through entity, the Company'sour allocable share of its excess inclusion income could be considered excess inclusion income of such entity. Accordingly, such investors should be aware that a portion of the Company'sour income may be considered excess inclusion income. Finally, if a subsidiary REIT of the Operating Partnership through which the Company held taxable mortgage pool securitizations were to fail to qualify as a REIT, the Company's taxable mortgage pool securitizations will be treated as separate taxable corporations for U.S. federal income tax purposes that could not be included in any consolidated U.S. federal corporate income tax return and that could prevent the Company from meeting the REIT asset tests.

 

The tax on prohibited transactions will limit the Company'sour ability to engage in transactions, including certain methods of securitizing mortgage loans, which would be treated as prohibited transactions for U.S. federal income tax purposes.

 

Net income that the Company deriveswe derive from a prohibited transaction is subject to a 100% tax. The term "prohibited transaction"“prohibited transaction” generally includes a sale or other disposition of property (including mortgage loans, but other than foreclosure property, as discussed below) that is held primarily for sale to customers in the ordinary course of a trade or business by the Companyus or by a borrower that has issued a shared appreciation mortgage or similar debt instrument to the Company. The Companyus. We might be subject to this tax if itwe were to dispose of or securitize loans, directly or through a subsidiary REIT, in a manner that was treated as a prohibited transaction for U.S. federal income tax purposes. The CompanyWe might also be subject to this tax if itwe were to sell assets in connection with a disposition of certain segments of the Company’sour business or in connection with a liquidation of the Company. The Company intendsus. We intend to conduct itsour operations so that no asset that the Companywe or a subsidiary REIT owns (or is treated as owning) will be treated as, or as having been, held for sale to customers, and that a sale of any such asset will not be treated as having been in the ordinary course of the Company'sour business or the business of a subsidiary REIT. As a result, the Companywe may choose not to engage in certain sales of loans at the REIT level, and may limit the structures the Company utilizeswe utilize for itsour securitization transactions, even though the sales or structures might otherwise be beneficial to the Company.us. In addition, whether property is held "primarily“primarily for sale to customers in the ordinary course of a trade or business"business” depends on the particular facts and circumstances. No assurance can be given that any property that the Company sellswe sell will not be treated as property held for sale to customers, or that the Companywe can comply with certain safe-harbor provisions of the Internal Revenue Code that would prevent such treatment. The 100% tax does not apply to gains from the sale of property that is held through a TRS or other taxable corporation, although such income will be subject to tax in the hands of the corporation at regular corporate rates. The Company intendsWe intend to structure itsour activities to avoid prohibited transaction characterization.

 

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Characterization of the Company'sour repurchase agreements entered into to finance itsour investments as sales for tax purposes rather than as secured lending transactions would adversely affect the Company'sour ability to qualify as a REIT.

 

The Company has enteredWe enter into repurchase agreements with counterparties to achieve itsour desired amount of leverage for the assets in which it intends towe invest. Under the Company'sour repurchase agreements, the Companywe generally sellssell assets to itsour counterparty to the agreement and receivesreceive cash from the counterparty. The counterparty is obligated to resell the assets back to the Companyus at the end of the term of the transaction. The Company believesWe believe that for U.S. federal income tax purposes the Companywe will be treated as the owner of the assets that are the subject of repurchase agreements and that the repurchase agreements will be treated as secured lending transactions notwithstanding that such agreements may transfer record ownership of the assets to the counterparty during the term of the agreement. It is possible, however, that the IRS could successfully assert that the Companywe did not own these assets during the term of the repurchase agreements, in which case the Companywe could fail to qualify as a REIT.

 

The Company's ability to invest in TBAs could be limited by the Company's REIT qualification.

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The failure of excess MSRs held by the Companyus to qualify as real estate assets, or the failure of the income from excess MSRs to qualify as interest from mortgages, could adversely affect the Company'sour ability to qualify as a REIT.

 

The CompanyWe may acquirehold excess MSRs. In recent private letter rulings, the IRS ruled that excess MSRs meeting certain requirements would be treated as an interest in mortgages on real property and thus a real estate asset for purposes of the 75% REIT asset test, and interest received by a REIT from such excess MSRs will be considered interest on obligations secured by mortgages on real property for purposes of the 75% REIT gross income test. A private letter ruling may be relied upon only by the taxpayer to whom it is issued, and the IRS may revoke a private letter ruling. Consistent with the analysis adopted by the IRS in such private letter rulings and based on advice of counsel, the Company intendswe intend to treat any excess MSRs that it acquireswe acquire that meet the requirements provided in the private letter rulings as qualifying assets for purposes of the 75% REIT gross asset test, and the Company intendswe intend to treat income from such excess MSRs as qualifying income for purposes of the 75% and 95% gross income tests. Notwithstanding the IRS'sIRS’s determination in the private letter rulings described above, it is possible that the IRS could successfully assert that any excess MSRs that the Company acquireswe acquire do not qualify for purposes of the 75% REIT gross asset test and income from such MSRs does not qualify for purposes of the 75% and/or 95% gross income tests, which could cause the Companyus to be subject to a penalty tax and could adversely impact the Company'sour ability to qualify as a REIT.

 

If the Companywe were to make a taxable distribution of shares of the Company'sour stock, stockholders may be required to sell such shares or sell other assets owned by them in order to pay any tax imposed on such distribution.

 

The CompanyWe may be able to distribute taxable dividends that are payable in shares of itsour stock. If the Companywe were to make such a taxable distribution of shares of itsour stock, stockholders would be required to include the full amount of such distribution as income. As a result, a stockholder may be required to pay tax with respect to such dividends in excess of cash received. Accordingly, stockholders receiving a distribution of the Company'sour shares may be required to sell shares received in such distribution or may be required to sell other stock or assets owned by them, at a time that may be disadvantageous, in order to satisfy any tax imposed on such distribution. If a stockholder sells the shares it receives as a dividend in order to pay such tax, the sale proceeds may be less than the amount included in income with respect to the dividend. Moreover, in the case of a taxable distribution of shares of the Company'sour stock with respect to which any withholding tax is imposed on a non-U.S. stockholder, the Companywe may have to withhold or dispose of part of the shares in such distribution and use such withheld shares or the proceeds of such disposition to satisfy the withholding tax imposed.

 

While the IRS, in certain private letter rulings, has ruled that a distribution of cash or shares at the election of a REIT's stockholders may qualify as a taxable stock dividend if certain requirements are met, it is unclear whether and to what extent the Company will be able to pay taxable dividends in cash and shares of common stock in any future period.

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Complying with REIT requirements may limit the Company'sour ability to hedge effectively.

 

The REIT provisions of the Internal Revenue Code may limit the Company'sour ability to hedge itsour assets and operations. Under these provisions, any income that the Company generateswe generate from transactions intended to hedge itsour interest rate risks will generally be excluded from gross income for purposes of the 75% and 95% gross income tests if (i) the instrument (A) hedges interest rate risk or foreign currency exposure on liabilities used to carry or acquire real estate assets or (B) hedges risk of currency fluctuations with respect to any item of income or gain that would be qualifying income under the 75% or 95% gross income tests, (C )or (C) hedges an instrument described in clause (A) or (B) for a period following the extinguishment of the liability or the disposition of the asset that was previously hedged by the hedged instrument, and (ii) such instrument is properly identified under applicable Treasury Regulations. In addition, anyAny income from other hedges would generally constitute non-qualifying income for purposes of both the 75% and 95% gross income tests. As a result of these rules, the Companywe may have to limit itsour use of hedging techniques that might otherwise be advantageous or implement those hedges through a TRS, which could increase the cost of the Company'sour hedging activities or result in greater risks associated with interest rate or other changes than the Companywe would otherwise incur.

 

Even if the Company qualifieswe qualify as a REIT, the Companywe may face tax liabilities that reduce the Company'sour cash flow.

 

Even if the Company qualifieswe qualify as a REIT, the Companywe may be subject to certain U.S. federal, state and local taxes on itsour income and assets, including taxes on any undistributed income, tax on income from some activities conducted as a result of foreclosures, and state or local income, franchise, property and transfer taxes, including mortgage relatedmortgage-related taxes. In addition, ZFC Funding TRS, ZFC Trust TRS, Honeybee TRS and any other domesticwe intend to hold a significant amount of our assets from time to time in our TRSs the Company owns will be subject toeach of which pay U.S. federal, state and local corporate taxes.income tax on its taxable income, and its after tax net income is available for distribution to us but is not required to be distributed to us by such TRS. In order to meet the REIT qualification requirements, or to avoid the imposition of a 100% tax that applies to certain gains derived by a REIT from sales of inventory or property held primarily for sale to customers in the ordinary course of business, the Companywe may hold some of itsour assets through taxable subsidiary corporations, including domestic TRSs. Any taxes paid by such subsidiary corporations would decrease the cash available for distribution to our stockholders. For example, as a result of ReadyCap Holding’ SBA license, ReadyCap Holding’

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ability to distribute cash and other assets is subject to significant limitations, and as a result, ReadyCap Holdings is required to hold certain assets that would be qualifying real estate assets for purposes of the Company's stockholders.REIT asset tests, would generate qualifying income for purposes of the REIT 75% income tests, and would not be subject to corporate taxation if held by our operating partnership. Also, we intend that loans that we originate or buy with an intention of selling in a manner that might expose us to the 100% tax on “prohibited transactions” will be originated or bought by a TRS. Furthermore, loans that are to be modified may be held by a TRS on the date of their modification and for a period of time thereafter. Finally, some or all of the real estate properties that we may from time to time acquire by foreclosure or other procedure will likely be held in one or more TRSs. Since our TRSs do not file consolidated returns with one another, any net losses generated by one such entity will not offset net income generated by any other such entity. In addition, the TRS rules impose a 100% excise tax on certain transactions between a TRS and its parent REIT that are not conducted on an arm’s-length basis. Furthermore, if the Company acquireswe acquire appreciated assets from a subchapter C corporation in a transaction in which the adjusted tax basis of the assets in the Company'sour hands is determined by reference to the adjusted tax basis of the assets in the hands of the C corporation, and if the Companywe subsequently disposesdispose of any such assets during the 10-year5-year period following the acquisition of the assets from the C corporation, the Companywe will be subject to tax at the highest corporate tax rates on any gain from such assets to the extent of the excess of the fair market value of the assets on the date that they were contributed to the Companyus over the basis of such assets on such date, which the Company referswe refer to as built-in gains. A portion of the assets contributed to Pre-Merger Sutherland in connection with the CompanyREIT formation transactions and contributed to ZAIS Financial in connection with its formation may be subject to the built-in gains tax. Although the Company expectswe expect that the built-in gains tax liability arising from any such assets should bede minimis, there is no assurance that this will be the case.

 

The Company'sOur qualification as a REIT and exemption from U.S. federal income tax with respect to certain assets may be dependent on the accuracy of legal opinions or advice rendered or given or statements by the issuers of assets that the Company acquires,we acquire, and the inaccuracy of any such opinions, advice or statements may adversely affect the Company'sour REIT qualification and result in significant corporate-level tax.

 

When purchasing securities, the Companywe may rely on opinions or advice of counsel for the issuer of such securities, or statements made in related offering documents, for purposes of determining whether such securities represent debt or equity securities for U.S. federal income tax purposes, and also to what extent those securities constitute REIT real estate assets for purposes of the REIT asset tests and produce income which qualifies under the 75% REIT gross income test. In addition, when purchasing the equity tranche of a securitization, the Companywe may rely on opinions or advice of counsel regarding the qualification of the securitization for exemption from U.S. corporate income tax and the qualification of interests in such securitization as debt for U.S. federal income tax purposes. The inaccuracy of any such opinions, advice or statements may adversely affect the Company'sour REIT qualification and result in significant corporate-level tax.

 

The CompanyWe may be subject to adverse legislative or regulatory tax changes that could reduce the value of the Company'sour common stock.

 

At any time, the U.S. federal income tax laws or regulations governing REITs or the administrative interpretations of those laws or regulations may be amended, possibly with retroactive effect. The CompanyWe cannot predict when or if any new U.S. federal income tax law, regulation or administrative interpretation, or any amendment to any existing U.S. federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective, and any such law, regulation or interpretation may take effect retroactively. The CompanyWe and itsour stockholders could be adversely affected by any such change in, or any new, U.S. federal income tax law, regulation or administrative interpretation.

 

Dividends payable by REITs do not qualify for the reduced tax rates on dividend income from regular corporations, which could adversely affect the value of the Company'sour common stock.

 

The maximum U.S. federal income tax rate for certain qualified dividends payable to U.S. stockholders that are individuals, trusts and estates is 20%. Dividends payable by REITs, however, are generally not eligible for these reduced qualified dividend rates. However, for taxable years beginning after December 31, 2017 and before January 1, 2026, under the reduced rates and thereforerecently enacted TCJA, noncorporate taxpayers may bededuct up to 20% of certain qualified business income, including "qualified REIT dividends" (generally, dividends received by a REIT shareholder that are not designated as capital gain dividends or qualified dividend income), subject to up to a 39.6%certain limitations, resulting in an effective maximum U.S. federal income tax rate of 29.6% on ordinarysuch income. Although the reduced U.S. federal income tax rate applicable to dividend incomequalified dividends from regular corporate dividendsC corporations does not adversely affect the taxation of REITs or dividends paid by REITs, the more favorable rates applicable to regular corporate dividends, together with the recently reduced corporate tax rate (currently, 21%), could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the

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value of the shares of REITs, including the Company'sour common stock. Dividends may also be subject to a 3.8% Medicare tax under certain circumstances.

 

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Qualifying as a REIT involves highly technical and complex provisionsThe tax basis that we use to compute taxable income with respect to certain interests in loans that were held by our operating partnership at the time of the Internal Revenue Code.REIT formation transaction could be subject to challenge.

 

Qualification as aPrior to the REIT involves the application of highly technical and complex Internal Revenue Code provisionsformation transactions, our operating partnership had accounted for which only limited judicial and administrative authorities exist. Even a technical or inadvertent violation could jeopardize the Company's REIT qualification. The Company's qualification as a REIT will depend on its satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis. In addition, the Company's ability to satisfy the requirements to qualify as a REIT depends in part on the actions of third parties over which the Company has no control or only limited influence, including in cases where the Company owns an equity interest in certain SBC securitizations as an entity that is classified asinterest in a partnershipsingle debt instrument for U.S. federal income tax purposes. In connection with the REIT formation transactions, the predecessor to our operating partnership was treated as terminated for U.S. federal income tax purposes, and our operating partnership was treated as a new partnership that acquired the assets of such predecessor for U.S. federal income tax purposes. Beginning with such transactions, our operating partnership has properly accounted for our interests in these securitizations as interests in the underlying loans for U.S. federal income tax purposes. Since we did not have complete information regarding the tax basis of each of the loans held by our operating partnership at the time of the REIT formation transactions, our computation of taxable income with respect to these interests could be subject to adjustment by the IRS. If any such adjustment would be significant in amount, the resulting redetermination of our gross income for U.S. federal income tax purposes could cause us or Pre-Merger Sutherland to fail to satisfy the REIT gross income tests, which could cause us to fail to qualify as a REIT. In addition, if any such adjustment resulted in an increase to our or Pre-Merger Sutherland's REIT taxable income, we could be required to pay a deficiency dividend in order to maintain our REIT qualification.

 

Potential changes to the U.S. tax laws could adversely impact us.

The U.S. federal income tax laws and regulations governing REITs and their stockholders, as well as the administrative interpretations of those laws and regulations, are constantly under review and may be changed at any time, possibly with retroactive effect. No assurance can be given as to whether, when, or in what form, the U.S. federal income tax laws applicable to us and our stockholders may be enacted. Changes to the U.S. federal income tax laws and interpretations of U.S. federal tax laws could adversely affect an investment in our common stock.

The newly enacted TCJA, which was signed into law on December 22, 2017, significantly changes U.S. federal income tax laws applicable to businesses and their owners, including REITs and their stockholders, and may lessen the relative competitive advantage of operating as a REIT rather than as a C corporation. For additional discussion, see "U.S. Federal Income Tax Legislation".

Risks Related to Our Organization and Structure 

Conflicts of interest could arise as a result of our REIT structure.

Conflicts of interest could arise in the future as a result of the relationships between us and our affiliates, on the one hand, and our operating partnership or any partner thereof, on the other. Our directors and officers have duties to our Company under Maryland law in connection with their management of our Company. At the same time, we have fiduciary duties, as a general partner, to our operating partnership and to the limited partners under Delaware law in connection with the management of our operating partnership. Our duties as a general partner to our operating partnership and our partners may come into conflict with the duties of our directors and officers.

Certain provisions of Maryland law could inhibit changes in control and prevent our stockholders from realizing a premium over the then-prevailing market price of our common stock.

Certain provisions of the Maryland General Corporation Law (“MGCL”) may have the effect of deterring a third party from making a proposal to acquire us or of impeding a change in control under circumstances that otherwise could provide the holders of shares of our common stock with the opportunity to realize a premium over the then-prevailing market price of such shares.

We are subject to the “business combination” provisions of the MGCL that, subject to limitations, prohibit certain business combinations (including generally, a merger, consolidation, share exchange, or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities) between us and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our outstanding voting stock

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or an affiliate or associate of ours who, at any time within the two-year period immediately prior to the date in question, was the beneficial owner of 10% or more of the voting power of our outstanding voting stock) or an affiliate thereof for five years after the most recent date on which the stockholder becomes an interested stockholder. After the five-year prohibition, any business combination between us and an interested stockholder generally must be recommended by our board of directors and approved by the affirmative vote of at least (i) 80% of the votes entitled to be cast by holders of outstanding shares of our voting stock; and (ii) two-thirds of the votes entitled to be cast by holders of voting stock of the corporation other than shares held by the interested stockholder with whom or with whose affiliate the business combination is to be effected or held by an affiliate or associate of the interested stockholder. These super-majority vote requirements do not apply if our common stockholders receive a minimum price, as defined under Maryland law, for their shares in the form of cash or other consideration in the same form as previously paid by the interested stockholder for its shares. These provisions of the MGCL do not apply, however, to business combinations that are approved or exempted by our board of directors prior to the time that the stockholder would otherwise have become an interested stockholder. Pursuant to the statute, our board of directors has by resolution exempted business combinations between us and (i) our operating partnership or its affiliates and (ii) any person, provided that such business combination is first approved by our board of directors (including a majority of our directors who are not affiliates or associates of such person). As a result, any person described above may be able to enter into business combinations with us that may not be in the best interest of our stockholders, without compliance with the super majority vote requirements and the other provisions of the statute.

The “control share” provisions of the MGCL provide that holders of “control shares” of a Maryland corporation (defined as voting shares of stock which, when aggregated with all other shares of stock owned by the stockholder or in respect of which the stockholder is able to exercise or direct the exercise of voting power (except solely by virtue of a revocable proxy), would entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership of or the power to direct the exercise of voting power with respect to “control shares,” subject to certain exceptions) have no voting rights with respect to the control shares except to the extent approved by our stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding votes entitled to be cast by the acquirer of control shares, our officers and our employees who are also our directors. Our bylaws contain a provision exempting from the control share acquisition statute any and all acquisitions by any person of shares of our stock. There can be no assurance that this provision will not be amended or eliminated at any time in the future.

Our ability to issue additional shares of common and preferred stock may prevent a change in our control.

Our charter authorizes us to issue additional authorized but unissued shares of common or preferred stock. In addition, our board of directors may, without common stockholder approval, amend our charter to increase or decrease the aggregate number of shares of our stock or the number of shares of stock of any class or series that we have the authority to issue. As a result, our board of directors may establish a class or series of shares of common or preferred stock that could delay or prevent a transaction or a change in control that might involve a premium price for shares of our common stock or otherwise be in the best interest of our stockholders.

Our rights and your rights to take action against our directors and officers are limited, which could limit your recourse in the event of actions not in your best interests.

As permitted by Maryland law, our charter eliminates the liability of our directors and officers to us and you for money damages, except for liability resulting from:

·

actual receipt of an improper benefit or profit in money, property or services; or 

·

a final judgment based upon a finding of active and deliberate dishonesty by the director or officer that was material to the cause of action adjudicated.

In addition, our charter authorizes us, to the maximum extent permitted by Maryland law, to obligate our Company, and our bylaws obligate us, to indemnify any present or former director or officer or any individual who, while a director or officer of our Company and at our request, serves or has served another corporation, real estate investment trust, limited liability company, partnership, joint venture, trust, employee benefit plan or other enterprise as a director, officer, member, manager, partner or trustee who is, or is threatened to be, made a party to, or witness in, a proceeding by reason of his or her service in any such capacity from and against any claim or liability to which that individual may become subject or which that individual may incur by reason of such service and to pay or reimburse his or her reasonable expenses in

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advance of final disposition of a proceeding. Our charter and bylaws also permit us to indemnify and advance expenses to any individual who served a predecessor of our Company in any of the capacities described above and any employee or agent of our Company or a predecessor of our Company.

Our amended and restated bylaws designates the Circuit Court for Baltimore City, Maryland as the sole and exclusive forum for some litigation, which could limit the ability of stockholders to obtain a favorable judicial forum for disputes with our Company.

Unless we consent in writing to the selection of an alternative forum, the Circuit Court for Baltimore City, Maryland, or, if that court does not have jurisdiction, the United States District Court for the District of Maryland, Baltimore Division is the sole and exclusive forum for (i) any derivative action or proceeding brought on behalf of our Company, (ii) any action asserting a claim of breach of any duty owed by any director or officer or other employee of our Company to our Company or to our stockholders, (iii) any action asserting a claim against our Company or any director or officer or other employee of our Company arising pursuant to any provision of the MGCL or our charter or bylaws, or (iv) any action asserting a claim against our Company or any director or officer or other employee of our Company that is governed by the internal affairs doctrine. Any person or entity purchasing or otherwise acquiring any interest in shares of our capital stock shall be deemed to have notice of and to have consented to the provisions described above. This forum selection provision may limit the ability of stockholders of our Company to obtain a judicial forum that they find favorable for disputes with our Company or our directors, officers, employees, if any, or other stockholders.

Item 1B. Unresolved Staff Comments.

 

None.

 

Item 2. Properties.

 

The Company usesOur principal executive offices are located at 1140 Avenue of the Americas, 7th Floor, New York, New York 10036, and our telephone number is (212) 257-4600. We also use the offices of ZAISReadyCap Lending located at Two Bridge420 Mountain Avenue, Suite 322, Red Bank,3rd Floor, New Providence, New Jersey, 07701-1106, telephone (732) 978-7518 in connection with its residential mortgage investments strategy07974, and ReadyCap Commercial, LLC, located at 1320 Greenway Drive, Suite 560, Irving, Texas, 75038.

We also use the offices of GMFS located at 7389 Florida Blvd, Suite 200A, Baton Rouge, Louisiana, 70806 for itsour residential mortgage banking operations. GMFS also has various branch locations which are located primarily throughout the southeastern United States.

 

Item 3. Legal Proceedings.

 

From time to time, the Company may be involved in various claims and legal actions in the ordinary course of business. As of December 31, 2015, the Company was not involved in any legal proceedings. Also, seeSee “Liquidity and Capital Resources – GMFS Transaction”Settlement” in Item 7. Management’s“Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this annual report on Form 10-K for a discussion relating to the tolling agreement executed by GMFS.GMFS and the related settlement agreement reached on April 25, 2017.

 

Currently, no material legal proceedings are pending or, to our knowledge, threatened against us.

Item 4.  Mine Safety Disclosures.

 

Not applicable.

 

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PART II

 

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

 

Market Information

 

The Company’s common stock is listedOn October 31, 2016, we completed our path to becoming a publicly traded company through our merger with and tradedinto a subsidiary of ZAIS Financial, with ZAIS Financial surviving the merger and changing its name to Sutherland Asset Management Corporation. On November 1, 2016, we began trading on the NYSE under the ticker symbol “ZFC.”“SLD”. On March 8, 201615, 2018 the last sales price for the Company’sour common stock on the NYSE was $14.66$15.10 per share. The following table presents the high and low sales prices per share of the Company’sour common stock during eachall four calendar quarter forquarters in the yearsfiscal year ended December 31, 2015 and2017, as well as the two months ended December 31, 2014:2016, reflecting the post-merger prices of our common stock. Prior to the completion of our merger with ZAIS Financial, shares of common stock of ZAIS Financial traded on the NYSE under the ticker symbol “ZFC”. Accordingly, the table also presents the high and low sales prices per share of common stock of ZAIS Financial prior to the merger for each of the first three calendar quarters and for the month of October in the fiscal year ended December 31, 2016. As described elsewhere in this annual report on Form 10-K, prior to and as a condition to the merger, ZAIS Financial disposed of its seasoned re-performing mortgage loan portfolio, such that upon the completion of the merger, ZAIS Financial’s assets largely consisted of its GMFS origination subsidiary, cash, conduit loans and RMBS.  As a result, ZAIS Financial’s business and financial results prior to the merger and during the period covered by the below table were significantly different from our business following the closing of the merger and the share prices before and after the merger may not be comparable.  

 

Period High  Low 
October 1, 2015 through December 31, 2015 $15.92  $13.13 
July 1, 2015 through September 30, 2015  16.70   13.08 
April 1, 2015 through June 30, 2015  19.00   16.10 
January 1, 2015 through March 31, 2015  18.40   17.05 

 

 

 

 

 

 

 

Period

    

                   High

    

                   Low

October 1, 2017 through December 31, 2017

 

$

16.10

 

$

15.05

July 1, 2017 through September 30, 2017

 

 

15.95

 

 

14.40

April 1, 2017 through June 30, 2017

 

 

15.30

 

 

14.15

January 1, 2017 through March 31, 2017

 

 

14.70

 

 

13.10

November 1, 2016 through December 31, 2016

 

 

14.00

 

 

12.40

October 1, 2016 through October 31, 2016

 

 

14.95

 

 

13.00

July 1, 2016 through September 30, 2016

 

 

14.76

 

 

13.47

April 1, 2016 through June 30, 2016

 

 

16.00

 

 

13.53

January 1, 2016 through March 31, 2016

 

 

15.61

 

 

12.63

 

 

 

 

 

 

 

Period High  Low 
October 1, 2014 through December 31, 2014 $18.51  $17.01 
July 1, 2014 through September 30, 2014  19.48   15.93 
April 1, 2014 through June 30, 2014  16.82   16.00 
January 1, 2014 through March 31, 2014  18.09   15.83 

Holders

 

As of March 8, 2016, the Company15, 2018, we had 1345 registered holders of itsour common stock. The 13 holders of record include Cede & Co., which holds shares as nominee for The Depository Trust Company, which itself holds shares on behalf of the beneficial owners of the Company’sour common stock. Such information was obtained through the Company’sour registrar and transfer agent.

 

Dividends

 

The Company hasWe have elected to be taxed as a REIT for U.S. federal income tax purposes commencing with the Company’sour taxable year ended December 31, 2011.2013. U.S. federal income tax law requires that a REIT distribute annually at least 90% of its REIT taxable income, excluding net capital gains and determined without regard to the dividends paid deduction, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its net taxable income. The Company’sOur current policy is to pay distributions, which will allow itus to satisfy the requirements to qualify as a REIT and generally not be subject to U.S. federal income tax on its undistributed income. Although the Companywe may borrow funds to make distributions, cash for such distributions is expected to be largely generated from the Company’sour consolidated results of operations. Dividends are declared and paid at the discretion of the Company’sour board of directors and depend on cash available for distribution, financial condition, the Company’sour ability to maintain its qualification as a REIT, and such other factors that the Company’sour board of directors may deem relevant. See Item 1A, “Risk Factors,” and Item 7, “Management’s Discussion and Analysis of Financial Conditions and Results of Operations,” of this annual report on Form 10-K, for information regarding the sources of funds used for dividends and for a discussion of factors, if any, which may adversely affect the Company’sour ability to pay dividends.

 

70


During 2015, the Company2017, we declared the following dividends:

 

Declaration Date Record Date Payment Date Amount per
Share and
OP Unit
 
March 19, 2015 March 31, 2015 April 15, 2015 $0.40 
June 18, 2015 June 30, 2015 July 15, 2015 $0.40 
September 17, 2015 September 30, 2015 October 15, 2015 $0.40 
December 17, 2015 December 31, 2015 January 15, 2016 $0.40 

 

 

 

 

 

 

 

 

 

 

    

 

    

 

    

Dividend per

Declaration Date

 

Record Date

 

Payment Date

 

Share and OP Unit

March 14, 2017

 

March 31, 2017

 

April 13, 2017

 

$

0.37

 

June 15, 2017

 

June 30, 2017

 

July 31, 2017

 

$

0.37

 

September 12, 2017

 

September 29, 2017

 

October 20, 2017

 

$

0.37

 

December 13, 2017

 

December 29, 2017

 

January 31, 2018

 

$

0.37

 

 

48

 

During 2014, the Company2016, we declared the following dividends:

 

Declaration Date Record Date Payment Date Amount per
Share and
OP Unit
 
March 19, 2014 March 31, 2014 April 14, 2014 $0.40 
June 17, 2014 June 30, 2014 July 15, 2014 $0.40 
September 17, 2014 September 30, 2014 October 15, 2014 $0.40 
December 18, 2014 December 31, 2014 January 15, 2015 $0.40 

 

 

 

 

 

 

 

 

 

 

    

 

    

 

    

Dividend per

Declaration Date

 

Record Date

 

Payment Date

 

Share and OP Unit

May 20, 2016

 

June 3, 2016

 

June 17, 2016

 

$

0.45

(1)

August 23, 2016

 

September 2, 2016

 

September 16, 2016

 

$

0.45

(1)

October 11, 2016

 

October 14, 2016

 

October 25, 2016

 

$

0.36

(1)

December 21, 2016

 

December 30, 2016

 

January 27, 2017

 

$

0.35

 

(1) Retrospectively adjusted for the equivalent number of shares after the reverse merger based on the ZAIS Financial exchange ratio of 0.8356 shares.

 

 

A portion of the dividends paid for 2015 and 2014 were characterized as a return of capital for U.S. federal income tax purposes.

 

Stockholder Return Performance

 

The stock performance graph and table below shall not be deemed, under the Securities Act or the Exchange Act, to be (i) “soliciting material” or “filed” or (ii) incorporated by reference by any general statement into any filing made by the Company with the SEC, except to the extent that the Company specifically incorporates such stock performance graph and table by reference.

 

The following graph is a comparison of the cumulative total stockholder return on the Company’sour shares of common stock, the Standard & Poor’s 500 Index (the “S&P 500 Index”), the Russell 2000 Index (the “Russell 2000”) and the SNL Finance REIT Index,a Competitor Composite Average1, a peer group index from February 8, 2013 (commencementJanuary 1, 2016 to December 31, 2017. As described above, on October 31, 2016, we completed our path to becoming a publicly traded company through our merger with and into a subsidiary of ZAIS Financial, with ZAIS Financial surviving the merger and changing its name to Sutherland Asset Management Corporation. On November 1, 2016, we began trading on the NYSE) toNYSE under the ticker symbol “SLD”. The following table presents the total return performance of our common stock during the two months ended December 31, 2015. 2016 and all four calendar quarters in the fiscal year ended December 31, 2017, reflecting the post-merger prices of our common stock. Prior to the completion of our merger with ZAIS Financial, shares of common stock of ZAIS Financial traded on the NYSE under the ticker symbol "ZFC". Accordingly, the table also presents the total return performance of shares of common stock of ZAIS Financial prior to the merger for each of the first three calendar quarters in the fiscal year ended December 31, 2016.  As described elsewhere in this annual report on Form 10-K, prior to and as a condition to the merger, ZAIS Financial disposed of its seasoned re-performing mortgage loan portfolio, such that upon the completion of the merger, ZAIS Financial’s assets largely consisted of its GMFS origination subsidiary, cash, conduit loans and RMBS.  As a result, ZAIS Financial's business and financial results prior to the merger and during the period covered by the below table were significantly different from our business following the closing of the merger and the total return performance before and after the merger may not be comparable.


1The Competitor Composite Average is a measure of the total return performance of mortgage REIT competitors based on actual share prices of the following companies: Blackstone Mortgage Trust Inc. (BXMT), Starwood Property Trust, Inc. (STWD),  Ares Commercial Real Estate Corporation (ACRE), Apollo Commercial Real Estate Finance Inc. Real Estate Trust (ARI), Arbor Realty Trust, Inc. (ABR), and  Ladder Capital Corporation (LADR).

71


The graph assumes that $100 was invested on February 8, 2013January 1, 2016 in the Company’s shares of common stock of ZAIS Financial, the S&P 500 Index, and  each of the Russell 2000 andCompanies shares of common stock included in the SNL Finance REIT IndexCompetitor Composite Average and that all dividends were reinvested without the payment of any commissions. There can be no assurance that the performance of the Company’sour common stock will continue in line with the same or similar trends depicted in the graph below.

 

  Period Ending 
Index 02/08/13  06/30/13  12/31/13  06/30/14  12/31/14  06/30/15  12/31/15 
ZAIS Financial Corp.  100.00   92.09   90.80   98.78   107.27   105.31   103.82 
S&P 500  100.00   106.73   124.14   133.00   141.13   142.87   143.09 
Russell 2000  100.00   107.63   128.97   133.08   135.28   141.71   129.31 
SNL US Finance REIT  100.00   89.06   88.15   101.98   100.95   96.79   92.57 

Source: SNL Financial LC, Charlottesville, VA © 2015

 

49

 

 

 

 

 

 

 

Total Return performance

Period Ending

Index

10/31/2016

12/31/2016

3/31/2017

6/30/2017

9/30/2017

12/31/2017

SLD

100.0
92.5
99.3
102.0
107.7
104.0

S&P 500

100.0
108.7
114.7
117.7
122.3
129.8

Competitor Composite Average*

100.0
104.4
109.8
108.0
107.2
108.2

 

* The Competitor Composite Average is a measure of the total return performance of mortgage REIT competitors based on actual share prices of the following companies: Blackstone Mortgage Trust Inc. (BXMT), Starwood Property Trust, Inc. (STWD),  Ares Commercial Real Estate Corporation (ACRE), Apollo Commercial Real Estate Finance Inc Real Estate Trust (ARI), Arbor Realty Trust, Inc. (ABR), and  Ladder Capital Corporation (LADR).

 

 

Securities Authorized For Issuance Under Equity Compensation Plans

 

During 2012, the Company adopted its 2012 equity incentive plan (the “2012 Plan”). The 2012 Plan authorizes the Compensation Committee to approve grantsinformation required by this item is set forth under Item 12 of equity-based awards to the Company’s officersPart III of this annual report on Form 10‑K and directors and officers and employees of the Advisor and its affiliates. The 2012 Plan provides for grants of equity awards up to, in the aggregate, the equivalent of 5% of the issued and outstanding shares of the Company’s common stock from time to time (on a fully diluted basis (assuming, if applicable, the exercise of all outstanding options and the conversion of all warrants and convertible securities into shares of common stock)) at the time of the award. As of March 8, 2016, the Company had 8,897,800 shares of common stock outstanding, which are comprised of (i) 7,970,886 shares of common stock and (ii) 926,914 OP Units, which are exchangeable, on a one-for-one basis, into cash or, at the Company’s option, for shares of the Company’s common stock. In addition, the Exchangeable Senior Notes are exchangeable for shares of the Company’s common stock or, to the extent necessary to satisfy NYSE listing requirements, cash, at an exchange rate of 54.3103 shares of common stock for each $1,000 aggregate principal amount of the Exchangeable Senior Notes, subject to adjustment and other limitations under certain circumstances. At December 31, 2015, no awards had been granted under the 2012 Plan, and at March 8, 2016, 533,868 shares were available for future issuance under the 2012 Plan, based on a total of 10,677,360 shares of common stock outstanding on a diluted basis, comprised of 7,970,886 shares of common stock, 926,914 OP Units and 1,779,560 shares of common stock issuable upon exchange of the Exchangeable Senior Notes without stockholder approval for issuances above this threshold.is incorporated herein by reference.

The following table presents certain information about the Company’s equity compensation plan as of December 31, 2015:

AwardNumber of securities
to be issued upon
exercise of
outstanding options
warrants and rights
Weighted-average
exercise price of
outstanding options,
warrants and rights
Number of
securities

remaining
available

for future issuance
under equity
compensation
plans

(excluding
securities

reflected in the
first

column of this
table) (1)
Equity compensation plans approved by stockholders$
Equity compensation plans not approved by stockholders (2)533,868
Total$533,868

(1)The 2012 Plan provides for grants of equity awards up to, in the aggregate, the equivalent of 5% of the issued and outstanding shares of the Company’s common stock from time to time (on a fully diluted basis (assuming, if applicable, the exercise of all outstanding options and the conversion of all warrants and convertible securities into shares of common stock)) at the time of the award.
(2)The 2012 Plan was adopted in December 2012, prior to the completion of the Company’s IPO. No awards have been granted pursuant to this plan.

 

Recent Sales of Unregistered Equity Securities; Use of Proceeds from Registered Securities

 

None.

 

Recent Purchases of Equity Securities

 

The Company did not purchase equity securities in 20152017 or 2014.2016.

 

50

Item 6.  Selected Financial Data.Data

 

The CompanyWe derived itsour selected consolidated financial data (i) as of and for the years ended December 31, 20152017 and December 31, 2016 and consolidated statements of income data for the year ended December 31, 2015; (ii) as of December 31, 2014 and for the year ended December 31, 2014; and (iii) as of December 31, 2013 and for the year ended December 31, 20132015 from itsour audited consolidated financial statements appearing in this annual report on Form 10-K. The CompanyWe derived itsour selected consolidated financialbalance sheet data as of December 31, 2014 and December 31, 2013 from our audited consolidated financial statements not appearing elsewhere in this annual report on Form 10-K. We derived our selected consolidated financial data for the quarter ended December 31, 2013, the nine months ended September 30, 2013 and the year ended December 31, 2012 from our audited consolidated financial statements not appearing elsewhere in this annual report on Form 10-K.

We prepared the consolidated financial statements utilizing the specialized accounting principles of Accounting Standards Codification Topic 946, Financial Services—Investment Companies (ASC Topic 946) from our inception through September 30, 2013. In accordance with this specialized accounting guidance, we carried our investments at fair value, did not consolidate loan securitizations on our consolidated financial statements and recorded investments in subsidiary entities as investments or using the equity method of accounting. Following the conversion from investment company to operating company accounting, we did not prepare our consolidated financial statements utilizing the

72


specialized accounting guidance for investment companies, and, therefore, we no longer reflected the SBC loan assets that were held in our securitization trusts as MBS, but instead consolidated the SBC loans held in these trusts and the associated notes on our consolidated balance sheet and included both the interest income from such SBC loans and the associated interest expense on the notes in our consolidated statements of income.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating Company Accounting(a)

 

 

Investment Company Accounting(b)

(In thousands, except share data)

 

For the Year Ended December 31, 2017

 

 

For the Year Ended December 31, 2016

 

 

For the Year Ended December 31, 2015

 

 

For the Year Ended December 31, 2014

 

 

For the Quarter Ended December 31, 2013

 

 

For the Nine Months Ended September 30, 2013

Income Statement Data

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

$

138,305

 

$

137,023

 

$

148,955

 

$

92,947

 

$

6,150

 

$

11,089

Interest expense

 

(74,646)

 

 

(57,772)

 

 

(47,806)

 

 

(19,245)

 

 

(2,183)

 

 

 -

Provision for loan losses

 

(2,363)

 

 

(7,819)

 

 

(19,643)

 

 

(11,797)

 

 

(1,749)

 

 

 -

Other non-interest income (expense)

 

(39,172)

 

 

(31,068)

 

 

(34,188)

 

 

(39,113)

 

 

(5,071)

 

 

(11,944)

Realized and unrealized gains

 

26,329

 

 

24,851

 

 

5,913

 

 

13,498

 

 

1,939

 

 

3,483

Provision for income taxes

 

(1,839)

 

 

(9,651)

 

 

(7,810)

 

 

(897)

 

 

 -

 

 

 -

Net income from continuing operations

 

45,814

 

 

55,564

 

 

45,421

 

 

35,393

 

 

(914)

 

 

2,668

Loss from discontinued operations, net of tax

 

 -

 

 

(2,158)

 

 

(653)

 

 

(2,671)

 

 

(1,294)

 

 

 -

Net income

 

45,814

 

 

53,406

 

 

44,768

 

 

32,722

 

 

(2,208)

 

 

2,668

Net income attributable to Sutherland Asset Management Corporation

 

43,290

 

 

49,169

 

 

40,383

 

 

29,337

 

 

(1,832)

 

 

2,628

Basic earnings per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Continuing operations

$

1.38

 

$

1.93

 

$

1.62

 

$

1.30

 

 

(0.05)

 

 

N/A

   Net income

$

1.38

 

$

1.85

 

$

1.59

 

$

1.19

 

 

(0.11)

 

 

N/A

Diluted earnings per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Continuing operations

$

1.38

 

$

1.93

 

$

1.62

 

$

1.30

 

 

(0.05)

 

 

N/A

   Net income

$

1.38

 

$

1.85

 

$

1.59

 

$

1.19

 

 

(0.11)

 

 

N/A

Dividends declared per share of common stock

$

1.48

 

$

1.61

 

$

1.78

 

$

1.15

 

 

 -

 

 

N/A

Weighted-average basic shares of common stock outstanding

 

31,350,102

 

 

26,647,981

 

 

25,287,277

 

 

24,595,199

 

 

17,007,632

 

 

N/A

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Data

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

$

2,523,503

 

$

2,605,267

 

$

2,329,781

 

$

1,680,896

 

$

621,659

 

 

N/A

Total liabilities

$

1,968,036

 

$

2,053,165

 

$

1,849,568

 

$

1,206,205

 

$

150,752

 

 

N/A

Total Sutherland Asset Management Corporation Stockholders' equity

$

536,073

 

$

513,097

 

$

441,321

 

$

425,560

 

$

420,980

 

 

N/A

Total non-controlling interests

$

19,394

 

$

39,005

 

$

38,892

 

$

49,131

 

$

49,927

 

 

N/A

(a) Non-investment Company Accounting applying other U.S. GAAP.

(b) Investment Company Accounting applying specialized industry-specific accounting guidance contained in ASC Topic 946.

On October 31, 2016, we became a publicly traded company through our merger with and into a subsidiary of ZAIS Financial, with ZAIS Financial surviving the merger and changing its name to Sutherland Asset Management Corporation.  We were designated as the accounting acquirer because of our larger pre-merger size relative to ZAIS Financial, the relative voting interests of our stockholders after consummation of the merger, and our senior management and board continuing on after the consummation of the merger.  Because we were designated as the accounting acquirer, our historical financial statements (and not those of ZAIS Financial) are the historical financial statements following the consummation of the merger and are included in this annual report on Form 10-K. Our results of operations for the year ended December 31, 2012; and as of December 31, 2011 and2016 include for the period from July 29, 2011 (the datelast two months of the Company’s inception)year the operating results related to December 31, 2011, from its audited consolidated financial statementsthe assets of ZAIS Financial which were not appearing in this annual report on Form 10-K.disposed of prior to the closing of the merger.

 

This information should be read in conjunction with Item 1, “Business,” Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the audited consolidated financial statements and notes thereto included in Item 8, “Financial Statements and Supplementary Data” included in this annual report on Form 10-K.

 

  

 

 

Year Ended
December 31,
2015

  Year Ended
December 31,
2014 (1)
  Year Ended
December 31,
2013
  Year Ended
December 31,
2012
  For the period
July 29, 2011
(date of the
Company’s
inception) to
December 31,
2011
 
  (dollars in thousands, except share and per share data) 
Operating Data:                    
                     
Total interest income $37,803  $41,593  $26,418  $9,398  $3,618 
Total interest expense  18,850   17,260   7,095   1,387   296 
Net interest income  18,953   24,333   19,323   8,011   3,322 
Mortgage banking activities, net  45,857   5,439          
Loan servicing fee income, net of direct costs  7,092   930          
Change in fair value of mortgage servicing rights  (4,128)  (1,684)         
Other (losses)/gains  (13,978)  18,931   (2,166)  16,436   (7,678)
Total expenses  50,855   18,994   9,604   4,181(2)  779 
Net (loss)/income attributable to ZAIS Financial Corp. common stockholders  (1,261)  26,742   6,658   19,434   (5,134)
Net (loss)/income per share applicable to common stockholders:                    
Basic $(0.16) $3.35  $0.92  $7.13  $(1.70)
Diluted $(0.16) $3.08  $0.92  $7.13  $(1.70)
                     
Weighted average number of shares of common stock outstanding:                    
Basic  7,970,886   7,970,886   7,273,366   2,724,252   3,022,617 
Diluted  8,897,800   10,677,360   8,200,280   2,773,845   3,022,617 
Dividends declared per share of common stock $1.60  $1.60  $2.12  $4.11  $ 

51

73


 

Table of Contents

  

 

As of
December 31,
2015

  As of
December 31,
2014
  As of
December 31,
2013
  As of
December 31,
2012
  As of
December 31,
2011
 
  (dollars in thousands, except per share data) 
Balance Sheet Data:                    
Total assets $775,139  $792,399  $620,081  $201,648  $154,105 
Total liabilities  597,361   599,015   442,312   136,507(3)  98,787 
Total ZAIS Financial Corp. stockholders’ equity  159,224   173,238   159,250   45,042   55,318 
Total non-controlling interests  18,554   20,145   18,519   20,099    
Stockholders’ equity per share of common stock and OP Units  19.98   21.73   19.98   21.68(4)  18.30 

(1)On October 31, 2014 the Company completed the acquisition of GMFS. The Company has recognized the revenues and earnings related to its investment in GMFS for the period from the acquisition date to December 31, 2014 in its consolidated statements of operations.
(2)Includes interest on common stock repurchase liability of $1.8 million.
(3)Includes $11.2 million in common stock repurchase liability which, as of December 31, 2012, the Company had expected to pay in January 2013 for the repurchase of 515,035 shares of its common stock from one of the Company’s institutional stockholders. In January 2013, the Company agreed with this institutional stockholder to repurchase only 265,245 of its shares (rather than 515,035 shares).
(4)The shares of common stock outstanding for purposes of this stockholders’ equity per share calculation do not include 515,035 shares of common stock that the Company agreed to repurchase from one of its institutional stockholders in January 2013 at a price per share equal to the book value per share as of December 31, 2012. In January 2013, the Company agreed with this institutional stockholder to repurchase only 265,245 of its shares (rather than 515,035 shares).

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

 

The following discussion should be read in conjunction with the Company’sour consolidated financial statements and accompanying Notes included in Item 8, “Financial Statements and Supplementary Data,” of this annual report on Form 10-K. In addition to historical data, this discussion contains forward-looking statements about our business, operations and financial performance based on current expectations that involve risks, uncertainties and assumptions. Our actual results may differ materially from those in this discussion as a result of various factors, including but not limited to those discussed in Part, 1. Item 1A, “Risk Factors” in this annual report on Form 10-K.

 

Overview

 

 The Company investsWe are a real estate finance company that acquires, originates, manages, services and finances primarily SBC loans. SBC loans range in residential mortgage loans. GMFS, a mortgage banking platform the Company acquiredoriginal principal amounts between $500,000 and $10 million and are used by small businesses to purchase real estate used in October 2014, originates, sellstheir operations or by investors seeking to acquire small multi-family, office, retail, mixed use or warehouse properties. Our acquisition and services mortgage loans and the Company acquires performing, re-performing and newly originated loans through other channels. The Company also invests in, finances and manages non-Agency RMBS with an emphasis on securities that, when originally issued, were rated in the highest rating category by one or moreorigination platforms consist of the nationally recognized statistical rating organizations and MSRs. The Company also has the discretion to invest in Agency RMBS, including through TBA contracts, and in other real estate-related and financial assets, such as IOs. The Company refers collectively to its assets as its ’target assets’.following four operating segments:

 

·

Loan Acquisitions.  We acquire performing and non-performing SBC loans and intend to continue to acquire these loans as part of our business strategy. We seek to maximize the value of the SBC loans acquired by us through proprietary loan modification programs.  We typically acquire non-performing loans at a discount to their UPB when we believe that resolution of the loans will provide attractive risk-adjusted returns.

·

SBC Originations. We originate SBC loans secured by stabilized or transitional investor properties using multiple loan origination channels through our wholly-owned subsidiary, ReadyCap Commercial.  Additionally, as part of this segment, we originate and service multi-family loan products under the Freddie Mac program.

·

SBA Originations, Acquisitions and Servicing. We acquire, originate and service owner-occupied loans guaranteed by the SBA under its Section 7(a) Program through our wholly-owned subsidiary, ReadyCap Lending. We hold an SBA license as one of only 14 non-bank SBLCs and have been granted preferred lender status by the SBA. In the future, we may originate SBC loans for real estate under the SBA 504 loan program, under which the SBA guarantees subordinated, long-term financing.

·

Residential Mortgage Banking. In connection with our merger on October 31, 2016, as described in greater detail below, we added a residential mortgage loan origination segment through GMFS.  GMFS originates residential mortgage loans eligible to be purchased, guaranteed or insured by Fannie Mae, Freddie Mac, FHA, USDA and VA through retail, correspondent and broker channels

 

As announced on November 4, 2015, the Company has engaged a financial advisor to assist in evaluating potential strategic alternatives to enhance stockholder value. The continuing strategic review includes the exploration of merger or sale transactions involving the Company or a liquidation of the Company's assets. The Company and its financial advisor have engaged in preliminary discussions with several potential counterparties. While the Company is currently engaged in discussions with a potential counterparty about a potential merger or sale transaction, there is no assurance that the discussions will lead to a definitive merger or sale transaction, which would be subject to approval by the Company’s board of directors and its stockholders. In the event that the Company does not reach a definitive agreement with respect to a merger or sale transaction, management of the Company intends to present to the Company’s board of directors for its consideration a plan of liquidation. There is no assurance that the Company’s board of directors will approve any plan of liquidation and recommend its acceptance by the Company’s stockholders. In light of the strategic review and in order to reduce current market risk in its investment portfolio,the Company has recently begun the process of selling its seasoned, re-performing mortgage loans from its residential mortgage investments segment. A sale of these assets is expected to be completed early 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 may therefore result in a decision to curtail dividends in the future. Additionally, as part of the strategic review, the Company has made the decision to cease the purchase of newly originated residential mortgage loans as part of its mortgage conduit purchase program and will begin the unwinding of 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 will be succeeded by Christian Zugel, the current Chairman of the Company’s board of directors. The Company does not intend to disclose further developments until the review is complete and the Company’s board of directors has taken action with respect to the strategic review.

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'sOur objective is to provide attractive risk-adjusted returns to itsour stockholders, primarily through quarterly distributionsdividends and secondarily through capital appreciation. In order to achieve this objective, we intend to continue to grow our investment portfolio and we believe that the breadth of our full service real estate finance platform will allow us to adapt to market conditions and deploy capital in our asset classes and segments with the most attractive risk-adjusted returns.

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The Company was incorporated in Maryland on May 24, 2011We are organized and has electedconduct our operations to be taxedqualify as a REIT forunder the Code. So long as we qualify as a REIT, we are generally not subject to U.S. federal income tax purposes commencing with itson our net taxable year ended December 31, 2011. The Company isincome to the extent that we annually distribute all of our net taxable income to stockholders. We are organized in a traditional UpREIT format pursuant to which it serveswe serve as the general partner of, and conductsconduct substantially all of itsour business through its Operating Partnership subsidiary, ZAIS FinancialSutherland Partners, L.P., a Delaware limited partnership. The Company is externally managed by the Advisor, a subsidiary of ZAIS, and has no employees except for those employed by GMFS, its wholly-ownedLP, or our operating partnership, which serves as our operating partnership subsidiary. GMFS had 246 employees at December 31, 2015. The CompanyWe also expectsintend to operate itsour business soin a manner that it is not requiredwill permit us to registerbe excluded from registration as an investment company under the 1940 Act.

 

Pursuant to the terms of the GMFS Merger Agreement among Honeybee TRS, Honeybee Acquisitions, 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, HUD/FHA Mortgagee, USDA approved originator and 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 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 December 31, 2015 the contingent consideration liability was $11.3 million). 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 $1,684,263 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 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 U.S. GAAP.

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

The residential mortgage investments segment includes a portfolio of mortgage loans which were either distressed, re-performing or newly originated at the time of purchase. The residential mortgage 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.

At December 31, 2015, the Company held a diversified portfolio of mortgage loans, RMBS and MSRs with an aggregate fair value of $671.2 million, comprised of the following:

Residential Mortgage Investments

·Performing, re-performing and newly originated loans with a fair value of $397.7 million;

·RMBS assets with a fair value of $109.3 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 $116.0 million; and

·MSRs with a fair value of $48.2 million.

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Factors Impacting Operating Results

 

The Company’sWe expect that our results of operations for the year ended December 31, 2015 were impacted by a number of factors. Home prices, which are a significant correlating factor to the Company’s performance, rose 5.25% for the 12 months ended November 2015 according to Case Shiller (20 City Index, seasonally adjusted). In addition, as the housing markets continue to recover from the credit crisis, most housing metrics continue to improve including: the level of distressed homes for sale, delinquencies and foreclosures. Interest rates moved modestly higher during the year, and in December the Federal Reserve initiated its first increase in the federal funds target rate since the financial crisis.  This served to raise short-term borrowing costs and was largely in line with market expectations.  Fixed income market volatility increased during the second half of the year, in particular in the high yield corporate debt markets.  This caused some spread widening in most fixed income credit sectors, including non-Agency RMBS.  The market for residential mortgage loans was also somewhat negatively impacted by these market dynamics. Labor market conditions showed improvement and a benign inflation environment continued, all of which are supportive of mortgage credit performance. The RMBS and whole loan portfolios saw a decline in market value during the year.

The Company expects that the results of its operations will also be affected by a number of factors and will primarily depend on, among other factors, includingthings, the level of its netthe interest income from our assets, the fairmarket value of itsour assets and the supply of, and demand for, SBC and SBA loans, residential loans, MBS and other assets we may acquire in the target assets in which it may invest. The Company'sfuture and the financing and other costs associated with our business. Our net interestinvestment income, which includes the amortization of purchase premiums and accretion of purchase discounts, varies primarily as a result of changes in market interest rates, the rate at which our distressed assets are liquidated and the prepayment speeds, as measured by Constant Prepayment Rates (“CPR”) on the Company's targetspeed of our performing assets. Interest rates and prepayment speeds

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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'sOur operating results may also be impacted by conditions in the financial markets, credit losses in excess of initial anticipationsestimates or unanticipated credit events experienced by borrowers whose mortgage loans are held directly by the Companyus or are included in its non-Agency RMBS or Other Investment Securities or in other assets it may originate or acquire.our MBS. Our operating results will also be impacted by our available borrowing capacity.

 

AtChanges in Market Interest Rates

We own and expect to acquire or originate fixed rate mortgages (“FRMs”), and ARMs, with maturities ranging from five to 30 years. Our loans typically have amortization periods of 15 to 30 years or balloon payments due in five to ten years. ARM loans generally have a fixed interest rate for a period of five, seven or ten years and then an adjustable interest rate equal to the sum of an index rate, such as the London Inter-bank Offered Rate (“LIBOR”), plus a margin, while FRM loans bear interest that is fixed for the term of the loan. As of December 31, 2015,2017, approximately 55% of the Company held a diversifiedloans in our portfolio were ARMs, and 45% were FRMs, based on UPB. The weighted average margin, above the floating rate, on ARMs was approximately 3.4% and the weighted average coupon on FRMs was approximately 5.8% as of mortgage loans held for investmentDecember 31, 2017. We utilize derivative financial and hedging instruments in an effort to hedge the interest rate risk associated with a fair value of $397.7 million, mortgage loans held for sale with a fair value of $116.0 million, RMBS assets with a fair value of $109.3 million and MSRs with a fair value of $48.2 million.our ARMs.

 

With respect to our business operations, increases in interest rates, in general, may over time cause:

·

the interest expense associated with our variable-rate borrowings to increase;

·

the value of fixed-rate loans, MBS and other real estate-related assets to decline;

·

coupons on variable-rate loans and MBS to reset to higher interest rates; and

·

prepayments on loans and MBS to slow.

Conversely, decreases in interest rates, in general, may over time cause:

·

the interest expense associated with variable-rate borrowings to decrease;

·

the value of fixed-rate loans, MBS and other real estate-related assets to increase;

·

coupons on variable-rate loans and MBS to reset to lower interest rates; and

·

prepayments on loans and MBS to increase.

Additionally, non-performing loans are not as interest rate sensitive as performing loans, as earnings on non-performing loans are often generated from restructuring the assets through loss mitigation strategies and opportunistically disposing of them. Because non-performing loans are short-term assets, the discount rates used for valuation are based on short-term market interest rates, which may not move in tandem with long-term market interest rates. A rising rate environment often means an improving economy, which might have a positive impact on commercial property values, resulting in increased gains on the disposition of these assets. While rising rates could make it more costly to refinance these assets, we expect that the impact of this would be mitigated by higher property values. Moreover, small business owners are generally less interest rate sensitive than large commercial property owners, and interest cost is a relatively small component of their operating expenses. An improving economy will likely spur increased property values and sales, thereby increasing the need for loan financing.

Changes in Fair Value of the Company’sOur Assets

 

The Company's mortgageOur originated loans held for investment, mortgage loans held for sale, RMBS and Other Investment Securities are carried at fair value and future mortgage-relatedmortgage related assets may also be carried at fair value. Accordingly, changes in the fair value of the Company'sour assets may impact the results of itsour 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.ABS. This factor is beyond the Company'sour 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

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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 December 31, 2015, 36.4% 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 December 31, 2015, 36.7% 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 December 31, 2015, 100.0 % of the Company's Other Investment Securities, as measured by fair value, consisted of the Fannie Mae Risk Transfer Notes (“FMSA Notes”) and the 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 MSRsABS 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 earnswe earn interest income. When interest rates fall, prepayment speeds on residential mortgage loans, and therefore, RMBS and MSRsABS tend to increase, thereby decreasing the period over which the Company earnswe earn interest income. Additionally, other factors such as the credit rating of the borrower, the rate of home priceproperty value 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.ABS.

 

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Spreads on Non-Guaranteed Mortgage Loans Held for Investment and SecuritiesABS

 

Since the financial crisis that began in 2007, the spreadsspread between swap rates and residential mortgage loans and non-Agency RMBS haveABS has 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'sour assets and itsour funding costs is an important factor in the performance of this aspect of the Company'sour business. Wider spreads imply greater income on new asset purchases but may have a negative impact on the Company'sour 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 Companyus 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'sour stated book value. Tighter spreads generally have a positive impact on asset prices. In this case, the Companywe may be able to reduce the amount of collateral required to secure borrowings.

 

MortgageLoan and ABS Extension Risk

 

The Advisor computesWaterfall estimates the projected weighted-average life of the Company'sour investments based on assumptions regarding the rate at which the borrowers will prepay the underlying mortgages andand/or the ratespeed at which defaults, foreclosures and recoveries will occur. In general, whenwe are able to liquidate an asset. If the Company originates or acquires a fixed-rate mortgage or hybrid ARM asset, the Company may, but is not requiredtimeline 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 relatedresolve non-performing assets could extend beyond the term of the swap agreement or other hedging instrument. Thisextends, this could have a negative impact on the Company's consolidatedour results of operations, as borrowingcarrying costs would no longermay therefore be fixed after the maturity or termination of hedging instruments while the income earned on the assets would remain fixed.higher than initially anticipated. This situation may also cause the fair market value of the Company's assetsour investment to decline with little or no offsetting gain fromif real estate values decline over the related hedging transactions.extended period. In extreme situations, the Companywe may be forced to sell assets to maintain adequate liquidity, which could cause the Companyus 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

 

Credit Risk

The Company isWe are subject to credit risk in connection with its investments. Although the Company does not expect to encounter credit riskour investments in its Agency RMBS, if any, it does expect to encounter credit risk related to its non-Agency RMBS, mortgage loans and ABS and other target assets including assets itwe may originate or acquire.acquire in the future. Increases in defaults and delinquencies will adversely impact the Company'sour operating results, while declines in rates of default and delinquencies maywill improve the Company'sour operating results from this aspect of itsour business. The Company isDefault rates are influenced by a wide variety of factors, including, property performance, property management, supply and demand factors, construction trends, consumer behavior, regional economics, interest rates, the strength of the United States economy and other factors beyond our control. All loans are subject to counterpartythe possibility of default. We seek to mitigate this risk under the FMSA Notesby seeking to acquire assets at appropriate prices given anticipated and FMRT Notes if Freddie Mac or Fannie Mae, respectively, is unableunanticipated losses and by deploying a value-driven approach to perform its obligations under the respective notes.underwriting and diligence, consistent with our historical investment strategy, with a focus on projected cash flows and potential risks to cash flow. We further mitigate our risk of potential losses while managing and servicing our loans by performing various workout and loss mitigation strategies with delinquent borrowers. Nevertheless, unanticipated credit losses could occur which could adversely impact operating results.

 

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 December 31, 2015.

Size of Investment Portfolio

 

The size of the Company'sour investment portfolio, as measured by the aggregate principal balance of its mortgage-related securitiesour loans and ABS and the other assets the Company owns,we own, is also a key driverrevenue driver. Generally, as the size of revenues and expenses. Theour investment portfolio grows, the amount of interest income the Company receives and the amount ofrealized gains we receive increases. A larger investment portfolio, however, drives increased expenses, as we may incur additional interest expense to finance these assets is generally dependent on the sizepurchase of the investment portfolio.

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Regulatory Update

our assets.

 

The Dodd-Frank Act directed

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Market Conditions

With the CFPB to integrate certain mortgage loan disclosures underonset of the TILAglobal financial crisis, SBC origination volume fell approximately 42.5% from the 2006 peak through 2009 and the RESPA,decline was accompanied by a reduction in the principal balance of outstanding SBC loans between 2008 and effective October 3, 2015, new disclosure rules went into effect2013. Based on publicly available data from Boxwood Means as of the first half of 2017, while commercial property prices have almost recovered to their 2007 peak, SBC property prices have increased only 21.5% from the 2012 trough. We believe this trend suggests continued tight credit in SBC lending and supports our belief that credit spreads in the SBC loan asset class should for newly originated residentialthe foreseeable future remain wider compared to large balance commercial mortgage loans. These rules include RESPASince late 2008, we have seen substantial volumes of non-performing SBC loans available for purchase from U.S. banks at significant discounts to their UPBs. We believe that banks have been motivated to sell SBC loans in order to improve their regulatory capital ratios, reduce their troubled asset ratios, a key measure monitored by regulators, investors and other stakeholders in assessing bank safety and soundness, relieve the strain on their operations caused by managing distressed loan books and to demonstrate to regulators, investors and other stakeholders that they are addressing their distressed asset issues and the drag they place on operating performance through controlled sales of these assets over time. We believe that banks will continue to be motivated to divest their non-performing SBC loan assets to address these issues over the next several years. We believe that as the economic recovery continues the volume of short-term loan extensions and restructurings will be reduced, resulting in increased opportunities for us to originate first mortgage SBC loans in the market. We believe that the supply of new consumer disclosure forms, new processes for determining when disclosures mustcapital to meet this increasing demand will continue to be updatedconstrained by the historically low activity levels in the ABS market.

Critical Accounting Policies and new timelines for providing disclosure documents to borrowers.  The new rules have createdUse of Estimates

Our financial statements are prepared in accordance with GAAP, which requires the need for substantial systemuse of estimates and process changesassumptions that affect the reported amounts of assets and new training within the mortgage loan origination industry.

Under the direction and guidanceliabilities as of the Federal Housing Finance Agency, Freddie Mac and Fannie Mae ("GSEs" or "Agencies") are developing a common securitization platform ("CSP") for their single-family mortgage securitization activities, including the issuance by both GSEs of a single MBS. The CSP is expected to be a common information technology platform that will use industry-standard software, systems and data requirements and will be adaptable for use by other market participants in the future. The CSP is being developed by a joint venture owned by the GSEs and will leverage the GSEs’ existing security structures and would encompass manydate of the pooling featuresfinancial statements and the reported amounts of revenues and expenses during the reporting period. We believe that all of the current Fannie Mae MBSdecisions and assessments upon which our financial statements are based were reasonable at the time made, based upon information available to us at that time. The following discussion describes the critical accounting estimates that apply to our operations and require complex management judgment. This summary should be read in conjunction with a more of the disclosure framework of the current Freddie Mac participation certificate. The Federal Housing Finance Agency is expected to make an announcement in 2016 as to the date that Freddie Mac is expected to begin using the CSP as part of its first phase, with Fannie Mae to begin using the CSP at a later time.

In October 2014, the Federal Housing Finance Agency announced a plan that could ease credit, enabling more people to qualify for mortgages by further relaxing agreements that determine when Fannie Mae and Freddie Mac can require lenders to buy back bad loans and permitting borrowers to qualify for certain mortgage loans with smaller down payments than are now required. In October 2015, Fannie Mae and Freddie Mac further modified their buy back policies (which took effect on January 1, 2016) to provide potential alternatives to repurchase in respect of certain categories of loan defects. These plans and policy changes are designed to provide lenders with more clarity and transparency and to offer reassurances to lenders that fear they could suffer unpredictable losses on the loans that they securitize through the GSEs. It remains unclear which, if any, of the currently proposed legislation or initiatives will be enacted, and, if any legislation or initiatives are enacted, what the impact of such legislation or initiatives will be. For acomplete discussion of additional risks relatingour accounting policies and use of estimates included in “Notes to the Company's business, seeConsolidated Financial Statements, Note 3 – Summary of Significant Accounting Policies” included in Item 1A, “Risk Factors” of8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K.

 

Loan impairment and allowance for loan losses

We evaluate each loan classified as heldforinvestment for impairment at least quarterly. Impairment occurs when it is deemed probable that we will not be able to collect all amounts due according to the contractual terms of the loan. If a loan is considered to be impaired, we record an impairment through the allowance for loan losses to reduce the carrying value of the loan to the present value of expected future cash flows discounted at the loan’s contractual effective rate or the fair value of the collateral, if repayment is expected solely from the collateral. Loans that are not assessed individually for impairment are assessed on a collective basis.

Our loans are typically collateralized by real estate. As a result, we regularly evaluate the extent and impact of any credit deterioration associated with the performance and/or value of the underlying collateral property, as well as the financial and operating capability of the borrower. These valuations require significant judgments, which include assumptions regarding LTVs, debt yield, property type, creditworthiness of major tenants, occupancy rates, availability of financing, exit plan, loan sponsorship, actions of other lenders, and other factors deemed necessary by our Manager. In addition, we consider the overall economic environment, real estate sector, and geographic submarket in which the borrower operates. Such impairment analyses are completed and reviewed by asset management and finance personnel.

Significant judgment is required when evaluating loans for impairment; therefore, actual results over time could be materially different. Refer to “Notes to Consolidated Financial Statements, Note 6 – Loans and Allowance for Loan Losses” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for results of our loan impairment evaluation.

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Valuation of financial assets and liabilities carried at fair value

We measure our MBS, derivative assets and liabilities, residential mortgage servicing rights, and any assets or liabilities where we have elected the fair value option at fair value, including certain loans we have originated that are expected to be sold to third parties or securitized in the near term.

We have established valuation processes and procedures designed so that fair value measurements are appropriate and reliable, that they are based on observable inputs where possible, and that valuation approaches are consistently applied and the assumptions and inputs are reasonable. We also have established processes to provide that the valuation methodologies, techniques and approaches for investments that are categorized within Level 3 of the ASC 820 Fair Value Measurement fair value hierarchy (the “fair value hierarchy”) are fair, consistent and verifiable. Our processes provide a framework that ensures the oversight of our fair value methodologies, techniques, validation procedures, and results.

When actively quoted observable prices are not available, we either use implied pricing from similar assets and liabilities or valuation models based on net present values of estimated future cash flows, adjusted as appropriate for liquidity, credit, market and/or other risk factors. Refer to “Notes to Consolidated Financial Statements, Note 7 – Fair Value Measurements” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a more complete discussion of our critical accounting estimates as they pertain to fair value measurements.

Servicing rights impairment

Servicing rights, at amortized cost, are initially recorded at fair value and subsequently carried at amortized cost. We have elected the fair value option on the acquired residential mortgage servicing rights, which are not subject to impairment. 

For purposes of testing our servicing rights, carried at amortized cost, for impairment, we first determine whether facts and circumstances exist that would suggest the carrying value of the servicing asset is not recoverable. If so, we then compare the net present value of servicing cash flow with its carrying value. The estimated net present value of servicing cash flows of the intangibles is determined using discounted cash flow modeling techniques which require management to make estimates regarding future net servicing cash flows, taking into consideration historical and forecasted loan prepayment rates, delinquency rates and anticipated maturity defaults. If the carrying value of the servicing rights exceeds the net present value of servicing cash flows, the servicing rights are considered impaired and an impairment loss is recognized in earnings for the amount by which carrying value exceeds the net present value of servicing cash flows. We monitor the actual performance of our servicing rights by regularly comparing actual cash flow, credit, and prepayment experience to modeled estimates.

Significant judgment is required when evaluating servicing rights for impairment; therefore, actual results over time could be materially different. Refer to “Notes to Consolidated Financial Statements, Note 9 – Servicing Rights” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a more complete discussion of our critical accounting estimates as they pertain to servicing rights impairment.

Refer to “Notes to Consolidated Financial Statements, Note 4– Recently Issued Accounting Pronouncements” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a discussion of recent accounting developments and the expected impact to the Company.

Fourth Quarter Highlights

Operating results: 

·

Achieved Net Income of $12.7 million during the three months ended December 31, 2017.

·

Basic and diluted earnings per share of $0.38 for the three months ended December 31, 2017.

·

Core Earnings of $12.4 million, or $0.37 per share, during the three months ended December 31, 2017.

·

Declared dividends of $0.37 per share, during the quarter ended December 31, 2017, representing a 9.8% dividend yield, based on the closing share price on December 31, 2017.

78


Loan originations and acquisitions:

·

Loan originations totaled $713.5 million including $216.5 million in SBC loans (72% of which are ARMs), $38.3 million of SBA Section 7(a) Program loans and $458.7 million of residential loans (based on fully committed amounts).

·

Acquired $67.3 million of SBC loans with a weighted average coupon of 6.0%.

·

Acquired a $54.3 million interest in an SBC loan pool through a joint venture.

2017 Highlights

Operating results: 

·

Achieved Net Income of $45.8 million during the year ended December 31, 2017.

·

Earnings per share of $1.38 for the year ended December 31, 2017.

·

Core Earnings of $47.0 million, or $1.41 per share, during the year ended December 31, 2017.

·

Declared dividends of $1.48 per share, during the year ended December 31, 2017, representing a 9.8% dividend yield, based on the closing share price on December 31, 2017.

Loan originations and acquisitions:

·

Loan originations totaled $2,971.6 million including $869.3 million in SBC loans (69% of which are ARMs), $131.7 million of SBA Section 7(a) Program loans and $1,970.6 million of residential loans (based on fully committed amounts).

·

Acquired $151.9 million of SBC loans with a weighted average coupon of 6.6% and acquired a $54.3 million interest in an SBC loan pool through a joint venture.

·

Completed the securitization of $154.9 million of acquired SBC owner-occupied loans and sold $139.4 million of senior bonds at a weighted average pass-through rate of 3.3%.

·

Completed issuance of a Collateralized Loan Obligation (“CLO”) of $243.8 million of originated transitional loans and sold $198.8 million of senior bonds at a floating rate of LIBOR plus 139 basis points.

·

Robust pipeline with substantial acquisition and origination opportunities (based on fully committed amounts):

o

Acquisition pipeline of $223.2 million in SBC loans and $16.0 million in SBA loans

o

Origination pipeline of:

§

$159.8 million SBC loans

§

$135.4 million of SBA Section 7(a) Program loans

§

$147.6 million of commitments to originate residential agency loans

We operate in a competitive market for investment opportunities and competition may limit our ability to originate or acquire the potential investments in the pipeline. The consummation of any of the potential loans in the pipeline depends upon, among other things, one or more of the following: available capital and liquidity, our Manager’s allocation policy, satisfactory completion of our due diligence investigation and investment process, approval of our Manager’s Investment Committee, market conditions, our agreement with the seller on the terms and structure of such potential loan, and the execution and delivery of satisfactory transaction documentation. Historically, we have acquired less than a majority of the assets in our Manager’s pipeline at any one time and there can be no assurance the assets currently in its pipeline will be acquired or originated by our Manager in the future.

79


Subsequent events:

·

In January 2018, we issued an additional $40.0 million in aggregate principal of 7.50% Senior Secured Notes due 2022 priced with a yield to par call date of 6.50%.

Return Information

The following tables present certain information related to our SBC and SBA loan portfolio as of December 31, 2017 and per share information for the three months ended December 31, 2017, which includes core earnings per share or return information. Core earnings is not a measure calculated in accordance with GAAP and is defined further within Item 7 – Non-GAAP Financial Measures in this Annual report on Form 10-K.

80


The following table provides a detailed breakdown of our calculation of return on equity and core return on equity for the three and twelve months ended December 31, 2017. Core return on equity is not a measure calculated in accordance with GAAP and is defined further within Item 7 – Non-GAAP Financial Measures in this Annual report on Form 10-K.

Portfolio Metrics

SBC Originations

The following table includes certain portfolio metrics related to our SBC Originations segment:

81


SBA Originations, Acquisitions, and Servicing

The following table includes certain portfolio metrics related to our SBA Originations, Acquisitions and Servicing segment:

Acquired Portfolio

The following table includes certain portfolio metrics related to our Loan Acquisitions segment:

82


Residential Mortgage Banking

The following table includes certain portfolio metrics related to our Residential Mortgage Banking segment:

Business Outlook

Our objective is to provide attractive risk-adjusted returns to our stockholders, primarily through dividends and secondarily through capital appreciation.  In order to achieve this objective, we will continue to grow our investment portfolio by originating new SBC, SBA, and residential mortgage loans, acquiring SBC and SBA loans from third parties and growing our SBA and residential servicing portfolio.  We intend to finance these assets in a manner that is designed to deliver attractive returns across a variety of market conditions and economic cycles.  Our ability to execute our business strategy is dependent upon many factors, including our ability to access capital and financing on favorable terms.  While there can be no assurance that we will continue to have access to the equity and debt markets, we will continue to pursue these and other available market opportunities as a means to increase our liquidity and capital base.  If we were to experience a prolonged downturn in the credit markets, it could cause us to seek alternative sources of potentially less attractive financing, and may require us to adjust our business plan accordingly.

Our business is affected by the macroeconomic conditions in the United States, including economic growth, unemployment rates, the political climate, interest rate levels and expectations. The recent economic environment has resulted in continued improvement in commercial real estate values, which has generally increased payoffs and reduced credit exposure in our loan portfolios.  Interest rates have risen recently as a result of improved labor markets, personal income growth and business investment.  We believe a modest increase in interest rates is unlikely to deter most borrowers who enjoy low loan coupons and still-rising property incomes.  Recent surveys indicate that banks remain optimistic about loan demand going forward even as they may be heading into a credit tightening cycle at this stage of market expansion.  We believe that this environment should support loan origination volumes in 2018.

83


ZAIS Financial Merger

On October 31, 2016, we became a publicly traded company through our merger with and into a subsidiary of ZAIS Financial, with ZAIS Financial surviving the merger and changing its name to Sutherland Asset Management Corporation.  We were designated as the accounting acquirer because of our larger pre-merger size relative to ZAIS Financial, the relative voting interests of our stockholders after consummation of the merger, and our senior management and board continuing on after the consummation of the merger.  Because we were designated as the accounting acquirer, our historical financial statements (and not those of ZAIS Financial) are the historical financial statements following the consummation of the merger and are included in this annual report on Form 10-K.

U.S. Federal Income Tax LegislationLegislation.

 

On December 18, 2015, President Obama22, 2017, the Tax Cuts and Jobs Act, H.R. 1 (the "TCJA") was signed into lawlaw. The TCJA makes significant changes to U.S. federal income tax laws applicable to businesses and their owners, including REITs and their stockholders, and may lessen the Consolidated Appropriations Actrelative competitive advantage of 2016, an omnibus spending bill, withoperating as a division referred toREIT rather than as the Protecting Americans From Tax Hikes Act of 2015 (the “PATH Act”). The PATH Act changes certaina C corporation.

Certain key provisions of the rules affecting REIT qualificationTCJA that could impact us and taxation of REITs and REIT shareholders, which are briefly summarized below.our stockholders, beginning in 2018, will have the following consequences:

 

·

Reduced Tax Rates. The highest individual U.S. federal income tax rate on ordinary income is reduced from 39.6% to 37% (through taxable years ending in 2025), and the maximum corporate income tax rate is reduced from 35% to 21%.  In addition, individuals, trusts, and estates that own our stock are permitted to deduct up to 20% of dividends received from us (other than dividends that are designated as capital gain dividends or qualified dividend income), generally resulting in an effective maximum U.S. federal income tax rate of 29.6% on such dividends (through taxable years ending in 2025). Further, the amount that we are required to withhold on distributions to non-U.S. stockholders that are treated as attributable to gains from our sale or exchange of U.S. real property interests is reduced from 35% to 21%.

·

Net Operating Losses.  We and our TRSs may not use net operating losses generated beginning in 2018 to offset more than 80% of our or our TRSs' taxable income (prior to the application of the dividends paid deduction).  Net operating losses generated beginning in 2018 can be carried forward indefinitely but can no longer be carried back.

·

Limitation on Interest Deductions. The amount of net interest expense that certain taxpayers, including us and our TRSs, may deduct for a taxable year is limited to the sum of (i) the taxpayer's business interest income for the taxable year, and (ii) 30% of the taxpayer's "adjusted taxable income" for the taxable year.  For taxable years beginning before January 1, 2022, adjusted taxable income means earnings before interest, taxes, depreciation, and amortization ("EBITDA"); for taxable years beginning on or after 2017, the percentage of a REIT's total assets that may be represented by securities of one or more Taxable REIT subsidiaries (“TRSs”)January 1, 2022, adjusted taxable income is reduced from 25%limited to 20%earnings before interest and taxes ("EBIT").

·

“Publicly offered REITs” (which generally include any REIT

Alternative Minimum Tax.  The corporate alternative minimum tax is eliminated.

·

Income Accrual.  We and our TRSs are required to file annual and periodic reportsrecognize certain items of income for U.S. federal income tax purposes no later than we would report such items on our financial statements. Earlier recognition of income for U.S. federal income tax purposes could impact our ability to satisfy the REIT distribution requirements.This provision generally applies to taxable years beginning after December 31, 2017, but will apply with the SEC, including the Company) are no longer subjectrespect to the preferential dividend rulesincome from a debt instrument having "original issue discount" for U.S. federal income tax purposes only for taxable years beginning after 2014.December 31, 2018.

Prospective investors are urged to consult with their tax advisors regarding the effects of the TCJA or other legislative, regulatory or administrative developments on an investment in our common stock.

·For taxable years beginning after 2015, debt instruments issued by publicly offered REITs are qualifying assets for purposes of the 75% REIT asset test. However, no more than 25% of the value of a REIT's assets may consist of debt instruments that are issued by publicly offered REITs that are not otherwise treated as real estate assets, and interest on debt of a publicly offered REIT will not be qualifying income under the 75% REIT gross income test unless the debt is secured by real property.

·For taxable years beginning after 2015, to the extent rent attributable to personal property is treated as rents from real property (because rent attributable to the personal property for the taxable year does not exceed 15% of the total rent for the taxable year for such real and personal property), the personal property will be treated as a real estate asset for purposes of the 75% REIT asset test. Similarly, debt obligation secured by a mortgage on both real and personal property will be treated as a real estate asset for purposes of the 75% asset test, and interest thereon will be treated as interest on an obligation secured by real property, if the fair market value of the personal property does not exceed 15% of the fair market value of all property securing the debt.

84


·For taxable years beginning after 2014, the period during which dispositions of properties with net built-in gains from C corporations in carry-over basis transactions will trigger the built-in gains tax is reduced from ten years to five years.

·For taxable years beginning after 2015, a 100% excise tax will apply to “redetermined services income, ” i.e., non-arm’s-length income of a REIT’s TRS attributable to services provided to, or on behalf of, the REIT (other than services provided to REIT tenants, which are potentially taxed as redetermined rents).

·The rate of withholding tax applicable under the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) to certain sales and other dispositions of U.S. real property interests (“USRPIs”) by non-U.S. persons, and certain distributions from corporations whose stock may constitute a USRPI, is increased from 10% to 15% for dispositions and distributions occurring after February 16, 2016.

Changes in Financial Condition

·For dispositions and distributions on or after December 18, 2015, the stock ownership thresholds for exemption from FIRPTA taxation on sale of stock of a publicly traded REIT and for recharacterizing capital gain dividends received from a publicly traded REIT as ordinary dividends is increased from not more than 5% to not more than 10%.

·Effective December 18, 2015, certain look-through presumption, and other rules will apply for purposes of determining if the Company qualifies as domestically controlled.

The following table compares our consolidated balance sheets as of December 31, 2017 and 2016 (amounts in thousands):

 

56

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31,

 

$ Change

 

% Change

(In Thousands)

    

2017

    

2016

 

2017 vs. 2016

 

2017 vs. 2016

Assets

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

63,425

 

$

59,566

 

$

3,859

 

6.5

%

Restricted cash

 

 

11,666

 

 

20,190

 

 

(8,524)

 

(42.2)

 

Short-term investments

 

 

 —

 

 

319,984

 

 

(319,984)

 

(100.0)

 

Loans, net (including $188,150 and $81,592 held at fair value)

 

 

1,017,920

 

 

1,011,121

 

 

6,799

 

0.7

 

Loans, held for sale, at fair value

 

 

216,022

 

 

181,797

 

 

34,225

 

18.8

 

Mortgage backed securities, at fair value

 

 

39,922

 

 

32,391

 

 

7,531

 

23.3

 

Loans eligible for repurchase from Ginnie Mae

 

 

95,158

 

 

137,986

 

 

(42,828)

 

(31.0)

 

Investment in unconsolidated joint venture

 

 

55,369

 

 

 —

 

 

55,369

 

NM(1)

 

Derivative instruments

 

 

4,725

 

 

5,785

 

 

(1,060)

 

(18.3)

 

Servicing rights (including $72,295 and $61,376 held at fair value)

 

 

94,038

 

 

83,854

 

 

10,184

 

12.1

 

Receivable from third parties

 

 

6,756

 

 

7,220

 

 

(464)

 

(6.4)

 

Other assets

 

 

56,840

 

 

54,277

 

 

2,563

 

4.7

 

Assets of consolidated VIEs

 

 

861,662

 

 

691,096

 

 

170,566

 

24.7

 

Total Assets

 

$

2,523,503

 

$

2,605,267

 

$

(81,764)

 

(3.1)

%

Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

Secured borrowings

 

 

631,286

 

 

927,462

 

 

(296,176)

 

(31.9)

 

Promissory note

 

 

6,107

 

 

7,378

 

 

(1,271)

 

(17.2)

 

Securitized debt obligations of consolidated VIEs, net

 

 

598,148

 

 

492,942

 

 

105,206

 

21.3

 

Convertible notes, net

 

 

108,991

 

 

 —

 

 

108,991

 

NM(1)

 

Senior secured notes, net

 

 

138,078

 

 

 —

 

 

138,078

 

NM(1)

 

Guaranteed loan financing

 

 

293,045

 

 

390,555

 

 

(97,510)

 

(25.0)

 

Contingent consideration

 

 

10,016

 

 

14,487

 

 

(4,471)

 

(30.9)

 

Liabilities for loans eligible for repurchase from Ginnie Mae

 

 

95,158

 

 

137,986

 

 

(42,828)

 

(31.0)

 

Derivative instruments

 

 

282

 

 

643

 

 

(361)

 

(56.1)

 

Dividends payable

 

 

12,289

 

 

11,505

 

 

784

 

6.8

 

Accounts payable and other accrued liabilities

 

 

74,636

 

 

70,207

 

 

4,429

 

6.3

 

Total Liabilities

 

$

1,968,036

 

$

2,053,165

 

$

(85,129)

 

(4.1)

%

Stockholders’ Equity

 

 

 

 

 

 

 

 

 

 

 

 

Common stock

 

 

 3

 

 

 3

 

 

 —

 

0.0

 

Additional paid-in capital

 

 

539,455

 

 

513,295

 

 

26,160

 

5.1

 

Deficit

 

 

(3,385)

 

 

(201)

 

 

(3,184)

 

NM(1)

 

Total Sutherland Asset Management Corporation equity

 

 

536,073

 

 

513,097

 

 

22,976

 

4.5

%

Non-controlling interests

 

 

19,394

 

 

39,005

 

 

(19,611)

 

(50.3)

 

Total Stockholders’ Equity

 

$

555,467

 

$

552,102

 

$

3,365

 

0.6

%

Total Liabilities and Stockholders’ Equity

 

$

2,523,503

 

$

2,605,267

 

$

(81,764)

 

(3.1)

%

(1) Not meaningful.

85


 

 

·For dispositions and distributions after December 18, 2015, certain “qualified foreign pension funds” satisfying certain requirements, as well as entities that are wholly owned by a qualified foreign pension fund, are exempt from income and withholding taxes applicable under FIRPTA. In addition, new FIRPTA rules apply to ownership of REIT shares by “qualified shareholders,” which generally include publicly traded non-U.S. stockholders meeting certain requirements.

Assets - Comparison of balances at December 31, 2017 to December 31, 2016

Cash and cash equivalents increased $3.9 million, primarily due to proceeds from our senior secured note issuances, proceeds from our convertible notes issuance and securitization of our transitional loan product, loan sales and pay-offs, offset by funding new originations, loan acquisitions, and other investment activity.

Short-term investments decreased by $320.0 million during the year ended December 31, 2017 as we sold Treasury securities and reinvested the capital to fund new loan originations and acquisitions.

Loans, net increased by $6.8 million as a result of new loan originations and loan acquisitions, which exceeded loan pay-offs, sales, or transfers of loans to securitizations included in consolidated VIEs. During the year ended December 31, 2017, we originated $310.8 million in transitional loans, $163.3 million in SBC conventional loans, and $131.7 million in SBA loans, which includes additional funding on loans originated in previous quarters. Additionally, we acquired $147.3 million in SBC loans. This was offset by transfers of loans to our consolidated securitizations during the year, Sutherland Commercial Mortgage Trust 2017-SBC6 (“SBC6”) and Ready Capital Mortgage Financing 2017-FL1 (“RCMF 2017-FL1”). The increase was further offset by sales and pay-offs of $422.1 million of acquired and originated loans.

Loans, held for sale, at fair value increased by $34.2 million as a result of Freddie Mac loan originations of $395.1 million and an overall increase in originated SBA loans held for sale. This was partially offset by sales of originated Freddie Mac loans to Freddie Mac as well as a net decrease in proceeds received from our residential mortgage banking segment as we originated $2.0 billion in residential agency loans and had loan sales of approximately $2.1 billion.

MBS increased by $7.5 million during the year due to purchases of Freddie Mac issued bonds, offset by sales and pay-downs of other CMBS positions.

During November of 2017, we acquired a $54.3 million interest in an SBC loan pool through a joint venture which is accounted for as an unconsolidated equity method investment.

Our servicing rights asset increased by $10.2 million, primarily due to loan sales and retention of servicing activities of $25.9 million across our SBA, Freddie Mac, and residential servicing portfolio, partially offset by loan pay-offs of $5.6 million, amortization and impairment of $6.0 million, and unrealized losses due to the changes in the fair value of our residential mortgage banking servicing rights of $4.0 million as a result of rising interest rates.

Assets in consolidated VIEs increased by $170.6 million, which included an increase in loans, net of $180.6 million due to the transfer of acquired loans into SBC6 and originated transitional loans into RCMF 2017-FL1, which were completed during the third quarter of 2017, as well as an increase in restricted cash of $15.0 million associated with the RCMF 2017-FL1 securitization. These increases were partially offset by a decrease in amounts due from servicers, which decreased $25.7 million.

Liabilities

Secured borrowings associated with our repurchase agreements and credit facilities decreased by $296.2 million due to pay-downs of shorter-term financings as a result of the maturity of our repurchase agreements financing our short term investments, sold during the period, as well as issuances of longer-term financing associated with our senior secured notes and convertible notes.

During the year ended December 31, 2017, we issued an aggregate principal balance of $140.0 million in 7.5% senior secured notes, maturing in February of 2022. In addition, we issued an aggregate principal balance of $115.0 million in our Convertible Notes.

Securitized debt obligations of consolidated VIEs, net increased $105.2 million, as a result of the completed SBC6 and RCMF 2017-FL1 securitizations during the year, resulting in net proceeds of $321.2 million, which was partially offset by pay-downs of existing loans in securitizations of $227.7 million.

86


Guaranteed loan financing decreased by $97.5 million as a result of an increase in guaranteed SBA sales and scheduled and unscheduled principal payments on guaranteed SBA loans.

Contingent consideration decreased $4.5 million due to the legal settlement during the second quarter of 2017 when we paid cash and issued $4.0 million in shares of the our common stock to the Counterparty under the Settlement.

Equity

Total equity attributable to our company increased by $23.0 million, primarily the result of an increase of $19.6 million due to a conversion of 1,171,494 OP units into common stock. This also increased due to the issuance of $4.0 million in shares of common stock due to a legal settlement noted above. The value of the remaining 1,150,827 OP units are reflected as non-controlling interest in the consolidated balance sheets.

 

Selected Financial HighlightsBalance Sheet Information by Business Segment and Corporate - Other

The following table presents certain selected balance sheet information by each of our four business segments, with the remaining amounts reflected in Corporate –Other, as of December 31, 2017:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(in thousands)

 

Loan Acquisitions

 

SBC Originations

 

SBA Originations, Acquisitions and Servicing

 

Residential Mortgage Banking

 

Corporate / Other

 

Total

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans, net (1)

 

$

373,608

 

$

1,040,510

 

$

437,969

 

$

2,013

 

$

 -

 

$

1,854,100

Loans, held for sale, at fair value

 

 

2,544

 

 

67,591

 

 

16,791

 

 

129,096

 

 

 -

 

 

216,022

Mortgage backed securities, at fair value

 

 

10,132

 

 

29,790

 

 

 -

 

 

 -

 

 

 -

 

 

39,922

Servicing rights (including $72,295 held at fair value)

 

 

 -

 

 

5,060

 

 

16,683

 

 

72,295

 

 

 -

 

 

94,038

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Secured borrowings

 

$

65,351

 

$

383,903

 

$

60,459

 

$

121,573

 

$

 -

 

$

631,286

Securitized debt obligations of consolidated VIEs

 

 

143,565

 

 

431,850

 

 

22,733

 

 

 -

 

 

 -

 

 

598,148

Guaranteed loan financing

 

 

 -

 

 

 -

 

 

293,045

 

 

 -

 

 

 -

 

 

293,045

Senior secured note, net

 

 

24,538

 

 

109,690

 

 

3,850

 

 

 -

 

 

 -

 

 

138,078

Convertible note, net

 

 

3,596

 

 

36,013

 

 

1,898

 

 

 -

 

 

67,484

 

 

108,991

(1) Includes Loan assets of consolidated VIEs

 

 A summary

87


Results of Operations

The following table compares our summarized results of operations for the years ended December 31, 2017, 2016 and 2015 (amounts in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Year Ended December 31,

 

$ Change

 

 

2017

 

2016

 

 

2015

 

2017 vs. 2016

 

2016 vs. 2015

Interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan acquisitions

 

$

37,198

 

$

49,311

 

$

63,001

 

$

(12,113)

 

$

(13,690)

SBC originations

 

 

59,021

 

 

40,586

 

 

31,349

 

 

18,435

 

 

9,237

SBA originations, acquisitions and servicing

 

 

38,108

 

 

46,417

 

 

54,605

 

 

(8,309)

 

 

(8,188)

Residential mortgage banking

 

 

3,978

 

 

709

 

 

 -

 

 

3,269

 

 

709

       Total interest income

 

$

138,305

 

$

137,023

 

$

148,955

 

$

1,282

 

$

(11,932)

Interest expense

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan acquisitions

 

 

(16,741)

 

 

(18,327)

 

 

(17,404)

 

 

1,586

 

 

(923)

SBC originations

 

 

(35,121)

 

 

(20,347)

 

 

(11,538)

 

 

(14,774)

 

 

(8,809)

SBA originations, acquisitions and servicing

 

 

(16,098)

 

 

(17,397)

 

 

(18,233)

 

 

1,299

 

 

836

Residential mortgage banking

 

 

(3,145)

 

 

(557)

 

 

 -

 

 

(2,588)

 

 

(557)

 Corporate - other

 

 

(3,541)

 

 

(1,144)

 

 

(631)

 

 

(2,397)

 

 

(513)

       Total interest expense

 

$

(74,646)

 

$

(57,772)

 

$

(47,806)

 

$

(16,874)

 

$

(9,966)

Net interest income before provision for loan losses

 

 

63,659

 

 

79,251

 

 

101,149

 

 

(15,592)

 

 

(21,898)

   Provision for loan losses

 

 

(2,363)

 

 

(7,819)

 

 

(19,643)

 

 

5,456

 

 

11,824

Net interest income after provision for loan losses

 

$

61,296

 

$

71,432

 

$

81,506

 

$

(10,136)

 

$

(10,074)

Non-interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan acquisitions

 

 

3,011

 

 

2,295

 

 

1,001

 

 

716

 

 

1,294

SBC originations

 

 

4,807

 

 

5,577

 

 

3,077

 

 

(770)

 

 

2,500

SBA originations, acquisitions and servicing

 

 

6,137

 

 

7,400

 

 

15,486

 

 

(1,263)

 

 

(8,086)

Residential mortgage banking (1)

 

 

59,197

 

 

9,580

 

 

 -

 

 

49,617

 

 

9,580

Corporate - other

 

 

 -

 

 

15,218

 

 

 -

 

 

 

 

 

 

         Total non-interest income

 

$

73,152

 

$

40,070

 

$

19,564

 

$

48,300

 

$

5,288

Non-interest expense

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan acquisitions

 

 

(9,727)

 

 

(9,785)

 

 

(4,981)

 

 

58

 

 

(4,804)

SBC originations

 

 

(21,881)

 

 

(19,108)

 

 

(16,552)

 

 

(2,773)

 

 

(2,556)

SBA originations, acquisitions and servicing

 

 

(15,100)

 

 

(16,403)

 

 

(14,780)

 

 

1,303

 

 

(1,623)

Residential mortgage banking

 

 

(48,584)

 

 

(7,292)

 

 

 -

 

 

 -

 

 

 -

Corporate - other

 

 

(17,832)

 

 

(18,550)

 

 

(17,439)

 

 

718

 

 

(1,111)

         Total non-interest expense

 

$

(113,124)

 

$

(71,138)

 

$

(53,752)

 

$

(694)

 

$

(10,094)

Net realized gains (losses) on financial instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan acquisitions

 

 

(323)

 

 

(293)

 

 

2,388

 

 

(30)

 

 

(2,681)

SBC originations

 

 

9,665

 

 

2,290

 

 

(3,534)

 

 

7,375

 

 

5,824

SBA originations, acquisitions and servicing

 

 

9,509

 

 

4,604

 

 

1,317

 

 

4,905

 

 

3,287

Residential mortgage banking (2)

 

 

 -

 

 

 -

 

 

 -

 

 

 -

 

 

 -

Corporate - other

 

 

478

 

 

313

 

 

10

 

 

165

 

 

303

         Total net realized gains (losses) on financial instruments

 

$

19,329

 

$

6,914

 

$

181

 

$

12,415

 

$

6,733

Net unrealized gains (losses) on financial instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan acquisitions

 

 

1,628

 

 

4,528

 

 

(4,617)

 

 

(2,900)

 

 

9,145

SBC originations

 

 

8,125

 

 

6,424

 

 

10,353

 

 

1,701

 

 

(3,929)

SBA originations, acquisitions and servicing

 

 

1,315

 

 

 -

 

 

 -

 

 

1,315

 

 

 -

Residential mortgage banking

 

 

(4,000)

 

 

6,917

 

 

 -

 

 

 -

 

 

 -

Corporate - other

 

 

(68)

 

 

68

 

 

(4)

 

 

(136)

 

 

72

         Total net unrealized gains (losses) on financial instruments

 

$

7,000

 

$

17,937

 

$

5,732

 

$

(20)

 

$

5,288

Income from continuing operations before provision for income taxes

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan acquisitions

 

 

13,020

 

 

21,310

 

 

26,235

 

 

(8,290)

 

 

(4,925)

SBC originations

 

 

24,421

 

 

15,336

 

 

13,155

 

 

9,085

 

 

2,181

SBA originations, acquisitions and servicing

 

 

23,729

 

 

23,307

 

 

31,905

 

 

422

 

 

(8,598)

Residential mortgage banking

 

 

7,446

 

 

9,357

 

 

 -

 

 

 -

 

 

 -

Corporate - other

 

 

(20,963)

 

 

(4,095)

 

 

(18,064)

 

 

(16,868)

 

 

13,969

         Total income from continuing operations before provision for income taxes

 

$

47,653

 

$

65,215

 

$

53,231

 

$

(15,651)

 

$

2,627

Provisions for income taxes

 

 

(1,839)

 

 

(9,651)

 

 

(7,810)

 

 

7,812

 

 

(1,841)

Net income from continuing operations

 

 

45,814

 

 

55,564

 

 

45,421

 

 

(9,750)

 

 

10,143

Loss from discontinued operations, net of tax

 

 

 -

 

 

(2,158)

 

 

(653)

 

 

2,158

 

 

(1,505)

Net income

 

$

45,814

 

$

53,406

 

$

44,768

 

$

(7,592)

 

$

8,638

(1) Includes  gains on sales of mortgage loans held for sale, net of direct loan expenses, changes in fair value on interest rate lock commitments ("IRLCs"), loan expenses, certain loan origination fee income, and income generated on new mortgage servicing rights.

(2) Realized gains (losses) on residential loans held for sale at fair value are included within "Gains on residential mortgage banking activities, net of variable loan expenses" on the consolidated statements of income and within "Other non-interest income" for purposes of the table above.

88


Loan Acquisition Segment Results

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Year Ended  December 31,

 

 

 

 

(In Thousands)

 

2017

 

2016

 

2015

 

$ Change
2017 vs 2016

 

$ Change
2016 vs 2015

Interest income

 

$

37,198

 

$

49,311

 

$

63,001

 

$

(12,113)

 

$

(13,690)

Interest expense

 

 

(16,741)

 

 

(18,327)

 

 

(17,404)

 

 

1,586

 

 

(923)

Net interest income before provision for loan losses

 

$

20,457

 

$

30,984

 

$

45,597

 

$

(10,527)

 

$

(14,613)

Provision for loan losses

 

 

(2,026)

 

 

(6,419)

 

 

(13,153)

 

 

4,393

 

 

6,734

Net interest income after provision for loan losses

 

$

18,431

 

$

24,565

 

$

32,444

 

$

(6,134)

 

$

(7,879)

Non-interest income

 

 

3,011

 

 

2,295

 

 

1,001

 

 

716

 

 

1,294

Non-interest expense

 

 

(9,727)

 

 

(9,785)

 

 

(4,981)

 

 

58

 

 

(4,804)

Total non-interest income (expense)

 

$

(6,716)

 

$

(7,490)

 

$

(3,980)

 

$

774

 

$

(3,510)

Net realized gain (loss) on financial instruments

 

 

(323)

 

 

(293)

 

 

2,388

 

 

(30)

 

 

(2,681)

Net unrealized gain on financial instruments

 

 

1,628

 

 

4,528

 

 

(4,617)

 

 

(2,900)

 

 

9,145

Net income before provision for income taxes

 

$

13,020

 

$

21,310

 

$

26,235

 

$

(8,290)

 

$

(4,925)

Interest income

Interest income of $37.1 million for the year ended December 31, 20142017 in our loan acquisitions segment represented a decrease of $12.1 million from the prior year, primarily due to a reduction of interest income generated on our acquired SBC loan portfolio due to a lower average carrying value of the portfolio ($402.5 million during 2017 compared to $460.0 million during 2016) as a result of re-deploying capital to our origination businesses and an overall migration from high yield non-performing loans to credit stabilized performing loans in our portfolio.

Interest income of $49.3 million for the year ended December 31, 2013 is below, followed2016 in our loan acquisitions segment represented a decrease of $13.7 million from the prior year, primarily due to a reduction of interest income generated on our acquired SBC loan portfolio due to a lower average carrying value of the portfolio as a result of re-deploying capital to our origination businesses and an overall migration from high yield non-performing loans to credit stabilized performing loans

89


in our portfolio. This was also the result of sales of MBS during the second half of 2016, resulting in a reduction in interest income of $7.2 million generated on these assets during 2016.

Interest expense

Interest expense of $16.7 million for the year ended December 31, 2017 in our loan acquisitions segment represented a decrease of $1.6 million from the prior year, reflecting a reduction in borrowing needs, as a result of deploying capital to our origination businesses and a lower average carrying value of the acquired portfolio.

Interest expense of $18.3 million for the year ended December 31, 2016 in our loan acquisitions segment represented an increase of $0.9 million from the prior year, as a result of higher average balances in the first half of 2016 resulting in higher borrowing costs.

Provision for loan losses

Provision for loan losses of $2.0 million for the year ended December 31, 2017 in our loan acquisitions segment represented a decrease of $4.4 million from the prior year, reflecting a reduction in our credit deteriorated loan portfolio due to pay-downs and sales and our increased focus on new loan originations with better credit qualities. As of December 31, 2017, our purchased credit impaired portfolio of SBC loans was $97.9 million, compared to $120.5 million as of December 31, 2016.

Provision for losses of $6.7 million for the year ended December 31, 2016 in our loan acquisitions segment represented a decrease $6.7 million compared to the year ended December 31, 2015, as a result of a reduction in our credit deteriorated loan portfolio due to pay-downs and sales. As of December 31, 2016, our purchased credit impaired portfolio of SBC loans was $120.5 million, compared to $172.5 million as of December 31, 2015.

Non-interest expense

Non-interest expense remained relatively flat year over year at $9.7 million and $9.8 million for the years ended December 31, 2017 and 2016, respectively.

Non-interest expense of $9.8 million for the year ended December 31, 2016 in our loan acquisitions segment represented an increase of $4.8 million compared to the year ended December 31, 2015, as a result of an increase in professional fee expense of $2.0 million and an increase in general operating expenses resulting from the merger completed during the year ended December 31, 2016.

Realized gains (losses) on financial instruments

Realized losses on financial instruments in our loan acquisitions segment remained flat year over year at $0.3 million for both years ended December 31, 2017 and 2016.

Realized losses of $0.3 million for the year ended December 31, 2016 in our loan acquisitions segment compared to realized gains of $2.4 million were the result of losses on sales of MBS of $3.1 million during the year ended December 31, 2016, offset by $0.4 million of additional gains on sales of acquired SBC loans during the year ended December 31, 2016.

Unrealized gains on financial instruments

Unrealized gains on financial instruments of $1.6 million for the year ended December 31, 2017 in our loan acquisitions segment represented a decrease of $2.9 million compared to the prior year, driven primarily by a reduction in

90


unrealized gains on MBS due to sales during the second half of 2016, reducing the size of the MBS portfolio and average balances in 2017.

Unrealized gains on financial instruments of $4.5 million for the year ended December 31, 2016 in our loan acquisitions segment represented an increase of $9.1 million compared to the prior year (unrealized losses of $4.6 million), driven primarily by the changes in fair value of MBS carried at fair value and derivative instruments carried at fair value.

SBC Originations Segment Results

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Year Ended December 31,

 

 

 

 

(In Thousands)

 

2017

 

2016

 

2015

 

$ Change
2017 vs 2016

 

$ Change
2016 vs 2015

Interest income

 

$

59,021

 

$

40,586

 

$

31,349

 

$

18,435

 

$

9,237

Interest expense

 

 

(35,121)

 

 

(20,347)

 

 

(11,538)

 

 

(14,774)

 

 

(8,809)

Net interest income before provision for loan losses

 

$

23,900

 

$

20,239

 

$

19,811

 

$

3,661

 

$

428

Provision for loan losses

 

 

(195)

 

 

(86)

 

 

 -

 

 

(109)

 

 

(86)

Net interest income after provision for loan losses

 

$

23,705

 

$

20,153

 

$

19,811

 

$

3,552

 

$

342

Non-interest income

 

 

4,807

 

 

5,577

 

 

3,077

 

 

(770)

 

 

2,500

Non-interest expense

 

 

(21,881)

 

 

(19,108)

 

 

(16,552)

 

 

(2,773)

 

 

(2,556)

Total non-interest income (expense)

 

$

(17,074)

 

$

(13,531)

 

$

(13,475)

 

$

(3,543)

 

$

(56)

Net realized gain on financial instruments

 

 

9,665

 

 

2,290

 

 

(3,534)

 

 

7,375

 

 

5,824

Net unrealized gain on financial instruments

 

 

8,125

 

 

6,424

 

 

10,353

 

 

1,701

 

 

(3,929)

Net income before provision for income taxes

 

$

24,421

 

$

15,336

 

$

13,155

 

$

9,085

 

$

2,181

Interest income

Interest income of $59.0 million for the year ended December 31, 2017 in our SBC originations segment represented an increase of $18.4 million from the prior year primarily reflecting an increase in SBC loan originations, resulting in higher average loan balances. SBC loan originations increased $295.1 million in the current year, or 51%, compared to 2016, primarily driven by an overviewincrease in Freddie Mac loan originations of $163.9 million and transitional loan originations of $96.2 million during the year ended December 31, 2017 compared to the year ended December 31, 2016. Originated transitional loans contributed $25.3 million in interest income during the year ended December 31, 2017, representing a $16.7 million increase from the year ended December 31, 2016.

Interest income of $40.6 million for the year ended December 31, 2016 in our SBC originations segment represented an increase of $9.2 million from the prior year ended December 31, 2015 primarily reflecting an increase in SBC loan originations, resulting in higher average loan balances. SBC loan originations increased $152.5 million during the year ended December 31, 2016, or 36%, compared to 2015, primarily driven by an increase in Freddie Mac loan originations of $109.6 million and transitional loan originations of $93.8 million during the year ended December 31, 2016 compared to the year ended December 31, 2015. Originated transitional loans contributed $8.6 million in interest income during the year ended December 31, 2016, representing a $6.9 million increase from the year ended December 31, 2015. Originated SBC loans contributed $17.9 million in interest income during the year ended December 31, 2016, representing a $3.1 million increase from the year ended December 31, 2015.

Interest expense

Interest expense of $35.1 million in our SBC originations segment represented an increase of $14.8 million from the prior year ended December 31, 2016, primarily reflecting an increase in borrowing activities under our shorter-term secured borrowings and borrowings under our senior secured notes and convertible notes allocated to the SBC originations segment, due to the need to finance a greater number of loan originations, which increased 51% during the year ended December 31, 2017, compared to the year ended December 31, 2016.

Interest expense of $20.3 million in our SBC originations segment represented an increase of $8.8 million from the prior year ended December 31, 2015, primarily reflecting an increase in borrowing activities due to the need to finance a

91


greater number of loan originations, which increased 36% during the year ended December 31, 2016 compared to the year ended December 31, 2015.

Non-interest income

Non-interest income of $4.8 million in our SBC originations segment represented a decrease of $0.8 million from the prior year ended December 31, 2016 primarily reflecting a decrease in loan origination income of $1.1 million and an increase in servicing income of $0.3 million. The decrease in loan origination income is due to an increase in the number of transitional loan originations compared to conventional SBC loan originations in the year ended December 31, 2017 compared to the year ended December 31, 2016. Origination fee income on transitional loans are accounted for as deferred fees, while origination fee income on conventional SBC loans are recognized when the loan funds. As a result, origination fee income on transitional loans will not have an immediate impact on income upon origination.

Non-interest income of $5.6 million in our SBC originations segment represented an increase of $2.5 million from the prior year ended December 31, 2015, primarily reflecting an increase of origination income due to the increase in the number of conventional SBC loan originations during the year ended December 31, 2016.

Non-interest expense

Non-interest expense of $21.9 million in our SBC originations segment represented an increase of $2.8 million from the prior year ended December 31, 2016, primarily reflecting an increase in other operating expenses of $2.8 million.

Non-interest expense of $19.1 million in our SBC originations segment represented an increase of $2.6 million from the prior year ended December 31, 2015, primarily reflecting an increase in other operating expenses of $1.3 million and an increase in professional fee expenses of $0.8 million.

Realized gains (losses) on financial instruments

Realized gains of $9.7 million in our SBC originations segment represented an increase of $7.4 million from the prior year ended December 31, 2016, primarily driven by sales of Freddie Mac loans, held-for-sale, resulting in additional gains of $5.6 million.

Realized gains of $2.3 million in our SBC originations segment represented an increase of $5.8 million from the prior year ended December 31, 2015, which experienced losses of $3.5 million, as a result of sales of Freddie Mac loans, held-for-sale, resulting in additional gains of $4.0 million.

Unrealized gains on financial instruments

Unrealized gains of $8.1 million in our SBC originations segment represented an increase of $1.7 million from the prior year ended December 31, 2016, primarily driven by overall portfolio growth during the current year, as well as changes in the fair value of the market conditionsSBC conventional loans and Freddie Mac loans that impacted the Company’s resultsare carried at fair value. The increase in average balances of our SBC loan portfolio are a result of an increase in loan originations during the year:current year. As noted above, SBC loan originations increased $295.1 million in the current year, or 51%, compared to 2016, primarily driven by an increase in Freddie Mac loan originations of $163.9 million, which are carried at fair value.

 

  Year Ended 
  

December 31,

2015

  

December 31,

2014

  

December 31,

2013

 
U.S. GAAP net (loss)/income $(1.4) million  $29.9 million  $7.6 million 
U.S. GAAP net (loss)/income per diluted weighted average share outstanding $(0.16) $3.08  $0.92 
Core Earnings $13.5 million  $11.9 million  $9.7 million 
Core Earnings per diluted weighted average share outstanding $1.52  $1. 33  $1.19 
Book value per share of common stock and OP Unit, at end of year $19.98  $21.73  $19.98 
Leverage ratio, at end of year  2.97x  2.84x  2.42x

Unrealized gains of $6.4 million for the year ended December 31, 2016 in our SBC originations segment represented a decrease of $3.9 million from the prior year ended December 31, 2015 primarily reflecting a decrease in the fair value of loans carried at fair value and resulting in $4.2 million less gains during the year ended December 31, 2016, which was

92


partially offset by changes in fair value of derivative instruments of $0.9 million which serve as interest rate and credit risk hedges on the underlying loans.

 

Non-U.S. GAAP

SBA Originations, Acquisitions and Servicing Segment Results

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Year Ended December 31,

 

 

 

 

(In Thousands)

 

2017

 

2016

 

2015

 

$ Change
2017 vs 2016

 

$ Change
2016 vs 2015

Interest income

 

$

38,108

 

$

46,417

 

$

54,605

 

$

(8,309)

 

$

(8,188)

Interest expense

 

 

(16,098)

 

 

(17,397)

 

 

(18,233)

 

 

1,299

 

 

836

Net interest income before provision for loan losses

 

$

22,010

 

$

29,020

 

$

36,372

 

$

(7,010)

 

$

(7,352)

Provision for loan losses

 

 

(142)

 

 

(1,314)

 

 

(6,490)

 

 

1,172

 

 

5,176

Net interest income after provision for loan losses

 

$

21,868

 

$

27,706

 

$

29,882

 

$

(5,838)

 

$

(2,176)

Non-interest income

 

 

6,137

 

 

7,400

 

 

15,486

 

 

(1,263)

 

 

(8,086)

Non-interest expense

 

 

(15,100)

 

 

(16,403)

 

 

(14,780)

 

 

1,303

 

 

(1,623)

Total non-interest income (expense)

 

$

(8,963)

 

$

(9,003)

 

$

706

 

$

40

 

$

(9,709)

Net realized gain on financial instruments

 

 

9,509

 

 

4,604

 

 

1,317

 

 

4,905

 

 

3,287

Net unrealized gain on financial instruments

 

 

1,315

 

 

 -

 

 

 -

 

 

1,315

 

 

 -

Net income before provision for income taxes

 

$

23,729

 

$

23,307

 

$

31,905

 

$

422

 

$

(8,598)

Interest income

Interest income of $38.1 million for the year ended December 31, 2017 in our SBA originations, acquisitions, and servicing segment represented a decrease of $8.3 million from the prior year ended December 31, 2016 primarily due to a reduction of interest income generated on our acquired SBA 7(a) loan portfolio as we have shifted capital to new SBA loan originations. Although our SBA loan originations increased $89.6 million in the current year, or 213%, compared to the prior year, this did not result in a direct, proportional increase in interest income, but rather, resulted in a realized gain on the sale of the SBA loan and an increase in servicing income, as we typically sell a 75% pro-rata interest in the loan at a premium, while retaining 25%, and also retain the servicing rights on the loan. Thus, the reduction in interest income is offset by an increase in realized gains on sales of SBA loans and an increase in originated SBA loans servicing income, discussed further below.

Interest income of $46.4 million for the year ended December 31, 2016 in our SBA originations, acquisitions, and servicing segment represented a decrease of $8.2 million from the prior year ended December 31, 2015 primarily due to a reduction of interest income generated on our acquired SBA 7(a) loan portfolio as we have shifted capital to new SBA loan originations. The reduction in interest income is offset by an increase in realized gains on sales of SBA loans and an increase in servicing income on originated SBA loans, as discussed further below.

Interest expense

Interest expense of $16.1 million in our SBA originations, acquisitions, and servicing segment represented a decrease of $1.3 million from the prior year ended December 31, 2016 primarily reflecting an reduction in borrowing activities under secured borrowings and guaranteed loan financing due to the reduced need to finance acquired SBA 7(a) loans on our balance sheet and originated SBA 7(a) loans, due to sales of the 75% pro-rata interest of these loans, while only 25% is retained on our consolidated balance sheet.

Interest expense of $17.4 million in our SBA originations, acquisitions, and servicing segment represented a decrease of $0.8 million from the prior year ended December 31, 2015 primarily reflecting an reduction in borrowing activities under secured borrowings and guaranteed loan financing due to the reduced need to finance acquired SBA 7(a) loans on our balance sheet and originated SBA 7(a) loans, due to sales of the 75% pro-rata interest of these loans, while only 25% is retained on our consolidated balance sheet.

93


Provision for loan losses

Provision for loan losses of $0.1 million for the year ended December 31, 2017 in our SBA originations, acquisitions, and servicing segment represented a decrease of $1.2 million from the prior year, reflecting a reduction in our credit deteriorated SBA loan portfolio due to pay-downs and sales and our increased focus on new SBA loan originations with better credit qualities. As of December 31, 2017, our acquired SBA loan balance was $400.6 million, compared to $532.7 million as of December 31, 2016.

Provision for losses of $1.3 million for the year ended December 31, 2016 in our SBA originations, acquisitions, and servicing segment represented a decrease $5.2 million compared to the year ended December 31, 2015, as a result of a reduction in our credit deteriorated SBA loan portfolio due to pay-downs and sales within our acquired SBA loan portfolio.

Non-interest income

Non-interest income of $6.1 million for the year ended December 31, 2017 in our SBA originations, acquisitions, and servicing segment represented a decrease of $1.3 million from the prior year ended December 31, 2016 primarily reflecting a decrease in servicing income of $0.9 million and other income of $0.3 million. The reduction in other income during the year ended December 31, 2017 compared to the year ended December 31, 2016 was the result of a release of the repair and denial reserve during 2016. The release of this reserve was driven by a reduction in defaults in the acquired SBA portfolio and decrease in the severity of repair claims on our Section 7(a) SBA loans.

Non-interest income of $7.4 million in for the year ended December 31, 2016 in our SBA originations, acquisitions, and servicing segment represented a decrease of $8.1 million from the prior year ended December 31, 2015 primarily reflecting a decrease in other income of $9.1 million, partially offset by an increase in servicing income of $1.0 million. The reduction in other income during the year ended December 31, 2016 compared to the year ended December 31, 2015 was the result of a release of the repair and denial reserve during 2015. The release of this reserve was driven by a reduction in defaults in the acquired SBA portfolio and a decrease in the severity of repair claims on our Section 7(a) SBA loans.

Non-interest expense

Non-interest expense of $15.1 million for the year ended December 31, 2017 in our SBA originations, acquisitions, and servicing segment represented a decrease of $1.3 million from the prior year ended December 31, 2016 primarily reflecting a decrease in professional fee expense of $1.7 million, partially offset by an increase in employee compensation expense of $1.1 million.

Non-interest expense of $16.4 million for the year ended December 31, 2016 in our SBA originations, acquisitions, and servicing segment represented an increase of $1.6 million from the prior year ended December 31, 2015 primarily reflecting an increase in loan servicing expense of $1.0 million and an increase in professional fee expense of $0.4 million.

Realized gains on financial instruments

Realized gains of $9.5 million for the year ended December 31, 2017 in our SBA originations, acquisitions, and servicing segment represented an increase of $4.9 million from the prior year, which is the result of an increase in sales of SBA loans due to an increase in loan originations. 

Realized gains of $4.6 million for the year ended December 31, 2016 in our SBA originations, acquisitions, and servicing segment represented an increase of $3.3 million from the prior year, which is the result of an increase in sales of SBA loans due to an increase in loan originations.

Unrealized gains on financial instruments

Unrealized gains of $1.3 million in our SBA originations, acquisitions, and servicing segment during the year ended December 31, 2017 represented an increase in unrealized gains on SBA loans, held for sale, at fair value.

94


Residential Mortgage Banking Segment Results

We acquired the GMFS business as part of the ZAIS Financial merger on October 31, 2016 and, therefore, the following results relate to only the year ended December 31, 2017 and the two months ended December 31, 2016. A discussion of comparative results is not included as it is not meaningful. See “Note 5 – Business Combinations” in Item 8. “Financial Statements and Supplemental Information” included in this annual report on Form 10-K for the pro forma results of the combined company for the years ended December 31, 2016 and 2015.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Year Ended December 31,

 

 

 

 

(In Thousands)

 

2017

 

2016

 

2015

 

$ Change
2017 vs 2016

 

$ Change
2016 vs 2015

Interest income

 

$

3,978

 

$

709

 

$

 -

 

$

3,269

 

$

709

Interest expense

 

 

(3,145)

 

 

(557)

 

 

 -

 

 

(2,588)

 

 

(557)

Net interest income before provision for loan losses

 

$

833

 

$

152

 

$

 -

 

$

681

 

$

152

Provision for loan losses

 

 

 -

 

 

 -

 

 

 -

 

 

 -

 

 

 -

Net interest income after provision for loan losses

 

$

833

 

$

152

 

$

 -

 

$

681

 

 

152

Non-interest income(1)

 

 

59,197

 

 

9,580

 

 

 -

 

 

49,617

 

 

9,580

Non-interest expense

 

 

(48,584)

 

 

(7,292)

 

 

 -

 

 

(41,292)

 

 

(7,292)

Total non-interest income (expense)

 

$

10,613

 

$

2,288

 

$

 -

 

$

8,325

 

$

2,288

Net realized gain on financial instruments

 

 

 -

 

 

 -

 

 

 -

 

 

 -

 

 

 -

Net unrealized gain (loss) on financial instruments

 

 

(4,000)

 

 

6,917

 

 

 -

 

 

(10,917)

 

 

6,917

Net income before provision for income taxes

 

$

7,446

 

$

9,357

 

$

 -

 

$

(1,911)

 

$

9,357

(1) Includes gains on sales of mortgage loans held for sale, net of direct loan expenses, changes in fair value on IRLCs, loan expenses, certain loan origination fee income, and income generated on new mortgage servicing rights.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

Interest income of $4.0 million in our residential mortgage banking segment for the year ended December 31, 2017 and $0.7 million for the two months ended December 31, 2016 was generated on originated residential agency loans held-for-sale, at fair value.

Interest expense

Interest expense of $3.1 million in our residential mortgage banking segment for the year ended December 31, 2017 and $0.6 million for the two months ended December 31, 2016, which reflects financing costs on our borrowings under credit facilities used to fund the origination of new loans.

Non-interest income

Non-interest income of $59.2 million in our residential mortgage banking segment for the year ended December 31, 2017 represents gains on sales of residential mortgage loans of $63.0 million, income generated on new mortgage servicing rights of $14.9 million, loan origination fee income of $8.2 million, and servicing income of $17.3 million, which is partially offset by correspondent fees and other direct loan expenses of $41.7 million.

Non-interest income of $9.6 million in our residential mortgage banking segment for the two months ended December 31, 2016 represents gains on sales of residential mortgage loans of $2.9 million, income generated on new mortgage servicing rights of $3.2 million, loan origination fee income of $1.4 million, and servicing income of $2.5 million, which is partially offset by correspondent fees and other direct loan expenses of $0.6 million

Non-interest expense

Non-interest expense of $48.6 million in our residential mortgage banking segment for the year ended December 31, 2017 represents employee compensation of $34.6 million, loan servicing expense of $6.4 million, and other general operating expenses of $6.5 million.

95


Non-interest expense of $7.3 million in our residential mortgage banking segment for the two months ended December 31, 2016 represents employee compensation of $5.6 million, loan servicing expense of $1.0 million, and other general operating expenses of $1.1 million.

Unrealized gains (losses) on financial instruments

Unrealized losses of $4.0 million for the year ended December 31, 2017 in our residential mortgage banking segment represents unrealized losses on our residential MSR, carried at fair value driven by changes in interest rates. Unrealized gains of $6.9 million in the two months ended December 31, 2016 as a result of unrealized gains due to changes in the fair value of our residential MSR due to changes in interest rates.

Corporate - Other

Interest expense

Interest expense of $3.5 million for the year ended December 31, 2017 increased $2.4 million from the year ended December 31, 2016 represented an increase in borrowing costs associated with our unallocated funds generated by our senior secured notes and convertible notes, both of which were issued during 2017.

Interest expense of $1.1 million for the year ended December 31, 2016 increased $0.5 million from the year ended December 31, 2015 represented an increase in our borrowings under repurchase agreements in order to finance our purchases of Treasury securities, which increased by approximately $100.0 million compared to the year ended December 31, 2015.

Non-interest income

There was a $15.2 million bargain purchase gain for the year ended December 31, 2016 related to the merger transaction. There were no other non-interest income items during the years ended December 31, 2017, 2016, or 2015.

Non-interest expense

Non-interest expense of $17.8 million for the year ended December 31, 2017 decreased $0.7 million from the year ended December 31, 2016 represented a decrease of $2.6 million in professional fee expense due to an increase in merger related costs in 2016,  partially offset by an increase in management fees due to our Manager of $0.6 million and an increase in employee compensation expense of $0.7 million as a result of business growth during 2017.

Non-interest expense of $18.6 million for the year ended December 31, 2016 represented an increase of $1.1 million from the year ended December 31, 2015 reflecting an increase of $3.5 million in professional fee expense due to merger related costs incurred during 2016, partially offset by an decrease in management and incentive fees paid to our Manager of $0.8 million and a reduction of other operating expenses of $2.0 million.

Non-GAAP Financial Measures

 

The Company believesWe believe 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 tointo the information used by management in itsour 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 TRSs 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.

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

96


We calculate Core Earnings as GAAP net income (loss) excluding the following:

i)

any unrealized gains or losses on certain MBS

ii)

any realized gains or losses on sales of certain MBS

iii)

any unrealized gains or losses on MSRs

iv)

one-time non-recurring gains or losses, such as gains or losses on discontinued operations, bargain purchase gains, or merger related expenses

 

The following table reconciles net (loss)/income computed in accordance with U.S. GAAPpresents our summarized consolidated results of operations and reconciliation to Core Earnings:

 

  Year Ended 
  

December 31,

2015

  

December 31,

2014

  

December 31,

2013

 
  (dollars in thousands, except per share data) 
Net (loss)/income after income taxes– U.S. GAAP $(1,419) $29,852  $7,553 
Recurring adjustments for non-core earnings:            
Change in unrealized gain or loss on mortgage loans held for investment  9,369   (22,814)  (7,136)
Change in unrealized gain or loss on real estate securities  4,851   2,994   7,171 
Change in unrealized gain or loss on Other Investment Securities  334   226    
Change in unrealized gain or loss on real estate owned  435   504    
Realized gain on mortgage loans held for investment  (1,479)  (1,839)  (1,299)
Realized (gain)/loss on real estate securities  (19)  (3,694)  9,046 
Realized loss/(gain) on other investment securities  155   (227)   
Realized loss/(gain) on real estate owned  160   (2)   
Loss/(gain) on derivative instruments related to investment portfolio  172   5,922   (5,615)
Change in fair value of MSRs resulting from changes in values of market related inputs or assumptions used in a valuation model, net of tax  (18)  852    
Change in contingent consideration, net of tax  (87)      
Amortization of deferred premiums, production and profitability earn-outs, net of tax  514       
Depreciation and amortization, net of tax  561   92    
Non-controlling interests  12       
Core Earnings – non-U.S. GAAP $13,541  $11,866  $9,720 
Core Earnings – per diluted weighted average share outstanding – non-U.S. GAAP $1.52  $1.33  $1.19(1)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

 

 

 

 

 

(in thousands)

2017

 

2016

 

2015

 

Change
2017 vs 2016

 

Change
2016 vs 2015

Net Income

$

45,814

 

$

53,406

 

$

44,768

 

$

(7,592)

 

$

8,638

Reconciling items:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  Unrealized (gain) loss on MBS

 

(1,077)

 

 

(3,680)

 

 

5,179

 

 

2,603

 

 

(8,859)

  Realized (gain) loss on MBS

 

 -

 

 

3,696

 

 

 -

 

 

(3,696)

 

 

3,696

  Unrealized (gain) loss on MSRs

 

4,000

 

 

(6,917)

 

 

 -

 

 

10,917

 

 

(6,917)

  Bargain purchase gain

 

 -

 

 

(15,218)

 

 

 -

 

 

15,218

 

 

(15,218)

  Merger transaction costs

 

70

 

 

4,510

 

 

 -

 

 

(4,440)

 

 

4,510

  Gain on sale of SBA license

 

 -

 

 

 -

 

 

(1,300)

 

 

 -

 

 

1,300

  Employee severance

 

 -

 

 

418

 

 

 -

 

 

(418)

 

 

418

  Restricted Stock Unit (RSU) grant to Independent Directors

 

290

 

 

 -

 

 

 -

 

 

290

 

 

 -

  Loss on discontinued operations

 

 -

 

 

3,538

 

 

912

 

 

(3,538)

 

 

2,626

     Total reconciling items

$

3,283

 

$

(13,653)

 

$

4,791

 

$

16,936

 

$

(18,444)

   Income tax adjustments

 

(2,119)

 

 

1,155

 

 

(259)

 

 

(3,274)

 

 

1,414

Core earnings

$

46,978

 

$

40,908

 

$

49,300

 

$

6,070

 

$

(8,392)

 

(1) Calculation has been revisedYear Ended December 31, 2017 Compared to conform with current period’s methodology.Year Ended December 31, 2016

 

Consolidated Net Income decreased by $7.6 million, from $53.4 million during the year ended December 31, 2016 to $45.8 million during the year ended December 31, 2017. Consolidated Core Earnings increased by $6.1 million, from $40.9 million during the year ended December 31, 2016 to $47.0 million during the year ended December 31, 2017.

57

 

The decrease in Consolidated Net Income was primarily due to a bargain purchase gain of $15.2 million in 2016, which was partially offset by merger transaction costs of $4.5 million relating to the ZAIS Financial merger transaction. The decrease in Consolidated Net Income was also attributable to unrealized gains on our residential mortgage servicing rights that are carried at fair value of $6.9 million experienced in 2016, compared to $4.0 million of unrealized losses on these assets during the year ended December 31, 2017. The decrease was also partially offset by a loss on discontinued operations of $3.5 million during 2016.

The increase in Consolidated Core Earnings during the year ended December 31, 2017 as compared to the year ended December 31, 2016 was $13.5primarily due to an increase in SBC and SBA loan originations, sales of Freddie Mac and SBA loans, a decrease in the provision for loan losses as a result of the shift from high yield non-performing loans to credit stabilized performing loans, as well as earnings attributable to our residential mortgage banking segment as a result of a complete year of operations.

Year Ended December 31, 2016 Compared to Year Ended December 31, 2015

Consolidated Net Income increased by $8.6 million, forfrom $44.8 million during the year ended December 31, 2015 compared to $11.9$53.4 million forduring the year ended December 31, 2014. The increase in2016. Consolidated Core Earnings was primarily due to an increase of $6.3decreased by $8.4 million, (net of income taxes) due to the acquisition of GMFS on October 31, 2014, offset by a decrease of $4.7from $49.3 million related to the Company’s residential mortgage investment portfolio due to the sale of RMBS to fund the acquisition of GMFS.

Core Earnings was $11.9 million for the year ended December 31, 2014 compared to $9.7 million for the year ended December 31, 2013. The increase in Core Earnings was primarily due to an increase of $2.2 million (net of income taxes) due to the acquisition of GMFS on October 31, 2014.

Financial Overview

The Company reported GAAP net loss forduring the year ended December 31, 2015 to $40.9 million during the year ended December 31, 2016.

97


The increase in Consolidated Net Income was primarily due to a bargain purchase gain of $15.2 million, or $0.16 per diluted weighted average share outstanding, compared withwhich was partially offset by merger transaction costs of $4.5 million relating to the ZAIS Financial merger transaction. The increase was also driven by unrealized gains from MBS and residential MSRs, whose fair values increased due to changes in interest rates. The reduction to net income related to changes in the fair value of $29.9 million or $3.08 per diluted weighted average share outstanding forinvestments was offset by an increase in non-recurring items including transaction expenses related to the same periodZAIS Financial merger, the sale of the brokerage operating segment contained in 2014.  Fordiscontinued operations in our consolidated financial statements and employee severance related to the optimization of overhead costs of the origination segment.

The reduction in Consolidated Core Earnings during the year ended December 31, 2016 as compared to the year ended December 31, 2015 the Company recognized unrealized and realized losses of $14.0 million related to its investment portfolio compared to unrealized and realized gains of $18.9 million for the same period in 2014. The unrealized losses in 2015 were primarily attributable to the market dynamics discussed in Item 1, “Business” of this annual report on Form 10-K as well as principal amortization from scheduled paydowns. These results include GMFS operations, which contributed $13.5 million of net income before income taxes for the year ended December 31, 2015 compared to $583,000 of net income for the same period in 2014. The 2014 results include GMFS for the period from October 31, 2014 (the date of acquisition) to December 31, 2014.

GMFS

Highlights of the GMFS operating activity (which is included in the Company’s residential mortgage banking segment) for the year ended December 31, 2015 are as follows:

Mortgage originations(1)
Unpaid principal balance$1.8 billion
Percentage of originations
Purchases65.1%
Refinancing34.9%
Interest rate locks entered into$2.3 billion
Mortgage loans sold(1)
Unpaid principal balance$1.8 billion
Percentage of unpaid principal balance
Fannie Mae or Freddie Mac securitizations58.0%
Ginnie Mae securitizations30.2%
Other investors11.8%
Core Earnings(2)(3)$13.5 million
Other (primarily the change in the fair value of the MSR portfolio due to changes in values of market related inputs or assumptions used in a valuation model)$(4)
Net income before income taxes(3)$13.5 million

58

(1) Excludes reverse mortgages.

(2) See definition of Core Earnings in the “Non-U.S. GAAP Financial Measures” section included in this annual report on Form 10-K.

(3) Excludes operating and other expenses and income taxes incurred in the residential mortgage banking segment by ZFC Honeybee TRS, LLC, the parent company of GMFS.

(4) Amount is less than $100,000

Highlights of the GMFS MSRs at December 31, 2015 are as follows:

MSR
Unpaid principal balance$4.2 billion
Fair market value$48.2 million
Percentage of unpaid principal balance serviced
Fannie Mae or Freddie Mac securitizations64.3%
Ginnie Mae securitizations35.7%
Weighted average gross coupon3.9%

Investment activity during the years ended, December 31, 2015, December 31, 2014 and December 31, 2013 and as of December 31, 2015 and December 31, 2014

��

Mortgage Loans Held for Investment, at fair value

The Company’s mortgage loans held for investment, at fair value consist of (i) loans which were distressed and re-performing and showed evidence of credit deterioration at the time of purchase and (ii) newly originated at the time of purchase:

Distressed and re-performing loans at the time of purchase

During the year ended December 31, 2015, the Company did not acquire any mortgage loans held for investment which showed evidence of credit deterioration at the time of purchase.

During the years ended December 31, 2014 and December 31, 2013, the Company's acquisition of mortgage loans held for investment which showed evidence of credit deterioration at the time of purchase was as follows:

  Year Ended 
  

December 31,

2014

  

December 31,

2013

 
  (dollars in thousands) 
Aggregate Unpaid Principal Balance $100,422  $412,865 
Loan Repurchase Facilities Used  60,557   231,981 

The Company did not sell any mortgage loans held for investment which showed evidence of credit deterioration at the time of purchase in during the years ended December 31, 2015, December 31, 2014 or December 31, 2013.

The following table sets forth certain information regarding the Company’s mortgage loan portfolio held for investment at December 31, 2015 and December 31, 2014 which showed evidence of credit deterioration at the time of purchase:

December 31, 2015

           

Gross Unrealized(1)

  Difference
Between Fair
Value and
Aggregate
  Weighted Average 
  Unpaid 
Principal
Balance
  Premium
(Discount)
  Amortized
Cost
  Gains  Losses  Fair 
Value
  Unpaid 
Principal
Balance
  Coupon  Unleveraged
Yield
 
  (dollars in thousands)       
Mortgage Loans Held for Investment                                    
Performing                                    
Fixed $240,031  $(44,651) $195,380  $23,627  $(2,522) $216,485  $(23,546)  4.70%  7.59%
ARM  143,626   (15,598)  128,028   5,918   (3,127)  130,819   (12,807)  3.63   7.15 
Total performing  383,657   (60,249)  323,408   29,545   (5,649)  347,304   (36,353)  4.30   7.41 
Non-performing(2)  40,101   (7,515)  32,586   991   (4,246)  29,331   (10,770)  4.65   7.78 
Total Mortgage Loans Held for Investment $423,758  $(67,764) $355,994  $30,536  $(9,895) $376,635  $(47,123)  4.34%  7.45%

59

December 31, 2014

           

Gross Unrealized(1)

  Difference
Between Fair
Value and
Aggregate
  Weighted Average 
  Unpaid
Principal
Balance
  Premium
(Discount)
  Amortized
 Cost
  Gains  Losses  Fair 
Value
  Unpaid
Principal
Balance
  Coupon  Unleveraged
Yield
 
  (dollars in thousands)       
Mortgage Loans Held for Investment                                    
Performing                                    
Fixed $265,307  $(51,501) $213,806  $26,732  $(1,384) $239,154  $(26,153)  4.50%  7.28%
ARM  162,858   (21,343)  141,515   9,569   (1,441)  149,643   (13,215)  3.59   7.10 
Total performing  428,165   (72,844)  355,321   36,301   (2,825)  388,797   (39,368)  4.15   7.21 
Non-performing(2)  35,945   (6,039)  29,906   840   (4,370)  26,376   (9,569)  5.48   7.13 
Total Mortgage Loans Held for Investment $464,110  $(78,883) $385,227  $37,141  $(7,195) $415,173  $(48,937)  4.26%  7.20%

(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:

Year Ended 
December 31,
2015
  December 31, 
2014
 
(dollars in thousands) 
$(9,413) $22,811 

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

Newly originated loans at the time of purchase

During the years ended December 31, 2015 and December 31, 2014, the Company's acquisition of mortgage loans held for investment which were newly originated at the time of purchase and sourced through its loan purchase program was as follows:

  Year Ended 
  December 31,
2015
  December 31,
2014
 
  (dollars in thousands) 
Aggregate Unpaid Principal Balance $21,336  $767 
Loan Repurchase Facilities Used  18,129   690 

During the year ended December 31, 2013, the Company did not acquire any mortgage loans held for investment which were newly originated at the time of purchase. The Company did not sell any mortgage loans held for investment which were newly originated at the time of purchase during the years ended December 31, 2015, December 31, 2014 or December 31, 2013.

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

December 31, 2015

           Gross Unrealized (1)     Weighted Average 
  Unpaid 
Principal
Balance
  Premium  Amortized 
Cost
  Gains  Losses  Fair Value  Coupon  Unleveraged 
Yield
 
  (dollars in thousands)       
Performing                                
Fixed $17,674  $316  $17,990  $58  $(99) $17,949   5.05%  4.89%
ARM  3,068   45   3,113      (18)  3,095   4.37   4.25 
Total - Mortgage Loans Held for Investment $20,742  $361  $21,103  $58  $(117) $21,044   4.95%  4.79%

60

December 31, 2014

           

Gross Unrealized(1)

     Weighted Average 
  Unpaid
Principal
Balance
  Premium
(Discount)
  Amortized
Cost
  Gains  Losses  Fair Value  Coupon  Unleveraged
Yield
 
  (dollars in thousands)       
Performing                                
Fixed $767  $16  $783  $4  $  $787   4.38%  4.20%
Total - Mortgage Loans Held for Investment $767  $16  $783  $4  $  $787   4.38%  4.20%

(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:

Year Ended 
December 31,
2015
  December 31,
2014
 
(dollars in thousands) 
$(63) $4 

Mortgage Loans Held for Sale, at Fair Value

The Company’s mortgage loans held for sale, at fair value consists of loans originated by its residential mortgage banking platform.

For the years ended December 31, 2015 and December 31, 2014, the Company's mortgage loans held for sale activity was as follows:

  Year Ended 
  December 31,
2015
  December 31,
2014
 
  (dollars in thousands) 
Balance at beginning of year $97,691  $ 
Acquisition of GMFS     92,512 
Originations and repurchases  1,851,207   253,935 
Proceeds from sales and principal payments  (1,893,834)  (245,141)
Transfers to mortgage loans held for investment, at cost, net  (444)   
Gain on sale  61,322   (3,615)
Balance at end of year $115,942  $97,691 

The following table sets forth certain information regarding the Company’s mortgage loans held for sale at December 31, 2015 and December 31, 2014:

  December 31, 2015  December 31, 2014 
  Unpaid
Principal
Balance
  Fair Value  Unpaid
Principal
Balance
  Fair Value 
  (dollars in thousands) 
Conventional $54,963  $56,587  $55,074  $57,058 
Governmental  30,531   32,131   13,408   14,602 
United States Department of Agriculture loans  16,222   17,060   16,105   17,069 
United States Department of Veteran Affairs loans  8,923   9,314   6,731   7,196 
Reverse mortgages  754   850   1,600   1,766 
   Total – Mortgage loans held for sale $111,393  $115,942  $92,918  $97,691 

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RMBS and Other Investment Securities

The Company’s RMBS consist of 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, 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.

Other Investment Securities consist of FMRT Notes and FMSA Notes at December 31, 2015. Other Investment Securities at December 31, 2014 consist of FMSA Notes.

During the years ended December 31, 2015, December 31, 2014 and December 31, 2013, the principal balance of the Company’s purchases and sales of RMBS and Other Investment Securities were as follows:

  Year Ended 
  December 31, 
2015
  December 31,
2014
  December 31,
2013
 
  (dollars in thousands) 
Purchases:            
Agency $  $  $159,209 
Non-Agency  7,428   63,015   375,435 
Other Investment Securities  17,344       
Sales:            
Agency $  $  $215,516 
Non-Agency  31,344   113,929   89,540 
Other Investment Securities  6,193       

During the year ended December 31, 2013, the Company acquired non-Agency RMBS with a principal balance of $17.4 million from a fund managed by ZAIS.

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

December 31, 2015

  Principal or        

Gross Unrealized (2)

     Weighted Average 
  Notional
Balance
  Premium
(Discount)
  Amortized 
Cost
  Gains  Losses  Fair Value  Coupon  Unleveraged
Yield
 
  (dollars in thousands)       
Real estate securities                                
Non-Agency RMBS:                                
Alternative – A $76,328  $(40,150) $36,178  $846  $(1,026) $35.998   2.01%  6.18%
Pay option adjustable rate  42,563   (7,481)  35,082   7   (2,879)  32,210   1.10   5.31 
Prime  37,366   (4,733)  32,633   564   (714)  32,483   3.62   5.95 
Subprime  12,668   (4,040)  8,628   112   (91)  8,649   0.93   6.63 
Total non-Agency RMBS $168,925  $(56,404) $112,521  $1,529  $(4,710) $109,340   2.05%  5.87%
Other Investment Securities(1) $13,399  $(34) $13,365  $1  $(562) $12,804   4.94%  6.65%

December 31, 2014

  Principal or        

 Gross Unrealized (2)

     Weighted Average 
  Notional
Balance
  Premium
(Discount)
  Amortized
Cost
  Gains  Losses  Fair Value  Coupon  Unleveraged
Yield
 
     (dollars in thousands)       
Real estate securities                                
Non-Agency RMBS:                                
Alternative – A $118,547  $(58,583) $59,964  $1,917  $(584) $61,297   3.44%  7.03%
Pay option adjustable rate  58,123   (11,492)  46,631   81   (1,171)  45,541   0.93   6.12 
Prime  43,804   (6,219)  37,585   1,545   (65)  39,065   3.60   6.79 
Subprime  6,028   (3,291)  2,737      (54)  2,683   0.33   16.98 
Total non-Agency RMBS $226,502  $(79,585) $146,917  $3,543  $(1,874) $148,586   2.62%  6.96%
Other Investment Securities(1) $2,250  $17  $2,267  $  $(226) $2,041   3.92%  5.90%

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At December 31, 2015 and December 31, 2014, Alternative-A non-Agency RMBS includes an IO with a notional balance of $35.0 million and $48.6 million, respectively.

(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 and Other Investment Securities. The Company recorded the changes in unrealized gain or loss in the consolidated statements of operations.

MSRs

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 losses by the FHA or partially guaranteed against loss by the VA.

The activity of MSRs for the years ended December 31, 2015 and December 31, 2014 is as follows:

  Year Ended 
  December 31,
2015
  December 31,
2014
 
  (dollars in thousands) 
Balance at beginning of year $33,378  $ 
Acquisition of MSRs in connection with purchase of GMFS     32,300 
Additions due to loans sold, servicing retained  18,959   2,763 
Change in fair value of MSRs(1)        
 Changes in values of market related inputs or assumptions used in a valuation model(2)  29   (1,421)
 Other changes(3)  (4,157)  (263)
 Total - Change in fair value of MSRs  (4,128)  (1,684)
         
Balance at end of year $48,209  $33,379 

(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 year.

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

  December 31, 2015  December 31, 2014 
  Unpaid Principal
Balance
  Fair Value  Unpaid Principal
Balance
  Fair Value 
  (dollars in thousands) 
Fannie Mae $1,880,178  $20,752  $1,640,799  $17,078 
Ginnie Mae  1,488,160   18,232   1,146,235   13,102 
Freddie Mac  805,590   9,225   291,940   3,199 
Total - MSRs $4,173,928  $48,209  $3,078,974  $33,379 

The following analysis focuses on the results generated during the years ended December 31, 2015 and December 31, 2014

Net Interest Income

The Company’s interest income is comprised of interest income generated from the Company’s mortgage loans held for investment, mortgage loans held for sale, non-Agency RMBS and Other Investment Securities. The Company’s interest expense is related to the Company’s warehouse lines of credit, the Loan Repurchase Facilities, securities repurchase agreements and the Exchangeable Senior Notes.

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 The Company’s net interest income for the years ended December 31, 2015 and December 31, 2014 was as follows:

  Year Ended 
  December 31,
2015
  December 31,
2014
 
  (dollars in thousands) 
Interest income $37,803  $41,593 
Interest expense  18,850   17,260 
Net interest income $18,953  $24,333 

The decrease in interest income was due to (i) a decrease in interest income of $0.2 million related to mortgage loans held for investment due to scheduled pay downs and payoffs and (ii) a decrease in interest income of $6.1 million related to RMBS; offset by an increase in interest income on mortgage loans held for sale of $2.6 million due to the acquisition of GMFS on October 31, 2014. The reduction in interest income from the RMBS portfolio is primarily due to the reallocation of capital to whole loans in 2014 consistent with the Company’s investment strategy and the sales of RMBS during the three months ended December 31, 2014 to fund the acquisition of GMFS.

The increase in interest expense was due to (i) an increase in interest expense of $2.0 million related to an increase in borrowings on the warehouse lines of credit and repurchase agreements used to finance the Company’s mortgage loans held for sale; (ii) an increase in interest expense of $0.5 million related to an increase in borrowings on the Company’s Loan Repurchase Facilities used to finance the Company’s residential mortgage loans held for investment; and (iii) an increase in interest expense of $0.1 million related to the issuance of the Exchangeable Senior Notes, offset by a decrease in interest expense of $1.1 million related to a decrease in borrowings on the securities repurchase agreements.

Net interest income is subject to interest rate risk. See Item 7A, “Quantitative and Qualitative Disclosures about Market Risk,” of this annual report on Form 10-K, for more information relating to interest rate risk and its impact on the Company’s operating results.

The weighted average net interest spreads between the yield on the Company’s assets and the cost of funds, including the impact of interest rate hedging, for the Company’s mortgage loans held for investment, non-Agency RMBS and Other Investment Securities at December 31, 2015 and December 31, 2014 were as follows:

  December 31,
2015
  December 31,
2014
 
Mortgage Loans Held for Investment  4.09%  4.02%
Non-Agency RMBS and Other Investment Securities  4.05%  5.18%

The Company’s net interest income is also impacted by prepayment speeds, as measured by the weighted average CPR on its assets. The three-month average and the six-month average CPR for the periods ended December 31, 2015 for the Company’s mortgage loans, non-Agency RMBS and Other Investment Securities were as follows:

  Three-Month
Average
  Six-Month
Average
 
Mortgage loans held for investment  1.7%  2.1%
Non-Agency RMBS(1)  9.9%  13.3%
Other Investment Securities  10.1%  11.2%

(1)CPR includes both voluntary and involuntary amounts.

Non-interest income

The Company’s non-interest income relates to the Company’s residential mortgage banking segment. The primary components of the Company’s non-interest income are its mortgage banking activities net, loan servicing income, net of direct costs and change in fair value of MSRs. For the years ended December 31, 2015 and December 31, 2014 the Company’s non-interest income included the following:

  Year Ended 
  December 31,
2015
  December 31,
2014
 
  (dollars in thousands) 
Gain on sale of mortgage loans held for sale, net of direct costs(1) $44,848  $5,344 
Loan expenses, including provision for loan indemnification  (762)  (119)
Loan origination fees  1,772   214 
Total - mortgage banking activities, net $45,858  $5,439 

(1)Includes the change in fair value related to IRLCs and MBS forward sales contracts held during the year ended December 31, 2015.

64

  Year Ended 
  December 31,
2015
  December 31,
2014
 
  (dollars in thousands) 
Loan servicing fee income $10,641  $1,413 
Sub-servicing costs  (3,549)  (483)
Total loan servicing fee income, net of direct costs $7,092  $930 
         
Change in fair value of MSRs $(4,128)  (1,684)

Non-interest income for the year ended December 31, 2014 reflects the income recognized from October 31, 2014 (the date the Company acquired GMFS) to December 31, 2014.

Expenses

Advisory Fee Expense (Related Party). Pursuant to the terms of the Investment Advisory Agreement, the Company incurred advisory fee expense and loan sourcing fees of $3.0 million for the year ended December 31, 2015 and $2.9 million for the year ended December 31, 2014. The increase of $0.1 million is due to an increase in loan sourcing fees due to the increased activity during 2015.

Salaries, commissions and benefits. For the year ended December 31, 2015, the Company incurred salaries, commissions and benefits of $30.9, as compared to $3.8 million for the year ended December 31, 2014. These expenses are directly attributable to the mortgage banking operations of GMFS. The amount for 2014 reflects the expenses recognized from October 31, 2014 (the date the Company acquired GMFS) to December 31, 2014.

Operating Expenses

Professional Fees. For the year ended December 31, 2015, the Company incurred professional fees (primarily related to legal fees, audit fees and consulting fees) of $4.1 million as compared to $4.8 million for the year ended December 31, 2014. The decrease in professional fees was primarily due to legalsales and audit fees incurred for the GMFS transaction and legal fees incurredpay-downs on MBS, resulting in conjunction with the launch of the loan conduit program in 2014.

General and Administrative Expense. For the year ended December 31, 2015, general and administrative expenses were $8.2 million as compared to $3.2 million for the year ended December 31, 2014. The increase in general and administrative expenses was primarily due to an increase of $4.0 million of GMFS expenses, an increase in research fees of $0.5 million; offset by a decrease in the contingent consideration liability of $0.1 million. The amounts relating to GMFS primarily relate to (i) rent and related occupancy expenses, (ii) marketing and advertising costs and (iii) other miscellaneous expenses. The expenses related to GMFS in 2014 reflect the expenses recognized from October 31, 2014 (the date the Company acquired GMFS) to December 31, 2014.

Other Expenses

Loan Servicing Fees. For the year ended December 31, 2015, loan servicing fees were $2.6 million, as compared to $2.2 million for the year ended December 31, 2014. The increase in loan servicing fees was due to a full year of servicing fees incurred in 2015 related to the acquisition of additional whole loans in March 2014 and increased servicing advances.

Transaction Costs. For the year ended December 31, 2015, transaction costs were $1.2 million as compared to $2.2 million for the year ended December 31, 2014. The decrease in transaction costs was largely attributable to due diligence costs and professional fees of $2.2 million related to the Company’s acquisition of GMFS incurred in 2014, which were partially offset by an increase in transaction costs in 2015 relating to the strategic alternatives being considered by the Company.

Amortization Expense.For the year ended December 31, 2015, amortization expense was $0.8 million as compared to $0.1 million for the year ended December 31, 2014. The increase is due to the amortization of the other intangible assets relating to the Company’s acquisition of GMFS on October 31, 2014.

Realized and Change in Unrealized Gain or Loss

The following amounts related to realized gains and losses, as well as changes in the estimated fair value of the Company’s investment portfolio, which consists of mortgage loans, RMBS, Other Investment Securities, real estate owned and derivative instruments, are included in the Company’s consolidated statements of operations.

65

  Year Ended 
  December 31,  December 31, 
  2015  2014 
  (dollars in thousands) 
Change in unrealized gain or loss on mortgage loans held for investment $(9,369) $22,814 
Change in unrealized gain or loss on real estate securities  (4,851)  (2,994)
Change in unrealized gain or loss on Other Investment Securities  (334)  (226)
Change in unrealized gain or loss on real estate owned  (435)  (504)
Realized gain on mortgage loans held for investment  1,479   1,839 
Realized gain on real estate securities  19   3,694 
Realized (loss)/gain on Other Investment Securities  (155)  227 
Realized (loss)/gain on real estate owned  (160)  2 
Loss on derivative instruments related to investment portfolio  (172)  (5,921)
Total other (losses)/gains $(13,978) $18,931 

There was no other than temporary impairment (“OTTI”) for RMBS for the years ended December 31, 2015 or December 31, 2014.

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

The Company recorded in earnings as loss on derivative instruments the change in fair value related to (i) an interest rate swaption agreement held during the year ended December 31, 2014 (ii) interest rate swap agreements held during the years ended December 31, 2015 and December 31, 2014 (iii) LPCs held during the years ended December 31, 2015 and December 31, 2014 and (iv) the conversion option related to the Exchangeable Senior Notes held during the years ended December 31, 2015 and December 31, 2014. The loss on derivative instruments also includes the net interest rate swap payments for the derivative instruments.

The Company has elected to record the change in fair value related to certain mortgage loans held for investment, mortgage loans held for sale, RMBS, Other Investment Securities and MSRs in earnings by electing the fair value option.

Dividends

During 2015, the Company declared the following dividends:

Declaration Date Record Date Payment Date Amount per
Share and
OP Unit
 
March 19, 2015 March 31, 2015 April 15, 2015 $0.40 
June 18, 2015 June 30, 2015 July 15, 2015 $0.40 
September 17, 2015 September 30, 2015 October 15, 2015 $0.40 
December 17, 2015 December 31, 2015 January 15, 2016 $0.40 

The following analysis focuses on the results generated during the years ended December 31, 2014 and December 31, 2013

Net Interest Income

The Company’s interest income is comprised of interest income generated from the Company’s mortgage loans held for investment, mortgage loans held for sale, non-Agency RMBS and Other Investment Securities. The Company’s interest expense is related to the Company’s warehouse lines of credit, the Loan Repurchase Facilities, securities repurchase agreements and the Exchangeable Senior Notes.

The Company’s net interest income for the years ended December 31, 2014 and December 31, 2013 was as follows:

  Year Ended 
  December 31,
2014
  December 31,
2013
 
  (dollars in thousands) 
Interest income $41,593  $26,418 
Interest expense  17,260   7,094 
Net interest income $24,333  $19,324 

66

The increase in interest income was due to having a fully levered portfolio primarily allocated to residential mortgage loans during the year ended December 31, 2014, compared to the first half of the prior year when the Company had more of its equity allocated to RMBS. The purchase of whole loans into the portfolio resulted in a $16.3 million increase in interest income in the year ended December 31, 2014, compared to the prior year. This increase was partially offset by a reduction in interest income, from the RMBS portfolio of $1.1 million primarilyas well as a reduction in interest income on loans due to the reallocationdecrease in accretion of capital to whole loans consistent withdiscount on the Company’s investment strategyacquired loan portfolio and a change in the sales of RMBS duringweighted average interest rate on the three months ended December 31, 2014 to fund the acquisition of GMFS.originated portfolio and principal pay-downs on existing loans.

 

The increase

Incentive Distribution Payable to Our Manager

Under the partnership agreement of our operating partnership, our Manager, the holder of the Class A special unit in interest expense was dueour operating partnership, is entitled to (i)receive an increaseincentive distribution, distributed quarterly in interest expense of $0.1 million related toarrears in an increase in borrowings on the warehouse lines of credit and repurchase agreements used to finance the Company’s mortgage loans held for sale; (ii) an increase in interest expense of $5.3 million related to an increase in borrowings on the Company’s Loan Repurchase Facilities used to finance the Company’s residential mortgage loans held for investment; and (iii) an increase in interest expense of $5.1 million relatedamount not less than zero equal to the issuancedifference between (i) the product of (A) 15% and (B) the difference between (x) core earnings (as described below) of our operating partnership, on a rolling four-quarter basis and before the incentive distribution for the current quarter, and (y) the product of (1) the weighted average of the Exchangeable Senior Notes, offset by a decreaseissue price per share of common stock or operating partnership unit (“OP unit”) (without double counting) in interest expenseall of $0.4 million related to a decrease in borrowings on the securities repurchase agreements.

Net interest income is subject to interest rate risk. See Item 7A, “Quantitative and Qualitative Disclosures about Market Risk,” of this annual report on Form 10-K, for more information relating to interest rate risk and its impact on the Company’s operating results.

The weighted average net interest spreads between the yield on the Company’s assets and the cost of funds, including the impact of interest rate hedging, for the Company’s mortgage loans held for investment, non-Agency RMBS and Other Investment Securities at December 31, 2014 and December 31, 2013 were as follows:

  December 31,
2014
  December 31,
2013
 
Mortgage loans Held for Investment  4.02%  3.91%
Non-Agency RMBS and Other Investment Securities  5.18%  4.61%

The Company’s net interest income is also impacted by prepayment speeds, as measuredour offerings multiplied by the weighted average CPR on its assets. The three-month averagenumber of shares of common stock outstanding (including any restricted shares of common stock and any other shares of common stock underlying awards granted under our 2012 equity incentive plan) and OP units (without double counting) in such quarter and (2) 8%, and (ii) the six-month average CPRsum of any incentive distribution paid to our Manager with respect to the first three quarters of such previous four quarters; provided, however, that no incentive distribution is payable with respect to any calendar quarter unless cumulative core earnings is greater than zero for the periods ended December 31, 2014 formost recently completed 12 calendar quarters, or the Company’s mortgage loans, non-Agency RMBS and Other Investment Securities were as follows:number of completed calendar quarters since the closing date of the ZAIS Financial merger, whichever is less.

 

  Three-Month
Average
  Six-Month
Average
 
Mortgage loans held for investment  10.30%  6.85%
Non-Agency RMBS(1)  13.23%  12.97%
Other Investment Securities  9.69%   

(1)CPR includes both voluntary and involuntary amounts.

Non-interest incomeFor purposes of calculating the incentive distribution prior to the completion of a 12-month period following the closing of the ZAIS Financial merger, core earnings was calculated on an annualized basis. In addition, for purposes of calculating the incentive distribution, the shares of common stock and OP units issued as of the closing of the ZAIS Financial merger in connection with the merger agreement were deemed to be issued at the per share price equal to (i) the sum of (A) the weighted average of the issue price per share of Sutherland common stock or Sutherland OP units (without double counting) issued prior to the closing of the ZAIS Financial merger multiplied by the number of shares of Sutherland common stock outstanding and Sutherland OP units (without double counting) issued prior to the closing of the merger plus (B) the amount by which the net book value of our Company as of the closing of the merger (after giving effect to the closing of the merger agreement) exceeded the amount of the net book value of Sutherland immediately preceding the closing of the merger, divided by (ii) all of the shares of our common stock and OP units issued and outstanding as of the closing of the merger (including the date of the closing of the mergers).

 

The Company’s non-interest income relatesincentive distribution shall be calculated within 30 days after the end of each quarter and such calculation shall promptly be delivered to our Company. We are obligated to pay the incentive distribution 50% in cash and 50% in either common stock or OP units, as determined in our discretion, within five business days after delivery to our Company of the written statement from the holder of the Class A special unit setting forth the computation of the incentive distribution for such quarter. Subject to certain exceptions, our Manager may not sell or otherwise dispose of any portion of the incentive distribution issued to it in common stock or OP units until after the three year anniversary of the date that such shares of common stock or OP units were issued to our Manager. The price of shares of our common stock for purposes of determining the number of shares payable as part of the incentive distribution is the closing price of such shares on the last trading day prior to the Company’s residential mortgage banking segment. The primary componentsapproval by our board of the Company’s non-interest income are its mortgage banking activities, loan servicing income, net of direct costs and change in fair value of MSR. For the year ended December 31, 2014 the Company’s non-interest income included the following:

  (dollars in thousands) 
Gain on sale of mortgage loans held for sale, net of direct costs(1) $5,344 
Loan expenses, including provision for loan indemnification  (119)
Loan origination fees  214 
Total - mortgage banking activities, net $5,439 

(1)Includes the change in fair value related to IRLCs and MBS forward sales contracts held during the year ended December 31, 2014.

  (dollars in thousands) 
Loan servicing fee income $1,413 
Sub-servicing cost  (483)
Total loan servicing fee income, net of direct costs $930 
     
Change in fair value of MSRs $(1,684)

Non-interest income for the year ended December 31, 2014 reflects the income recognized from October 31, 2014 (the date the Company acquired GMFS) to December 31, 2014. The Company did not have any noninterest income during the year ended December 31, 2013.

67

Expensesincentive distribution.

 

Advisory Fee Expense (Related Party). PursuantFor purposes of determining the incentive distribution payable to our Manager, core earnings is defined under the partnership agreement of our operating partnership in a manner that is similar to the termsdefinition of Core Earnings described above under "Non-GAAP Financial Measures" but with the following additional adjustments which (i) further exclude: (a) the incentive distribution, (b) non-cash equity compensation expense, if any, (c) unrealized gains or losses on SBC loans (not just MBS and MSRs), (d) depreciation and amortization (to the extent we foreclose on any property), and (e) one-time events pursuant to changes in U.S. GAAP and certain other non-cash charges after discussions between our

98


Manager and our independent directors and after approval by a majority of the Investment Advisory Agreement,independent directors and (ii) add back any realized gains or losses on the Company incurred advisory fee expensesales of $2.9 million for the year ended December 31, 2014, as compared to $2.6 million for the year ended December 31, 2013. The increase in advisory fee expense was due to an increase in stockholders’ equity resultingMBS and on discontinued operations which were excluded from the Company’s February 2013 IPO.

Salaries, commissions and benefits. For the year ended December 31, 2014, salaries, commissions and benefits were $3.8 million and were directly attributable to the mortgage banking operationsdefinition of GMFS. The Company did not incur salaries, commissions and benefits expense for the year ended December 31, 2013.The amount for 2014 reflects the expenses recognized from October 31, 2014 (the date the Company acquired GMFS) to December 31, 2014.

Operating Expenses

Professional Fees .. For the year ended December 31, 2014, the Company incurred professional fees (primarily related to legal fees, audit fees and consulting fees) of $4.8 million as compared to $3.5 million for the year ended December 31, 2013. The increase in professional fees was primarily due to legal and audit fees incurred for the GMFS transaction and legal fees incurred in conjunction with the launch of the loan conduit program.

General and Administrative Expenses . For the year ended December 31, 2014, general and administrative expenses were $3.2 million as compared to $2.0 million for the year ended December 31, 2013. The increase in general and administrative expenses was primarily due to $0.8 million of GMFS expenses and an increase in research fees and insurance costs, partially offset by a decrease in public company expenses. The amounts relating to GMFS for 2014 reflects the expenses recognized from October 31, 2014 (the date the Company acquired GMFS) to December 31, 2014.

Other Expenses

Loan Servicing Fees. For the year ended December 31, 2014, loan servicing fees were $2.2 million, as compared to $0.9 million for the year ended December 31, 2013. The increase in loan servicing fees was due to the acquisition of additional whole loans and increased servicing advances.

Transaction Costs. For the year ended December 31, 2014, transaction costs were 2.2 million as compared to $0.6 million for the year ended December 31, 2013. The increase in transaction costs was largely attributable to due diligence costs and professional fees of $2.2 million related to the Company’s acquisition of GMFS, which were partially offset by a decrease in whole loan transaction costs.

Realized and Change in Unrealized Gain or Loss

The following amounts related to realized gains and losses, as well as changes in estimated fair value of the Company’s investment portfolio which consists of mortgage loans, RMBS, Other Investment Securities, real estate owned and derivative instruments are included in the Company’s consolidated statements of operations.

  Year Ended 
  December 31,  December 31, 
  2014  2013 
  (dollars in thousands) 
Change in unrealized gain or loss on mortgage loans held for investment $22,814  $7,136 
Change in unrealized gain or loss on real estate securities  (2,994)  (7,171)
Change in unrealized gain or loss on Other Investment Securities  (226)   
Change in unrealized gain or loss on real estate owned  (504)   
Realized gain on mortgage loans held for investment  1,839   1,299 
Realized gain/(loss) on real estate securities  3,694   (9,046)
Realized gain on Other Investment Securities  227    
Realized gain on real estate owned  2    
(Loss)/gain on derivative instruments related to investment portfolio  (5,921)  5,615 
Total other gains/(losses) $18,931  $(2,167)

There was no other than temporary impairment (“OTTI”) for RMBS for the year ended December 31, 2014. Realized gain on real estate securities includes realized losses relating to OTTI of $1.1 million for the year ended December 31, 2013.

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

68

The Company recorded the change in fair value related to (i) an interest rate swaption agreement held during the year ended December 31, 2014, (ii) interest rate swap agreements held during the years ended December 31, 2014 and December 31, 2013, (iii) TBAs held during the year ended December 31, 2013 and (iv) LPCs held during the year ended December 31, 2014 in earnings as (loss)/gain on derivative instruments. Included in (loss)/gain on derivative instruments are the net interest rate swap payments and net TBA payments for the derivative instruments.

The Company has elected to record the change in fair value related to certain mortgage loans held for investment, mortgage loans held for sale, RMBS, Other Investment Securities and MSRs in earnings by electing the fair value option.

Dividends

During 2014, the Company declared the following dividends:

Declaration Date Record Date Payment Date Amount per
Share and
OP Unit
 
March 19, 2014 March 31, 2014 April 14, 2014 $0.40 
June 17, 2014 June 30, 2014 July 15, 2014 $0.40 
September 17, 2014 September 30, 2014 October 15, 2014 $0.40 
December 18, 2014 December 31, 2014 January 15, 2015 $0.40 

Critical Accounting Policies and Use of Estimates

See “Notes to ConsolidatedCore Earnings described above under "Non-GAAP Financial Statements, Note 2 – Summary of Significant Accounting Policies” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for the Company’s Critical Accounting Policies and Use of Estimates.Measures".

 

Liquidity and Capital Resources

 

Liquidity is a measure of the Company'sour ability to turn non-cash assets into cash and to meet potential cash requirements. The Company usesWe use significant cash to purchase SBC loans and other target assets, originate new SBC loans, pay dividends, repay principal and interest on itsour borrowings, fund itsour operations and meet other general business needs. The Company'sOur primary sources of liquidity are itswill include our existing cash balances, borrowings, under warehouse lines of credit andincluding securitizations, re-securitizations, repurchase agreements, related to the GMFS mortgage banking platform, the Loan Repurchase Facilities, securities repurchase agreements,warehouse facilities, bank credit facilities (including term loans and revolving facilities), the net proceeds fromof this and future offerings of equity and debt securities, notes issued by the Operating Partnership,including our Senior Secured Notes and Convertible Notes, and net cash provided by operating activities, additional private funding sources, including other borrowings structured as repurchase agreements, term financingsactivities.

Cash Flow Activity for the Years Ended December 31, 2017, 2016, and derivative agreements, and future issuances of common equity, preferred equity, convertible securities, exchangeable notes, trust preferred and/or debt securities.2015

 

The borrowingsfollowing table provides a summary of the Companynet change in our cash and cash equivalents:

 

 

 

 

 

 

 

 

 

 

 

 

For the years ended December 31,

(in thousands)

 

2017

 

2016

 

2015

Cash flows provided by (used in) operating activities (1)

 

$

352,489

 

$

14,763

 

$

28,929

Cash flows provided by (used in) investing activities (1)

 

 

(242,234)

 

 

384,695

 

 

(188,689)

Cash flows provided by (used in) financing activities

 

 

(106,396)

 

 

(381,461)

 

 

144,589

 

 

 

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

$

3,859

 

$

17,997

 

$

(15,171)

(1) Includes discontinued operations

 

 

 

 

 

 

 

 

 

Year ended December 31, 2017 compared to the year ended December 31, 2016

Cash and cash equivalents increased by $3.9 million during the year ended December 31, 2017, reflecting:

·

Net cash provided by operating activities of $352.5 million for the year related primarily to:

-

Proceeds on sales and principal payments of loans, held for sale, at fair value of $2.6 billion, offset by $2.5 billion of originations and purchases of loans, held for sale, at fair value.

-

Proceeds from sales or maturity of short-term investments and trading securities of $1.2 billion, offset by $839.4 million of purchases of short-term investments and trading securities.

·

Net cash used in investing activities of $242.2 million for the current year related primarily to:

-

Cash outflows of $602.3 million relating to originations and purchases of loans, held at fair value and held-for-investment loans, offset by cash inflows relating to repayments of loans, held at fair value and held-for-investment of $422.1 million. 

-

Cash outflows of $54.3 million relating to a joint venture investments and $14.4 million of cash outflows relating to purchases of MBS.

·

Net cash used in financing activities of $106.4 million for the current quarter related primarily to:

-

Proceeds provided by our convertible note issuance of approximately $115.0 million and proceeds provided by our senior secured notes of approximately $142.0 million, offset by net repayments of secured borrowings $296.2 million.

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Year ended December 31, 2016 compared to the year ended December 31, 2015

Cash and cash equivalents increased by $18.0 million during the year ended December 31, 2016, reflecting:

·

Net cash provided by operating activities of $14.8 million for the year related primarily to:

-

Proceeds on sales of loans, held for sale, at fair value of $646.0 million, offset by $621.3 million of originations and purchases of loans, held for sale, at fair value.

·

Net cash provided by investing activities of $384.7 million for the current year related primarily to:

-

Cash inflows of $480.0 million relating to repayments of loans, held at fair value and held-for-investment, offset by cash outflows of $414.0 million relating to originations and purchases of loans, held at fair value and held-for-investment loans.

-

Cash inflows of $297.3 million relating to sales of MBS, offset by cash outflows relating to purchases of MBS of $17.4 million.

·

Net cash used in financing activities of $381.5 million for the current quarter related primarily to:

-

Net repayments of our secured borrowings of $187.5 million, dividend payments on our common stock of $46.9 million, net repayments of guaranteed loan financing of $122.6 million and a $57.5 million repayment of our senior exchangeable note.

Securitization Activity

Our Manager’s extensive experience in loan acquisition, origination, servicing and securitization strategies has enabled us to complete several securitizations of SBC and SBA loan assets since January 2011. These securitizations allow us to match fund the SBC and SBA loans on a long-term, non-recourse basis. Four of these securitizations, including Waterfall Victoria Mortgage Trust 2011-1 (“SBC-1”), Waterfall Victoria Mortgage Trust 2011-3 (“SBC-3”), Sutherland Commercial Mortgage Trust 2015-4 (“SBC-4”), and Sutherland Commercial Mortgage Trust 2017 (“SBC-6”) are trusts, whose debt is collateralized by non-performing and re-performing acquired SBC loans and a fifth securitization Waterfall Victoria Mortgage Trust 2011-2 (“SBC-2”) is a real estate mortgage investment conduit (“REMIC”) whose debt is collateralized by performing acquired SBC loans. We have completed three securitizations of newly originated SBC loans, each a REMIC, including ReadyCap Commercial Mortgage Trust 2014-1 (“RCMT 2014-1”), ReadyCap Commercial Mortgage Trust 2015-2 (“RCMT 2015-2”), and ReadyCap Commercial Mortgage Trust 2016-3 (“RCMT 2016-3”). We also completed Ready Capital Mortgage Financing 2017 (“RCMF 2017-FL1), a securitization whose debt is collateralized by originated transitional loans, and ReadyCap Lending Small Business Trust 2015-1 (“RCLSBL 2015-1”), a securitization collateralized by SBA Section 7(a) Program loans.

In addition, we completed three securitizations of newly originated multi-family Freddie Mac loans, including Freddie Mac Small Balance Mortgage Trust 2016-SB11 (“FRESB 2016-SB11”), Freddie Mac Small Balance Mortgage Trust 2016-SB18 (“FRESB 2016-SB18”), and Freddie Mac Small Balance Mortgage Trust 2017-SB33 (“FRESB 2017-SB33”).

The assets pledged as collateral for these securitizations were contributed from our portfolio of assets. By contributing these SBC and SBA assets to the various securitizations, these transactions created capacity for us to fund other investments.

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The following table presents information on the securitization structures and related issued tranches of notes to investors:

Deal Name

Asset Class

Issuance

Ratings

Bonds Issued

WVMT 2011-SBC1

SBC Acquired Loans

February 2011

NR

$

40.5 million

WVMT 2011-SBC2

SBC Acquired Loans

March 2011

DBRS

  97.6 million

WVMT 2011-SBC3

SBC Acquired Loans

October 2011

NR

143.4 million

SCML 2015-SBC4

SBC Acquired Loans

August 2015

NR

125.4 million

SCMT 2017-SBC6

SBC Acquired Loans

August 2017

NR

139.4 million

  Total - SBC Acquired loan securitizations

$

546.3 million

RCMT 2014-1

SBC Originated Conventional

September 2014

MDY / DBRS

$

181.7 million

RCMT 2015-2

SBC Originated Conventional

November 2015

MDY / Kroll

218.8 million

RCMT 2016-3

SBC Originated Conventional

November 2016

MDY / Kroll

162.1 million

  Total SBC Originated loan securitizations

$

562.6 million

RCMF 2017-FL1

SBC Originated Transitional

August 2017

MDY / Kroll

198.8 million

  Total Transitional loan securitizations

$

198.8 million

FRESB 2016-SB11

Originated Agency Multi-family

January 2016

GSE Wrap

110.0 million

FRESB 2016-SB18

Originated Agency Multi-family

July 2016

GSE Wrap

118.0 million

FRESB 2017-SB33

Originated Agency Multi-family

June 2017

GSE Wrap

197.9 million

  Total Freddie Mac Originated loan securitizations

$

425.9 million

RCLSBL 2015-1

SBA 7(a) Loans

June 2015

S&P

$

189.5 million

  Total SBA loan securitizations

$

189.5 million

       Total securitizations

$

1,923.1 million

We used the proceeds from the sale of the tranches issued to purchase and originate SBC and SBA loans.  We are the primary beneficiary of SBC-1, SBC-2, SBC-3, RCMT 2014-1, RCMT 2015-2, RCMT 2016-3, RCMF 2017-FL1, RCLSBL 2015-1, SBC-4, and SBC-6, therefore they are consolidated in our financial statements.

Deutsche Bank Loan Repurchase Facility

Our subsidiaries, ReadyCap Commercial, Sutherland Asset I, and Sutherland Warehouse Trust II renewed their master repurchase agreement on February 14, 2017, pursuant to which ReadyCap Commercial, Sutherland Asset I and Sutherland Warehouse Trust II may be advanced an aggregate principal amount of up to $275 million on originated mortgage loans (the “DB Loan Repurchase Facility”). As of December 31, 2017, we had $173.8 million outstanding under the DB Loan Repurchase Facility. The DB Loan Repurchase Facility is used to fundfinance SBC loans, and the purchaseinterest rate is LIBOR plus a spread, which varies depending on the type and age of itsthe loan. The DB Loan Repurchase Facility has been extended through February 2018 and our subsidiaries have an option to extend the DB Loan Repurchase Facility for an additional year, subject to certain conditions. ReadyCap Commercial’s, Sutherland Asset I’s, and Sutherland Warehouse Trust II’s obligations are fully guaranteed by us.

The eligible assets for the DB Loan Repurchase Facility are loans secured by a first mortgage lien on commercial properties subject to certain eligibility criteria, such as property type, geographical location, LTV ratios, debt yield and debt service coverage ratios. The principal amount paid by the bank for each mortgage loan is based on a percentage of the lesser of the mortgaged property value or the principal balance of such mortgage loan. ReadyCap Commercial, Sutherland Asset I, and Sutherland Warehouse Trust II paid the bank an up-front fee and are also required to pay the bank availability fees, and a minimum utilization fee for the DB Loan Repurchase Facility, as well as certain other administrative costs and expenses. The DB Loan Repurchase Facility also includes financial maintenance covenants, which include (i) an adjusted tangible net worth that does not decline by more than 25% in a quarter, 35% in a year or 50% from the highest adjusted tangible net worth, (ii) a minimum liquidity amount of the greater of (a) $5 million and (b) 3% of the sum of any outstanding recourse indebtedness plus the aggregate repurchase price of the mortgage loans heldon the Repurchase Agreement, (iii) a debt-to-assets ratio no greater than 80% and (iv) a tangible net worth at least equal to the sum of (a) the product of 1/9 and the amount of all non-recourse indebtedness (excluding the aggregate repurchase price) and other securitization indebtedness and (b) the product of 1/3 and the sum of the aggregate repurchase price and all recourse indebtedness.

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JPMorgan Loan Repurchase Facility

Our subsidiaries, ReadyCap Warehouse Financing LLC (“ReadyCap Warehouse Financing”) and Sutherland Warehouse Trust entered into master repurchase agreement in December 2015, pursuant to which ReadyCap Warehouse Financing and Sutherland Warehouse Trust, may sell, and later repurchase, mortgage loans in an aggregate principal amount of up to $250 million. Our subsidiaries renewed their master repurchase agreement with JPMorgan on December 8, 2017 for investment and RMBS totaled $426.6an aggregate principal amount of up to $200 million at(the “JPM Loan Repurchase Facility”). As of December 31, 20152017, we had $55.4 million outstanding under the JPM Loan Repurchase Facilities, masterFacility. The JPM Loan Repurchase Facility is used to finance commercial transitional loans, conventional commercial loans and commercial mezzanine loans and securities repurchase agreements with four counterparties and the Exchangeable Senior Notes. Additionally,interest rate is LIBOR plus a spread, which is determined by the borrowings GMFS used to fund its origination platform totaled $100.8 million atlender on an asset-by-asset basis. The JPM Loan Repurchase Facility is committed through December 31, 2015 under its warehouse lines of credit10, 2020, and repurchase agreements with four lenders.ReadyCap Warehouse Financing’s and Sutherland Warehouse Trust’s obligations are fully guaranteed by us.

 

The eligible assets for the JPM Loan Repurchase FacilitiesFacility are loans secured by first and junior mortgage liens on commercial properties and subject to approval by JPM as the Buyer. The principal amount paid by the bank for each mortgage loan is based on the principal balance of such mortgage loan. ReadyCap Warehouse Financing and Sutherland Warehouse Trust paid the bank a structuring fee and are also required to pay the bank unused fees for the JPM Loan Repurchase Facility, as well as certain other administrative costs and expenses. The JPM Loan Repurchase Facility also includes financial maintenance covenants, which include (i) total stockholders’ equity must not be permitted to be less than the sum of (a) 60% of total stockholders equity as of the closing date of the facility plus (b) 50% of the net proceeds of any equity issuance after the closing date (ii) maximum leverage of 3:1 and (iii) liquidity equal to at least the lesser of (a) 4% of the sum of (without duplication) (1) any outstanding indebtedness plus (2) amounts due under the repurchase agreement and (b) $15,000,000.

Citibank Loan Repurchase Agreement

Our subsidiaries, Waterfall Commercial Depositor and Sutherland Asset I renewed a master repurchase agreement in June 2017 with Citibank, N.A. (the "Citi Loan Repurchase Facility" and, together with the DB Loan Repurchase Facility and the JPM Loan Repurchase Facility, the "Loan Repurchase Facilities"), pursuant to which Waterfall Commercial Depositor and Sutherland Asset I may sell, and later repurchase, a trust certificate (the “Trust Certificate”), representing interests in mortgage loans in an aggregate principal amount of up to $200 million, $125 million of which is committed. As of December 31, 2017, we had $88.1 million outstanding under the Citi Loan Repurchase Facility. The Citi Loan Repurchase Facility is used to finance SBC loans, and the interest rate is LIBOR plus 3.00%. The Citi Loan Repurchase Facility is committed for a period of 364 days, and Waterfall Commercial Depositor’s and Sutherland Asset I’s obligations are fully guaranteed by us.

The eligible assets for the Citi Loan Repurchase Facility are loans secured by a first mortgage lien on commercial properties which, amongst other things, generally have a UPB of less than $10 million. The principal amount paid by the bank for the Trust Certificate is based on a percentage of the lesser of the market value or the UPB of such mortgage loans backing the Trust Certificate. Waterfall Commercial Depositor and Sutherland Asset I  are also required to pay the bank a commitment fee for the Citi Loan Repurchase Facility, as well as certain other administrative costs and expenses. The Citi Loan Repurchase Facility also includes financial maintenance covenants, which include (i) our operating partnership’s net asset value not (A) declining more than 15% in any calendar month, (B) declining more than 25% in any calendar quarter, (C) declining more than 35% in any calendar year, or (D) declining more than 50% from our operating partnership’s highest net asset value set forth in any audited financial statement provided to the bank; (ii) our operating partnership maintaining liquidity in an amount equal to at least 1% of our outstanding indebtedness; and (iii) the ratio of our operating partnership’s total indebtedness (excluding non-recourse liabilities in connection with any securitization transaction) to our net asset value not exceeding 4:1 at any time.

Securities Repurchase FacilitiesAgreements

 

As of December 31, 2017, we had $23.3 million and $42.1 million of secured borrowings related to SBC ABS and pledged Trust Certificates, respectively, with three counterparties (lenders).

General Statements Regarding Loan and Security Repurchase Facilities

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At December 31, 2015, the Company2017, we had a total of $394.9$557.1 million in fair value of trust certificates representing interests in residential mortgageTrust Certificates and loans (the "Trust Certificates") pledged against itsour borrowings under the Loan Repurchase Facilities $95.6and $37.4 million in fair value of RMBSSBC ABS and $2.0 million of Other Investment Securitiesshort term investments pledged against itsour securities repurchase agreement borrowings, and GMFS had $116.0 million in fair value of mortgage loans held for sale pledged against its repurchase agreement borrowings and warehouse lines of credit.borrowings.

 

Under the Loan Repurchase Facilities and securities repurchase agreements, the Companywe may be required to pledge additional assets to itsour counterparties (lenders) in the event that the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral, which may take the form of additional assets or cash. Generally, the Company'sLoan Repurchase Facilities and securities repurchase agreements contain a LIBOR-based financing rate, term and haircuts depending on the types of collateral and the counterparties involved. Further, at December 31, 2015,2017, the range ofaverage haircut provisions associated with the Company'sour repurchase agreements was between 10% and 28%33.0% for pledged Trust Certificates 15% and 35%loans and was 33.0% and 30.9% for pledged non-Agency RMBS,SBC ABS and 0% and 5% for pledged mortgage loans held for sale. The haircut provision associated with the Company’s repurchase agreements for Other Investment Securities was 30%.short-term investments, respectively.

The Loan Repurchase Facilities 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. Additionally, the repurchase agreements used to finance the Company’s mortgages held for sale 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 as of and for the years ended December 31, 2015 and December 31, 2014.

69

 

If the estimated fair value of the assets increases due to changes in market interest rates or market factors, lenders may release collateral back to the Company. Specifically, marginus. Margin calls may result from a decline in the value of the investments securing the Company'sLoan Repurchase Facilities and securities repurchase agreements, prepayments on the mortgagesloans securing such investments and from changes in the estimated fair value of such investments generally due to principal reduction of such investments from scheduled amortization and resulting from changes in market interest rates and other market factors. Counterparties also may choose to increase haircuts based on credit evaluations of theour Company and/or the performance of the assets in question. Historically, disruptions in the financial and credit markets have resulted in increased volatility in these levels, and this volatility could persist as market conditions continue to change rapidly.change. Should prepayment speeds on the mortgages underlying the Company'sour investments or market interest rates suddenly increase, margin calls on the Company'sLoan Repurchase Facilities and securities repurchase agreements could result, causing an adverse change in itsour liquidity position. To date, the Company haswe have satisfied all of itsour margin calls and hashave never sold assets in response to any margin call under these borrowings.

 

The Loan Repurchase Facilities are used to fund purchases of the Company's mortgage loans held for investment. The Citi Loan Repurchase Facility closed on May 30, 2013 with a borrowing capacity of $250.0 million, of which $150.0 million was committed for a period of 364 days from inception. On March 27, 2014, the Company entered into an amendment of the Citi Loan Repurchase Facility providing it with an additional $75.0 million of uncommitted borrowing capacity. On May 22, 2015 the Company entered into an amendment with Citi extending the termination date of the facility to May 20, 2016. The obligations are fully guaranteed by the Company. The Company is required to pay Citi a commitment fee, as well as certain other administrative costs and expenses in connection with Citi's structuring, management and ongoing administration of the Citi Loan Repurchase Facility.

On August 14, 2014, the Company entered into the Credit Suisse Loan Repurchase Facility, pursuant to which the Company may sell, and later repurchase, a trust certificate representing ownership interests in a trust holding residential mortgage loans in aggregate principal amount of up to $100 million, all of which was committed. The Credit Suisse Loan Repurchase Facility was committed for a period of 364 days from inception and the obligations are fully guaranteed by the Company. On June 29, 2015, the Company entered into an amendment with Credit Suisse to reduce the committed amount to $25.0 million and extend the maturity date to June 27, 2016. The Company is required to pay Credit Suisse a commitment fee, as well as certain other administrative costs and expenses in connection with Credit Suisse's structuring, management and ongoing administration of the Credit Suisse Loan Repurchase Facility.

The Company'sOur borrowings under repurchase agreements are renewable at the discretion of itsour lenders and, as such, the Company'sour ability to roll-over such borrowings is not guaranteed. The terms of the repurchase transaction borrowings under the Company'sour repurchase agreements generally conform to the terms in the standard master repurchase agreement as published by SIFMA,the Securities Industry and Financial Markets Association, as to repayment, margin requirements and the segregation of all assets the Company haswe have initially sold under the repurchase transaction. In addition, each lender typically requires that the Companywe include supplemental terms and conditions to the standard master repurchase agreement. Typical supplemental terms and conditions, which differ by lender, may include changes to the margin maintenance requirements, required haircuts and purchase price maintenance requirements, requirements that all controversies related to the repurchase agreement be litigated in a particular jurisdiction, and cross default and setoff provisions.

 

Loan Repurchase FacilitiesJPMorgan Credit Facility

 

The following tables present certain information regarding the Loan Repurchase FacilitiesWe renewed our master loan and security agreement with JPMorgan in the Company’s residential mortgage investments segment atJune 2017 providing for a credit facility of up to $250 million. As of December 31, 20152017, we had $60.5 million outstanding under this credit facility. The credit facility is structured as a secured loan facility in which ReadyCap Lending and Sutherland 2016‑1 JPM Grantor Trust act as borrowers. Under this facility, ReadyCap and Sutherland 2016-1 JPM Grantor Trust pledge loans guaranteed by the SBA under the SBA Section 7(a) Loan Program, SBA 504 loans and other loans which were part of the CIT loan acquisition. We act as a guarantor under this facility. The agreement contains financial maintenance covenants, which include (i) total stockholders’ equity must not be permitted to be less than the sum of (a) 60% of total stockholders equity as of the closing date of the facility plus (b) 50% of the net proceeds of any equity issuance after the closing date (ii) maximum leverage of 3:1 and (iii) liquidity equal to at least the lesser of (a) 4% of the sum of (without duplication) (1) any outstanding indebtedness plus (2) amounts due under the repurchase agreement and (b) $25,000,000. The amended terms have an interest rate based on loan type ranging from three month LIBOR (reset daily), plus 3.25-3.5% per annum. The term of the facility is one year, with an option to extend for an additional year.

At December 31, 2014:

  December 31,
2015
  

December 31,

2014

 
  (dollars in thousands) 
Total facility size $425,000  $425,000 
Counterparties  2   2 

  December 31, 2015  December 31, 2014 
  (dollars in thousands) 
  Balance  Weighted
Average Rate
  Balance  Weighted 
Average Rate
 
Maturity            
91-180 days $296,789   3.14% $299,402   2.92%
181 days to 1 year        690   2.46%
Total balance and weighted average rate $296,789   3.14% $300,092   2.92%

The Loan Repurchase Facilities are secured by2017, we had a portionleverage ratio of the Company’s mortgage loan portfolio and bear interest at1.6x on a rate that has historically moved in close relationship to LIBOR.

70

Securities Repurchase Agreementsdebt-to-equity basis.

 

The following tables presentWe maintain certain information regardingassets, which, from time to time, may include cash, unpledged SBC loans, SBC ABS and short term investments (which may be subject to various haircuts if pledged as collateral to meet margin requirements) and collateral in excess of margin requirements held by our counterparties, or collectively, the Company’s securities repurchase agreements“Cushion”, to meet routine margin calls and protect against unforeseen reductions in its residential mortgageour borrowing capabilities. Our ability to meet future margin calls will be impacted by the Cushion, which varies based on the fair value of our investments, segment atour cash position and margin requirements. Our cash position fluctuates based on the timing of our operating, investing and financing activities

103


and is managed based on our anticipated cash needs. At December 31, 2015 and2017, we were in compliance with all debt covenants.

At December 31, 2014:

  December 31, 
2015
  December 31, 
2014
 
Repurchase agreements  31   32 
Counterparties  4   4 

  December 31, 2015 
  Non-Agency RMBS  Other Investment 
Securities
 
  Balance  Weighted
Average Rate
  Balance  Weighted
Average Rate
 
  (dollars in thousands) 
Maturity            
30 days or less $71,911   1.80% $1,389   2.17%
Total balance/weighted average rate $71,911   1.80% $1,389   2.17%

  December 31, 2014 
  Non-Agency RMBS  Other Investment 
Securities
 
  Balance  Weighted
Average Rate
  Balance  Weighted
Average Rate
 
  (dollars in thousands) 
Maturity            
30 days or less $101,553   1.57% $1,461   1.66%
Total balance/weighted average rate $101,553   1.57% $1,461   1.66%

The securities repurchase agreements are secured by2017, we had $2.9 million of restricted cash collateralpledged against our derivative instruments and a portion of the Company’s RMBS and Other Investment Securities and bear interest at rates that have historically moved in close relationship to LIBOR.

Warehouse Lines of Credit

The borrowings GMFS used to fund its origination platform totaled $100.8 million at December 31, 2015, which includes borrowings under repurchase agreements with two lenders totaling $42.7 million. GMFS has a master repurchase agreement in aggregate principal amount of up to $65.0 million, of which the entire $65.0 million is committed, expiring on November 25, 2016. GMFS also has a master repurchase agreement in aggregate principal amount of up to $20.0 million, of which the entire $20.0 million is committed, expiring on June 30, 2016.agreements.

 

In addition to the repurchase agreements described above, Other credit facilities

GMFS funds its origination platform through warehouse lines of credit with twofour counterparties with total borrowings outstanding of $58.1$94.7 million at December 31, 2015.2017. GMFS hasutilizes a $60.0$150 million committed warehouse line of credit agreement expiringwhich expired on September 26, 2016 andMarch 14, 2018, a $40.0$40 million committed warehouse line of credit expiring on August 13, 2016.11, 2018, and a $40 million committed warehouse line of credit expiring on May 31, 2018. On March 14, 2018, the Company extended our borrowings pursuant to the expired committed warehouse line of credit agreement. The amended agreement has a maximum advance amount of $125 million and a pricing rate of LIBOR plus 2.1% The lines are collateralized by the underlying mortgages and related documents and instruments and contain a LIBOR-based financing rate and term, haircut and collateral posting provisions which depend on the types of collateral and the counterparties involved. These 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 wasWe were in compliance with all significant debt covenants as of and for the yearsyear ended December 31, 20152017.

ReadyCap Holdings’ 7.50% Senior Secured Notes due 2022

On February 13, 2017, ReadyCap Holdings issued $75.0 million in aggregate principal amount of its 7.50% Senior Secured Notes due 2022 in a private placement. On June 13, 2017, ReadyCap Holdings, issued an additional $65.0 million in aggregate principal amount of 7.50% Senior Secured Notes due 2022, which have identical terms (other than issue date and at December 31, 2014.issue price) to the notes issued on February 13, 2017 (collectively “Senior Secured Notes”). The additional $65.0 million in Senior Secured Notes were priced with a yield-to-maturity of 6.75%. The Senior Secured Notes are senior secured obligations of ReadyCap Holdings. Payments of the amounts due on the Senior Secured Notes are fully and unconditionally guaranteed by the Guarantors, Sutherland Partners LP, Sutherland Asset I, LLC, and ReadyCap Commercial, LLC.

 

The following tables present certain information regardingSenior Secured Notes bear interest at 7.50% per annum payable semiannually on each February 15 and August 15, beginning on August 15, 2017. The Senior Secured Notes will mature on February 15, 2022, unless redeemed or repurchased prior to such date. ReadyCap Holdings may redeem the Company's warehouse linesSenior Secured Notes prior to November 15, 2021, at its option, in whole or in part at any time and from time to time, at a price equal to 100% of creditthe outstanding principal amount thereof, plus the applicable “make-whole” premium as of, and repurchase agreementsunpaid interest, if any, accrued to, the redemption date. On and after November 15, 2021, ReadyCap Holdings may redeem the Senior Secured Notes, at its option, in its residential mortgage banking segmentwhole or in part at December 31, 2015any time and December 31, 2014:from time to time, at a price equal to 100% of the outstanding principal amount thereof plus unpaid interest, if any, accrued to the redemption date.

 

  December 31,
2015
  December 31,
2014
 
  (dollars in thousands) 
Availability $185,000  $130,000 
Counterparties  4   4 

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  December 31, 2015  December 31, 2014 
  Balance  Weighted
Average Rate
  Balance  Weighted
Average Rate
 
Maturity (dollars in thousands) 
30 days or less $   % $21,210   2.47%
31 – 90 days            
181 days to 1 year  100,768   2.72   57,119   2.46 
Greater than 1 year        11,089   2.92 
Total balance and weighted average rate $100,768   2.72% $89,418   2.52%

The warehouse lines of creditReadyCap Holdings’ and repurchase agreementsthe Guarantors’ respective obligations under the Senior Secured Notes and the Guarantees are secured by a perfected first-priority lien on the capital stock of ReadyCap Holdings and ReadyCap Commercial and certain other assets owned by certain of our Company’s mortgage loans held for salesubsidiaries as described in greater detail in our Current Report on Form 8-K filed on June 15, 2017. The Senior Secured Notes were issued pursuant to an indenture (the "Indenture") and bear interest at a ratefirst supplemental indenture (the "First Supplemental Indenture"), which contains covenants that, has historically moved in close relationshipamong other things: (i) limit the ability of our Company and its subsidiaries (including ReadyCap Holdings and the other Guarantors) to LIBOR.incur additional indebtedness; (ii) require that our Company maintain, on a consolidated basis, quarterly compliance with the applicable consolidated recourse indebtedness to equity ratio of our Company and consolidated indebtedness to equity ratio of our Company and specified ratios of our Company’s stockholders’ equity to aggregate principal amount of the outstanding Senior Secured Notes and our Company's consolidated unencumbered assets to aggregate principal amount of the outstanding Senior Secured Notes; (iii) limit the ability of ReadyCap Holdings and ReadyCap Commercial to pay dividends or distributions on, or redeem or repurchase, the capital stock of ReadyCap Holdings or ReadyCap Commercial; (iv) limit (1) ReadyCap's Holdings ability to create or incur any lien on the collateral and (2) unless the Senior Secured Notes are equally and ratably secured, (a) ReadyCap's Holdings ability to create or incur any lien on the capital stock of its wholly-owned subsidiary, ReadyCap Lending and (b) ReadyCap's Holdings ability to permit ReadyCap Lending to create or incur any lien on its assets to secure indebtedness of its affiliates other than its subsidiaries or any securitization

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entity; and (v) limit ReadyCap Holding's and the Guarantors' ability to consolidate, merge or transfer all or substantially all of ReadyCap' Holdings and the Guarantors’ respective properties and assets. The First Supplemental Indenture also requires that our Company ensure that the Replaceable Collateral Value (as defined therein) is not less than the aggregate principal amount of the Senior Secured Notes outstanding as of the last day of each of our Company's fiscal quarters.

 

ExchangeableAs of December 31, 2017, we are in compliance with all covenants with respect to the Senior NotesSecured Notes.

 

Convertible Notes

On November 25, 2013,August 9, 2017, the Operating Partnership issuedCompany closed an underwritten public sale of $115.0 million aggregate principal amount of its 7.00% convertible senior notes due 2023. The Convertible Notes will mature on August 15, 2023, unless earlier repurchased, redeemed or converted. During certain periods and subject to certain conditions, the Exchangeable Seniornotes will be convertible by holders into shares of the Company's common stock at an initial conversion rate of 1.4997 shares of common stock per $25 principal amount of the Convertible Notes, which may be exchanged foris equivalent to an initial conversion price of approximately $16.67 per share of common stock. Upon conversion, holders will receive, at the Company's discretion, cash, shares of the Company's common stock or to the extent necessary to satisfy NYSE listing requirements, cash, at the applicable exchange rate at any time prior to the close of business on the scheduled trading day prior to November 15, 2016 (the “Maturity Date”). a combination thereof.

The Company may, not elect to issue sharesupon the satisfaction of common stock upon exchangecertain conditions, redeem all or any portion of the Exchangeable SeniorConvertible Notes, at its option, on or after August 15, 2021, at a redemption price payable in cash equal to the extent such election would result in the issuance of 20% or more100% of the common stock outstanding immediately prior to the issuance of the Exchangeable Senior Notes (or 1,779,560 or more shares). The initial exchange rate for each $1,000 aggregate principal amount of the Exchangeable SeniorConvertible Notes was 52.5417 shares of common stock, equivalent to an exchange price of approximately $19.03 per share, representing an approximate 15% premium to the last reported sale price of the common stock on November 19, 2013 (the date of the initial sale of the Exchangeable Senior Notes), which was $16.55 per share. 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 anyredeemed, plus accrued and unpaid interest. In addition, ifAdditionally, upon the occurrence of 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 the Exchangeable Senior Notes due in 2016. 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 common share and OP Unit declared on December 19, 2013. Pursuant to a registration rights agreement, the Company agreed to file with the SEC within 120 days from the issue date, and to use its commercially reasonable efforts to cause to become effective within 180 days, a shelf registration statement with respect to the resales of the Company's common stock that may be issued upon exchange of the Exchangeable Senior Notes. The Company filed this shelf registration statement with the SEC on March 14, 2014, and the SEC declared it effective on May 23, 2014. If the Company fails to comply with certain of its obligations under the registration rights agreement, the Company will be required to pay liquidated damages totransactions, holders of the Exchangeable Senior Notes. The Company will increase the exchange rate by 3% for holders that exchange the Exchangeable Senior Notes when a registration default exists with respect to shares of the Company's common stock.

 At December 31, 2015 and December 31, 2014, the Company had Exchangeable Senior Notes outstanding totaling $57.5 million of aggregate principal balance which matures on the Maturity Date. The Exchangeable Senior Notes bear interest at a rate of 8.0% per year payable semiannually in arrears on May 15 and November 15 of each year, beginning on May 15, 2014. The effective interest rate of the Exchangeable Senior Notes, which is equal to the stated rate of 8.0% plus the amortization of the original issue discount and associated costs, is 10.2%.

The Exchangeable Senior Notes will mature on the Maturity Date, unless previously exchanged or repurchased in accordance with their terms. If the Company undergoes certain corporate events, that constitute a "fundamental change," the holders of the Exchangeable Senior Notes may require the Company to repurchasepurchase the Convertible Notes for cash all or part of their Exchangeable Senior Notes at a repurchasepurchase price equal to 100% of the principal amount of the Exchangeable SeniorConvertible Notes to be repurchased,purchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date. The Companyinterest.

GMFS Settlement Agreement

A counterparty (the “Counterparty”) whose predecessor purchased mortgage loans from GMFS, which is currently evaluating alternatives to settle the obligation at maturity in light of the pending strategic review.

For additional information related to the Exchangeable Senior Notes, see "Notes to Consolidated Financial Statements—8.0% Exchangeable Senior Notes due 2016."

Derivative Instruments

Residential Mortgage Investments Segment

At December 31, 2015 and December 31, 2014, the Company had outstanding interest rate swap agreements designed to mitigate the effects of increases in interest rates under a portion of its repurchase agreements. These interest rate swap agreements provide for the Company to pay fixed interest rates and receive floating interest rates indexed to LIBOR. The swap agreements effectively fixed the floating interest rates on a portion of the borrowings under the Company’s repurchase agreements. At December 31, 2014, the Company also had an interest rate swaption agreement outstanding which gave the Company the right, but not the obligation, to enter into a previously agreed upon interest rate swap contract on a future date which would obligate the Company to pay a fixed rate of interest and receive a floating rate of interest. The swaption matured in January 2015.

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

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Swaption Expiration Notional
Amount
  Strike Rate  Swap Maturity 
  (dollars in thousands) 
2015 $225,000   3.64%  2025 
             

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

  December 31,
2015
  December 31,
2014
 
  (dollars in thousands) 
Maturity 2023  2023 
Notional Amount $17,200  $17,200 
Weighted Average Pay Rate  2.72%  2.72%
Weighted Average Receive Rate  0.33%  0.23%
Weighted Average Years to Maturity  7.6   8.6 

At December 31, 2015 and December 31, 2014, the Company also had outstanding loan purchase commitments (“LPCs”), interest rate lock commitments (“IRLCs”) and MBS forward sales contracts.

The Company enters into LPCs as a means to avoid 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. These “best efforts” contracts provide that the loan be delivered if and when it closes and are subject to “pair off” fees if the loan is not delivered by the seller.

The Company had no exposure to TBA contracts at any time during the years ended December 31, 2015 and December 31, 2014. At December 31, 2015 and December 31, 2014 the Company did not have any TBA contracts outstanding.

Residential Mortgage Banking Segment

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.

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. 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.

The following table summarizes information related to the Company’s LPCs, IRLCs and MBS forward sales contracts at December 31, 2015 and December 31, 2014:

Non-hedge derivatives December 31, 2015  December 31, 2014 
  (dollar amounts in thousands) 
LPCs (Principal balance of underlying loans) $18,494  $1,905 
IRLCs (Principal balance of underlying loans) $190,933  $118,486 
Notional amount of MBS forward sales contracts $179,417  $154,000 

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

See “Note to Consolidated Financial Statements, Note 24 – Offsetting Assets and Liabilities” included in Item 8, “Financial Statements and Supplementary Data” in this annual report on Form 10-K for discussion about the Company’s master netting arrangements.

Leverage Ratio

At December 31, 2015, the Company had a leverage ratio of 2.97x. The leverage ratio is the ratio of the warehouse lines of credit, Loan Repurchase Facilities, securities repurchase agreements and Exchangeable Senior Notes (including the conversion option which is part of the notes) to the Company’s stockholders equity.

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Restricted Cash

The Company maintains certain assets, which, from time to time, may include cash, unpledged mortgage loans, non-Agency RMBS and Other Investment Securities (which may be subject to various haircuts if pledged as collateral to meet margin requirements) and collateral in excess of margin requirements held by the Company's counterparties (collectively, the "Cushion") to meet routine margin calls and protect against unforeseen reductions in the Company's borrowing capabilities. The Company's ability to meet future margin calls will be impacted by the Cushion, which varies based on the fair value of its assets, its cash position and margin requirements. The Company's cash position fluctuates based on the timing of its operating, investing and financing activities and is managed based on the Company's anticipated cash needs. At December 31, 2015, the Company had a Cushion of $25.0 million in addition to certain reserves held with respect to the Loan Repurchase Facilities. The Company's calculation of its Cushion excludes GMFS's warehouse lines of credit and repurchase agreements.

At December 31, 2015, the Company had a total of $4.4 million of restricted cash pledged against its interest rate swaps and repurchase agreements related to its mortgage loans held for investment and RMBS portfolios.

The Company believes these identified sources of liquidity will be adequate for purposes of meeting its short-term (within one year) liquidity and long-term liquidity needs. However, the Company's ability to meet its long-term liquidity and capital resource requirements may require additional financing.

The Company's short-term and long-term liquidity needs include funding future investments and operating costs. In addition, to qualify as a REIT, the Company must distribute annually at least 90% of its net taxable income, excluding net capital gains. These distribution requirements limit the Company's ability to retain earnings and thereby replenish or increase capital for operations.

GMFS Transaction

Pursuant to the GMFS Merger Agreement the Company merged with and into GMFS, with GMFS surviving the merger as an indirectour subsidiary, of the Company (see Item 1, “Business,” of this annual report on Form 10-K). The transaction closed on October 31, 2014. The final purchase price was approximately $61.2 million which was comprised of (i) the fair market value of GMFS's MSR portfolio, (ii) the fair market value of GMFS's net tangible assets and (iii) a purchase price premium. In addition to cash paid at closing, the total consideration included two contingent $1 million deferred premium payments payable in cash over two years, plus 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 and December 31, 2015 was $11.4 million and $11.3 million, respectively, based on the future production and earnings projections of GMFS over the four-year earn-out period. The Company funded the closing cash payment through a combination of available cash and the liquidation of a portion of its non-Agency RMBS portfolio.

As disclosed in the Company's annual report on Form 10-K for the year ended December 31, 2014 and the Company’s quarterly reports on Form 10-Q filed in 2015, GMFS had executed a statute of limitations tolling agreement with at least one counterparty with respect to mortgage loans that were sold by GMFS to this counterparty’s predecessor. This tolling agreement extends the time period which this counterparty could bring claim against GMFS.

The initial tolling agreement was executed by GMFS on December 12, 2013 and then further amended to extend the expiration date. Based on communications received in April 2015 from this counterparty, the Company believes that when this tolling agreement expires, absent further extension of the tolling agreement or settlement of the counterparty'sasserted claims it is probable that the counterparty will initiate litigation(the “Claims”) against GMFS seeking substantial damages based on alleged breachesfor breach of representations and warranties made by GMFS. The most recent amendment of the tolling agreement extended the expiration date to June 2, 2016 and can be further extended by agreement of the parties. The Company also understands that this counterparty has commenced or threatened litigation arising out of historicalthese mortgage loan purchases by its predecessor against a number of other mortgage loan originators. The Company estimatessales. We estimate that dating back to a period that began approximately 16 years ago in 1999 and ended in 2006, approximately $1 billion of mortgage loans were sold and servicing was released by GMFS to the predecessor to this counterparty. While the historical claims experienceCounterparty. GMFS entered into a statute of limitations tolling agreement with the Counterparty on December 12, 2013 related to the Claims, which was further amended to extend the expiration date, most recently to May 15, 2017.

On April 25, 2017, the Company and GMFS entered into a definitive agreement (the “Settlement Agreement”) to settle all Claims with respectthe Counterparty and provide for mutual releases. Pursuant to purchasersthe Settlement Agreement, the Company has paid a total of mortgage loans from $6.0 million in cash and issued approximately $4.0 million in shares of the Company's common stock (275,862 shares issued) to the Counterparty (the “Shares”), resulting in a total of $10.0 million of consideration paid. The Shares were issued on May 2, 2017, in a private placement transaction. As part of the settlement, the Company has granted the Counterparty customary resale registration rights.

During the period beginning on the 24-month anniversary of the date of the Settlement Agreement (and ending 30 days thereafter), the Counterparty will have the right, but not the obligation, to require that the Company repurchase any and all the Shares that the Counterparty then owns at a price per share equal to 65% of the then last reported book value per share of the Company's common stock.

GMFS overwas an indirect subsidiary of ZAIS Financial when the 1999 to 2006 period has not resulted in material damages claimed against or paid by GMFS, as furtherCompany completed its merger transaction with ZAIS on October 31, 2016.  As disclosed in the Company'sJoint Proxy Statement Prospectus used in connection with the merger transaction and in our annual report on Form 10-K for the year ended December 31, 2016, ZAIS had originally acquired GMFS on October 31, 2014 (the “GMFS 2014 acquisition”) from investment partnerships that were advised by our Manager, and from certain other entities controlled by GMFS management (together, the “2014 GMFS sellers”). The terms of the GMFS 2014 acquisition provided for the payment of both cash consideration and the Company's quarterly reportspossible payment of additional contingent consideration based on Form 10-Q filedthe achievement by GMFS of certain financial milestones specified in 2015, claims brought by this counterparty could exposethe GMFS to substantial damages that may be material, cause the Company and GMFS to devote significant management time and attention and other resources to resolving or defending these claims, require GMFS, the Company or its other subsidiaries to incur significant costs, or cause significant losses that may be material.2014 acquisition agreement.

 

Although the Company has established a loan indemnification reserve for potential losses related to loan saleThe GMFS 2014 acquisition agreement contained representations and warranties with a corresponding provision recorded for loan losses duerelated to GMFS, as well as indemnification obligations to cover breaches of representations and warranties, repurchase claims or demands from investors in respect of mortgage loans originated, purchased or sold by GMFS prior to the early stage of this matter and the limited information available the Company is not able to determine the likelihoodclosing date of the outcome.acquisition.  The Company believes that losses in excessGMFS 2014 acquisition agreement also established an escrow fund to support the payment of

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indemnification claims and allowed for indemnification claims to be offset against the loan indemnification reserve will be recovered by the Company as either a reduction of the total contingent consideration owedthat would otherwise be payable to the GMFS 2014 sellers under the GMFS Merger Agreement given2014 acquisition agreement. 

Under the terms of the indemnification provisions contained in the GMFS Merger Agreement or by withdrawing funds from an escrow account established by2014 acquisition agreement, the 2014 GMFS sellers at the time of the acquisition (as of December 31, 2015, the balance in the escrow account was $4,004,424). Additionally, the Company has delayed the first year installment payment of the contingent consideration. 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 indemnificationare liable for any losses or any amounts paid in settlement althoughof Claims made with their consent, which consent was not to be unreasonably withheld or delayed. Certain of the 2014 GMFS sellers did not consent to the settlement, and as a result, there can be no assurance that such claimsthe exercise of the right to indemnification by the Company under the terms of the 2014 acquisition agreement would be successful or that any amounts available for indemnification would be adequate.successful. 

 

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DividendsSince the resolution of the Claims and related settlement occurred subsequent to the March 31, 2017 balance sheet date, but before the issuance of the financial statements, included in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2017, the effects had been reflected and recognized in the consolidated financial statements as of March 31, 2017.

 

The Company's current policy is to pay quarterly distributions which will allow it to qualify as a REIT and generallysettlement did not be subject to U.S. federal income tax on its undistributed income. Taxable and U.S. GAAP earnings will typically differ due to differences in premium amortization and discount accretion, certain non-taxable unrealized and realized gains and losses, and non-deductible general and administrative expenses.

In light of the strategic review and in order to reduce current market risk in its investment portfolio, the Company has recently begun the process of selling its seasoned, re-performing mortgage loans from its residential mortgage investments segment. A sale of these assets is expected to be completed early in the second quarter of 2016. Additionally, as part of the strategic review, the Company has made the decision to cease the purchase of newly originated residential mortgage loans as part of its mortgage conduit program and will begin the unwinding of the Company’s mortgage conduit business. If completed, these transactions are likely to result in a reductioncharge to our earnings or otherwise adversely impact our results of the Company’s investment income and may therefore result in a decision to curtail dividends in the future.operations.

Cash (Used In) Provided by Operating Activities

The Company’s cash flows (used in) provided by operating activities for the years ended December 31, 2015, December 31, 2014 and December 31, 2013 were as follows:

Year Ended 
December 31, 
2015
  December 31,
 2014
  December 31, 
2013
 
(dollars in thousands) 
$(23,081) $(4,690) $8,131 

The cash flows (used in)/provided by operating activities for the years ended December 31, 2015, December 31, 2014 and December 31, 2013 are primarily a result of income earned on the Company’s assets, partially offset by interest expense on the Company’s borrowings and operating expenses. Additionally, as a result of the acquisition of GMFS, cash flows from operating activities for the years ended December 31, 2015 and December 31, 2014 are also impacted by the origination of mortgage loans held for sale and an increase in MSRs offset by non-interest income and proceeds from the sale of these mortgage loans.

Cash Provided By (Used in) Investing Activities

The cash flows provided by/(used in) the Company's investing activities for the years ended December 31, 2015, December 31, 2014 and December 31, 2013 are as follows:

  Year Ended 
  December 31, 
2015
  December 31,
2014
  December 31,
2013
 
  (dollars in thousands) 
Cash paid for the acquisition of GMFS, net of cash acquired $  $(49,543) $ 
Origination of mortgage loans held for investment  (6,201)      
Acquisitions of mortgage loans held for investment  (16,353)  (85,579)  (334,162)
Proceeds from sales and principal repayments on mortgage loans held for investment  36,798   31,519   13,871 
Acquisitions of real estate securities, net of changes in payable for real estate securities purchased  (6,362)  (47,034)  (406,264)
Proceeds from principal repayments on real estate securities  17,888   28,198   46,753 
Proceeds from sales of real estate securities, net of changes in receivable for real estate securities sold  26,771   102,635   291,349 
Acquisitions of other investment securities  (17,031)  (12,927)   
Proceeds from principal repayments on Other Investment Securities  10       
Proceeds from sales of Other Investment Securities  5,962   11,067    
Purchase of swaption     (4,804)   
Proceeds received for the final reconciliation of purchase price relating to the acquisition of GMFS  1,684       
Restricted cash provided by/(used in) investment activities  2,771   (5,015)  1,640 
Net cash provided by/(used in) investing activities $45,937  $(31,483) $(386,813)

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Cash Provided by Financing Activities

The cash flows (used in)/ provided by the Company's financing activities for the years ended December 31, 2015, December 31, 2014 and December 31, 2013 are as follows:

  Year Ended 
  December 31, 
2015
  December 31,
2014
  December 31,
2013
 
  (dollars in thousands) 
Proceeds from issuance of common stock, net $  $  $118,863 
Payment of common stock repurchase liability        (5,751)
Net borrowings under warehouse lines of credit  11,351   3,577    
Net (repayments)/borrowings under loan repurchase facilities  (3,303)  64,033   236,059 
Borrowings from securities repurchase agreements  5,243   138,210   366,104 
Repayments of securities repurchase agreements  (34,957)  (173,788)  (343,593)
Proceeds from issuance of Exchangeable Senior Notes        54,451 
Allocation of proceeds to conversion option on Exchangeable Senior Notes        1,324 
Dividends on common stock and distributions on OP Units (net of change in dividends and distributions payable)  (14,236)  (19,130)  (10,410)
Repurchase of preferred stock including dividend        (148)
Equity raise payments        (217)
Contributions from non-controlling interests  50       
Net cash (used in)/provided by financing activities $(35,852) $12,902  $416,682 

 

Contractual Obligations

 

The Company has entered into an Investment Advisory Agreement with the Advisor. following table provides a summary of our contractual obligations as of December 31, 2017:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(in thousands)

 

Total

 

<  1 year

 

1 to 3 years

 

3 to 5 years

 

>  5 years

Borrowings under credit facilities

 

$

248,674

 

$

248,674

 

$

 —

 

$

 —

 

$

 —

Borrowings under repurchase agreements

 

 

382,612

 

 

327,257

 

 

55,355

 

 

 —

 

 

 —

Guaranteed loan financing

 

 

293,045

 

 

1,990

 

 

5,964

 

 

9,577

 

 

275,514

Senior secured notes, net

 

 

138,078

 

 

 —

 

 

 —

 

 

 —

 

 

138,078

Convertible notes, net

 

 

108,991

 

 

 —

 

 

 —

 

 

 —

 

 

108,991

Promissory note payable

 

 

6,107

 

 

 —

 

 

 —

 

 

6,107

 

 

 —

Future operating lease commitments 

 

 

5,696

 

 

1,792

 

 

896

 

 

427

 

 

2,581

Total 

 

$

1,183,203

 

$

579,713

 

$

62,215

 

$

16,111

 

$

525,164

The Advisor is entitled to receive a quarterly advisory fee, loan sourcing fee and the reimbursement of certain expenses; however, these obligationstable above does not include amounts due under our management agreement or derivative agreements as those contracts do not have fixed and determinable payments.

The following table presents contractual obligations and commitments at December 31, 2015, as discussed above under “Liquidity and Capital Resources”:

Contractual Obligations Total  Less than 1
year
  1-3 years  3-5 years  More than 5
years
 
  (dollars in thousands) 
Warehouse lines of credit $100,768  $100,768  $  $  $ 
Interest on warehouse lines of credit(1)  2,105   2,105          
Loan repurchase facilities  296,789   296,789          
Interest on loan repurchase facilities(1)  4,152   4,152          
Repurchase agreements  73,300   73,300          
Interest on securities repurchase agreements(1)  278   278          
Exchangeable Senior Notes  57,500   57,500          
Interest on Exchangeable Senior Notes  4,600   4,600          
Operating leases  2,602   982   1,490   130    
Total $542,094  $540,474  $1,490  $130  $ 

(1)Interest is calculated based on the interest rates in effect at December 31, 2015 and includes all interest expense incurred and expected to be incurred in the future through the contractual maturity of the associated borrowings.

 

Off-Balance Sheet Arrangements

 

As of the date of this annual report on Form 10-K, the Companywe had no off-balance sheet arrangements.

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Inflation

 

Virtually all of the Company'sour assets and liabilities are and will be interest rate sensitive in nature. As a result, interest rates and other factors influence our performance far more than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. The Company'sOur consolidated financial statements are prepared in accordance with U.S. GAAP and the Company'sour activities and balance sheet shall be measured with reference to historical cost and/or fair market value without considering an independent inflation factor.inflation.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

 

The primary componentsIn the normal course of the Company’sbusiness, we enter into transactions in various financial instruments that expose us to various types of risk, both on and off balance sheet, which are associated with such financial instruments and markets for which we invest. These financial instruments expose us to varying degrees of market risk, are related tocredit risk, interest rate risk, liquidity risk, off balance sheet risk and prepayment risk.

Market Risk

Market risk is the potential adverse changes in the values of the financial instrument due to unfavorable changes in the level or volatility of interest rates, foreign currency exchange rates, or market values of the underlying financial instruments. We attempt to mitigate our exposure to market risk by entering into offsetting transactions, which may include purchase or sale of interest bearing securities and equity securities.

106


Credit Risk

We are subject to credit risk in connection with our investments in SBC loans and fair value risk. WhileSBC ABS and other target assets we may acquire in the Company does not seek to avoid risk completely, the Company believes that risk can be quantified from historical experience and the Company will seek to actively manage that risk, to earn sufficient compensation to justify taking risk and to maintain capital levels consistent with the risks the Company undertakes.

Credit Risk

The Company expects to encounter credit risk related to its non-Agency RMBS and mortgage loans, including assets it may originate or acquire. A portion of the Company's assets are comprised of residential mortgage loans that are unrated.future. The credit risk related to these investments pertains to the ability and willingness of the borrowers to pay, the mortgage loan payments, the ability of which is assessed before credit is granted or renewed and periodically reviewed throughout the loan or security term. The Company believesWe believe that residual loan credit quality is primarily determined by the borrowers'borrowers’ credit profiles and loan characteristics. Changes in home price appreciation haveWe seek to mitigate this risk by seeking to acquire assets at appropriate prices given anticipated and unanticipated losses and by deploying a significantvalue-driven approach to underwriting and diligence, consistent with our historical investment strategy, with a focus on projected cash flows and potential risks to cash flow. We further mitigate our risk of potential losses while managing and servicing our loans by performing various workout and loss mitigation strategies with delinquent borrowers. Nevertheless, unanticipated credit losses could occur which could adversely impact on the performance of non-Agency RMBS and mortgage loans.operating results.

 

Interest Rate Risk

 

Interest rate risk is highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond the Company'sour control.

 

The Company is subject to interest rate riskOur operating results will depend, in connection with any floating or inverse floating ratepart, on differences between the income from our investments and its repurchase agreements. The Company's repurchase agreements may be of limited duration and are periodically refinanced at current market rates. The Company intends to manage this risk using interest rate derivative agreements. These instruments are intended to serve as a hedge against future interest rate increases on the Company's borrowings. The Company primarily assesses its interest rate risk by estimating and managing the duration of its assets relative to the duration of its liabilities. Duration measures the change in the fair value of an assetour financing costs. Our debt financing is based on a changefloating rate of interest calculated on a fixed spread over the relevant index, subject to a floor, as determined by the particular financing arrangement. The general impact of changing interest rates are discussed above under “— Factors Impacting Operating Results —  Changes in Market Interest Rates.” In the event of a significant rising interest rate environment and/or economic downturn, defaults could increase and result in credit losses to us, which could materially and adversely affect our business, financial condition, liquidity, results of operations and prospects. Furthermore, such defaults could have an adverse effect on the spread between our interest-earning assets and interest-bearing liabilities.

Additionally, non-performing SBC loans are not as interest rate. The Companyrate sensitive as performing loans, as earnings on non-performing loans are often generated from restructuring the assets through loss mitigation strategies and opportunistically disposing of them. Because non-performing SBC loans are short-term assets, the discount rates used for valuation are based on short-term market interest rates, which may not move in tandem with long-term market interest rates. A rising rate environment often means an improving economy, which might have a positive impact on commercial property values, resulting in increased gains on the disposition of these assets. While rising rates could make it more costly to refinance these assets, we expect that the impact of this would be mitigated by higher property values. Moreover, small business owners are generally calculates duration using various financial modelsless interest rate sensitive than large commercial property owners, and empirical data. Different modelsinterest cost is a relatively small component of their operating expenses. An improving economy will likely spur increased property values and methodologies can produce different duration numberssales, thereby increasing the need for the same securities.SBC financing.

   

The borrowingsfollowing table projects the Company used to fund its portfolio included $527.4 million atimpact on our interest income and expense for the twelve month period following December 31, 2015 under the warehouse lines2017, assuming an immediate increase or decrease of credit25, 50, 75 and repurchase agreements with four lenders, Loan Repurchase Facilities, master securities repurchase agreements with four counterparties and the Exchangeable Senior Notes. At December 31, 2015, the Company also had interest rate swaps with an outstanding notional amount of $17.2 million, resulting100 basis points in variable rate debt of $453.7 million. A 50 basis point increase in LIBOR would increase the annual interest expense related to the $453.7 million in variable rate debt by $2.3 million.LIBOR:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

12-month pretax net interest income sensitivity profiles

 

 

Instantaneous change in rates

(in thousands)

 

25 basis point increase

 

50 basis point increase

 

75 basis point increase

 

100 basis point increase

 

25 basis point decrease

 

50 basis point decrease

 

75 basis point decrease

 

100 basis point decrease

Assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Loans held for investment

$

1,937

$

3,885

$

5,829

$

7,764

$

(1,569)

$

(2,943)

$

(4,172)

$

(5,192)

   Interest rate swap hedges

 

502

 

1,004

 

1,505

 

2,007

 

(502)

 

(1,004)

 

(1,505)

 

(2,007)

Total

$

2,439

$

4,889

$

7,334

$

9,771

$

(2,071)

$

(3,947)

$

(5,677)

$

(7,199)

Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Recourse debt

$

(944)

$

(1,889)

$

(2,833)

$

(3,777)

$

944

$

1,889

$

2,833

$

3,777

   Non-recourse debt

 

(532)

 

(1,064)

 

(1,596)

 

(2,128)

 

532

 

1,064

 

1,596

 

2,128

Total

$

(1,476)

$

(2,953)

$

(4,429)

$

(5,905)

$

1,476

$

2,953

$

4,429

$

5,905

Total Net Impact to Net Interest Income (Expense)

$

963

$

1,936

$

2,905

$

3,866

$

(595)

$

(994)

$

(1,248)

$

(1,294)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

      Such hypothetical impact of interest rates on the Company'sour variable rate debt does not consider the effect of any change in overall economic activity that could occur in a rising interest rate environment. Further, in the event of such a change in interest

107


rates, the Companywe may take actions to further mitigate itsour exposure to such a change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, this analysis assumes no changes in the Company'sour financial structure.

Net Interest IncomeLiquidity Risk

 

The Company's operating results will dependLiquidity risk arises in part on differencesour investments and the general financing of our investing activities. It includes the risk of not being able to fund acquisition and origination activities at settlement dates and/or liquidate positions in a timely manner at a reasonable price, in addition to potential increases in collateral requirements during times of heightened market volatility. If we were forced to dispose of an illiquid investment at an inopportune time, we might be forced to do so at a substantial discount to the market value, resulting in a realized loss. We attempt to mitigate our liquidity risk by regularly monitoring the liquidity of our investments in SBC loans, ABS and other financial instruments. Factors such as our expected exit strategy for, the bid to offer spread of, and the number of broker dealers making an active market in a particular strategy and the availability of long-term funding, are considered in analyzing liquidity risk. To reduce any perceived disparity between the income from its investmentsliquidity and its borrowing costs. Mostthe terms of the Company's Loan Repurchase Facilities, securitiesdebt instruments in which we invest, we attempt to minimize our reliance on short-term financing arrangements. While we may finance certain investment in security positions using traditional margin arrangements and reverse repurchase agreements, other financial instruments such as collateralized debt obligations, and warehouse linesother longer-term financing vehicles may be utilized to attempt to provide us with sources of credit and repurchase agreements related tolong-term financing.

Prepayment Risk

Prepayment risk is the GMFS mortgage banking platform, provide financing basedrisk that principal will be repaid at a different rate than anticipated, causing the return on a floating rate of interest calculated on a fixed spread over LIBOR. If the federal funds rate is increased above its existing target range, the Company would ordinarily expect LIBOR to also increase. If this unfolds, the Company would expect the borrowing costs associated with the Company'scertain investments to increase while the income earned by the Company on its fixed interest rate investments to remain substantially unchanged. This will result in a narrowing of the net interest spread between existing assets and borrowings and may result in a decline in asset value or otherwise result in losses. In addition, an increase in the federal funds rate, if accompanied by broader increase in interest rates, may also cause other challenges for the Company's business by, for example, reducing the demand for newly originated mortgage loans due to the higher cost of borrowing, which could adversely impact loan production from GMFS.

Hedging techniques are partly based on assumed levels of prepayments of the Company's residential mortgage loans and RMBS. If prepayments are slower or faster than assumed, the effectiveness of any hedging strategies the Company uses will be reduced and may cause losses on such transactions. Hedging strategies involving the use of derivative securities are complex and may produce volatile returns. The Company is considering a variety of steps to address the impact on the Company’s business of a rising interest rate environment, including the sale of existing assets that may be sensitive to higher interest rates, changes to the Company’s asset and liability hedging strategy, acquiring new assets that may be less sensitive to rising rates or reducing the amount of leverage the Company uses in its business. There can be no assurance that such steps or others which the Company may implement in the near to medium term will be effective in mitigating the impact of a rising rate environment.

77

Prepayment Risk

than expected. As the Company receiveswe receive prepayments of principal on its investments,our assets, any premiums paid on such investments will beassets are amortized against interest income. In general, an increase in prepayment rates will accelerateaccelerates the amortization of purchase premiums, thereby reducing the interest income earned on the investments.assets. Conversely, discounts on such investmentsassets are accreted into interest income. In general, an increase in prepayment rates will accelerateaccelerates the accretion of purchase discounts, thereby increasing the interest income earned on the investments.assets.

 

SBC Loan and ABS Extension Risk

 

Our Manager computes the projected weighted‑average life of our assets based on assumptions regarding the rate at which the borrowers will prepay the mortgages or extend. If prepayment rates decrease in a rising interest rate environment or extension options are exercised, the life of the fixed-rate portion of the relatedfixed‑rate assets could extend beyond the term of the swap agreement or other hedging instrument.secured debt agreements. This could have a negative impact on the Company'sour results from operations, as borrowing costs would no longer be fixed after the end of the hedging instrument, while the income earned on the hybrid adjustable-rate assets would remain fixed. This situation may also cause the fair market value of the Company's hybrid adjustable-rate assets to decline, with little or no offsetting gain from the related hedging transactions.operations. In extremesome situations, the Companywe may be forced to sell assets to maintain adequate liquidity, which could cause itus to incur losses.

Fair ValueReal Estate Risk

 

The Company intendsmarket values of commercial mortgage assets are subject to electvolatility and may be affected adversely by a number of factors, including, but not limited to, national, regional and local economic conditions (which may be adversely affected by industry slowdowns and other factors); local real estate conditions; changes or continued weakness in specific industry segments; construction quality, age and design; demographic factors; and retroactive changes to building or similar codes. In addition, decreases in property values reduce the fair value option of accounting on most of its residential mortgage investmentsthe collateral and the potential proceeds available to a borrower to repay the underlying loans, held for sale, MSRs and securities investments and account for them at their estimated fair value with unrealized gains and losses included in earnings pursuantwhich could also cause us to accounting guidance. suffer losses.

Fair Value Risk

The estimated fair value of these residential mortgage loans, MSRs and securitiesour investments fluctuates primarily due to changes in interest rates and other factors. Generally, in a rising interest rate environment, the estimated fair value of these residential mortgage loans and securitiesthe fixed‑rate investments would be expected to decrease and MSRs would be expected to increase,decrease; conversely, in a decreasing interest rate environment, the estimated fair value of these residential mortgage loans, and securitiesthe fixed‑rate investments would be expected to increase and MSRs wouldincrease. As market volatility increases or liquidity decreases, the fair value of our assets recorded and/or disclosed may be expectedadversely impacted. Our economic exposure is generally limited to decrease.our net investment position as we seek to fund fixed rate investments with fixed rate financing or variable rate financing hedged with interest rate swaps.

 

108


Counterparty Risk

 

The Company financesWe finance the acquisition of a significant portion of itsour commercial and residential mortgage loans, RMBSMBS and Other Investment Securitiesother assets with itsour repurchase agreements and warehouse lines of credit.credit facilities. In connection with these financing arrangements, the Company pledges its residentialwe pledge our mortgage loans and securities as collateral to secure the borrowings. The amount of collateral pledged will typically exceed the amount of the borrowings (i.e.(i.e. the haircut) such that the borrowings will be over-collateralized. As a result, the Company iswe are exposed to the counterparty if, during the term of the financing, a lender should default on its obligation and the Company iswe are not able to recover itsour pledged assets. The amount of this exposure is the difference between the amount loaned to the Companyus plus interest due to the counterparty and the fair value of the collateral pledged by the Companyus to the lender including accrued interest receivable on such collateral.

We are exposed to changing interest rates and market conditions, which affects cash flows associated with borrowings. We enter into derivative instruments, such as interest rate swaps and credit default swaps (“CDS”), to mitigate these risks. Interest rate swaps are used to mitigate the exposure to changes in interest rates and involve the receipt of variable-rate interest amounts from a counterparty in exchange for us making payments based on a fixed interest rate over the life of the swap contract. CDSs are executed in order to mitigate the risk of deterioration in the current credit health of the commercial mortgage market.

 

Certain of the Company'sour subsidiaries have entered into over-the-counter interest rate swap agreements to hedge risks associated with movements in interest rates. Because certain interest rate swaps were not cleared through a central counterparty, the Company remainswe remain exposed to the counterparty's ability to perform its obligations under each such swap and cannot look to the creditworthiness of a central counterparty for performance. As a result, if an over-the-counter swap counterparty cannot perform under the terms of an interest rate swap, the Company'sour subsidiary would not receive payments due under that agreement, the Companywe may lose any unrealized gain associated with the interest rate swap and the hedged liability would cease to be hedged by the interest rate swap. While the Companywe would seek to terminate the relevant over-the-counter swap transaction and may have a claim against the defaulting counterparty for any losses, including unrealized gains, there is no assurance that the Companywe would be able to recover such amounts or to replace the relevant swap on economically viable terms or at all. In such case, the Companywe could be forced to cover itsour unhedged liabilities at the then current market price. The CompanyWe may also be at risk for any collateral the Company haswe have pledged to secure the Company'sour obligations under the over-the-counter interest rate swap if the counterparty becomes insolvent or files for bankruptcy. Therefore, upon a default by an interest rate swap agreement counterparty, the interest rate swap would no longer mitigate the impact of changes in interest rates as intended.

 

78

During the past several years, certain repurchase agreement and interest rate swap counterparties in the United States and Europe have experienced financial difficulty and have been either rescued by government assistance or otherwise benefited from accommodative monetary policy of their respective central banks.

The following table summarizes the Company’s exposure to its repurchase agreements warehouse lines ofand credit and derivativefacilities counterparties at December 31, 2015:2017:

 

  Number of
Counterparties
  Repurchase
Agreement
Borrowings
 (1)
  Warehouse
Lines of Credit
  Swaps &
Swaption at
Fair Value
  Exposure 
(2)
  Exposure as a
Percentage of
Total Assets
 
  (dollars in thousands) 
North America:                        
U.S.  4  $285,379  $62,360  $  $109,067   14.1%
Canada(3)  1   54,167         17,145   2.2 
   5   339,546   62,360      126,212   16.3%
Europe:(3)                        
United Kingdom  1   11,077      (1,009)  6,359   0.8%
Switzerland  2   19,746   38,408      8,248   1.1 
   3   30,823   38,408   (1,009)  14,607   1.9%
Total Counterparty Exposure  8  $370,369  $100,768  $(1,009) $140,819   18.2%

 

 

 

 

 

 

 

 

 

 

(in thousands)

 

Borrowings under repurchase
agreements and credit facilities
(1)

 

Assets pledged on borrowings under repurchase agreements and credit facilities

 

Net Exposure (2)

 

Exposure as a
Percentage of
Total Assets

Total Counterparty Exposure

 

$ 632,473

 

$ 898,453

 

$ 265,980

 

10.6

%

(1) Includes accrued interest payable

 

 

 

 

 

 

 

 

 

(2) The exposure reflects the difference between (a) the amount loaned to the Company through repurchase agreements and credit facilities, including interest payable, and (b) the cash and the fair value of the assets pledged by the Company as collateral, including accrued interest receivable on such assets

 

(1)Includes accrued interest payable.
(2)The exposure reflects the difference between (a) the amount loaned to the Company through repurchase agreements and warehouse lines of credit, including interest payable, plus the derivative liability and (b) the cash and the fair value of the assets pledged by the Company as collateral, including accrued interest receivable on such assets, plus derivative assets.
(3)Includes foreign based counterparties as well as U.S. domiciled subsidiaries of such counterparties, as such transactions are generally entered into with a U.S. domiciled subsidiary of such counterparties.

 

The following table presents information with respect to any counterparty for repurchase agreements for which theour Company had greater than 5% of stockholders’ equity at risk in the aggregate at December 31, 2015:2017:

 

Counterparty Counterparty
Rating (1)
 Amount of
Risk (2)
  Weighted
Average
Months to
Maturity for
Repurchase
Agreements
  Percentage of
Stockholders’
Equity
 
  (dollars in thousands)
Citigroup Inc.(3) A/A1 $97,688   5   55.4%
RBC Capital Markets, LLC AA-/A2 $17,145   <1   9.7%

 

 

 

 

 

 

 

 

 

(in thousands)

 

Counterparty
Rating
(1

Amount of Risk (2)

 

Weighted
Average
Months to
Maturity for
Agreement

 

Percentage of
Stockholders’
Equity

Deutsche Bank AG

 

A- / Baa2

$ 78,571

 

 2

 

14.1

%

Citibank, N.A.

 

A+/A1

$ 68,090

 

 6

 

12.3

%

JPMorgan Chase Bank, N.A.

 

A+ / Aa3

$ 62,317

 

15

 

11.2

%

(1) The counterparty rating presented is the long-term issuer credit rating as rated at December 31, 2017 by S&P and Moody’s, respectively.

 

(2) The amount at risk reflects the difference between (a) the amount loaned to the Company through repurchase agreements, including interest payable, and (b) the cash and the fair value of the assets pledged by the Company as collateral, including accrued interest receivable on such securities

 

 

 

 

 

 

 

 

 

 

109


 

Capital Market Risk

(1)The counterparty rating presented is the long-term issuer credit rating as rated at December 31, 2015 by S&P and Moody’s, respectively.
(2)The amount at risk reflects the difference between (a) the amount loaned to the Company through repurchase agreements, including interest payable, plus the net unrealized gain on swaps including collateral pledged and (b) the cash and the fair value of the assets pledged by the Company as collateral, including accrued interest receivable on such securities.
(3)Includes amounts at risk with Citibank, N.A. and Citigroup Global Markets Inc. Counterparty rating is for Citibank, N.A. which represents $94.9 million of the total exposure. The remaining exposure is to Citigroup Global Markets Inc. which was rated A/Baa2 by S&P and Moody’s, respectively at December 31, 2015.

We are exposed to risks related to the equity capital markets, and our related ability to raise capital through the issuance of our common stock or other equity instruments. We are also exposed to risks related to the debt capital markets, and our related ability to finance our business through borrowings under repurchase obligations or other financing arrangements. As a REIT, we are required to distribute a significant portion of our taxable income annually, which constrains our ability to accumulate operating cash flow and therefore requires us to utilize debt or equity capital to finance our business. We seek to mitigate these risks by monitoring the debt and equity capital markets to inform our decisions on the amount, timing, and terms of capital we raise.

Off Balance Sheet Risk

Off balance sheet risk refers to situations where the maximum potential loss resulting from changes in the level or volatility of interest rates, foreign currency exchange rates or market values of the underlying financial instruments may result in changes in the value of a particular financial instrument in excess of the reported amounts of such assets and liabilities currently reflected in the accompanying consolidated balance sheets.

Inflation Risk

Most of our assets and liabilities are interest rate sensitive in nature. As a result, interest rates and other factors influence our performance significantly more than inflation does. Changes in interest rates may correlate with inflation rates and/or changes in inflation rates. Our consolidated financial statements are prepared in accordance with U.S. GAAP and our distributions are determined by our board of directors consistent with our obligation to distribute to our stockholders at least 90% of our REIT taxable income on an annual basis in order to maintain our REIT qualification; in each case, our activities and balance sheet are measured with reference to historical cost and/or fair value without considering inflation.

 

79

110


 

111

80

 

Report of Independent Registered Public Accounting Firm

 

To the Stockholders and the Board of Directors and Shareholders of Sutherland Asset Management Corporation:

ZAISOpinion on the Financial Corp. and Subsidiaries:Statements

In our opinion,We have audited the accompanying consolidated balance sheets of Sutherland Asset Management Corporation and subsidiaries (the "Company") as of December 31, 2017, and 2016, the related consolidated statements of operations,income, shareholders' equity, and cash flows present fairly, in all material respects, the financial position of ZAIS Financial Corp. and its subsidiaries (the “Company”) at December 31, 2015 and December 31, 2014, and the results of their operations and their cash flows, for each of the three years in the period ended December 31, 20152017, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017, and 2016, and the results of their operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with accounting principles generally accepted in the United States of America.

Basis for Opinion

These financial statements are the responsibility of the Company’sCompany's management. Our responsibility is to express an opinion on thesethe Company's financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States).PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. Anmisstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit includesof its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.

Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence supportingregarding the amounts and disclosures in the financial statements, assessingstatements. Our audits also included evaluating the accounting principles used and significant estimates made by management, andas well as evaluating the overall presentation of the financial statement presentation.statements. We believe that our audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopersDELOITTE & TOUCHE LLP

New York, NYNew York

March 10, 201616, 2018

We have served as the Company's auditor since 2012.

112


113


SUTHERLAND ASSET MANAGEMENT CORPORATION

CONSOLIDATED BALANCE SHEETSZAIS Financial Corp. and Subsidiaries
Consolidated Balance Sheets

 

  December 31,
2015
  December 31,
2014
 
  (Expressed in United States Dollars,
except share data)
 
Assets        
Cash $20,793,716  $33,791,013 
Restricted cash  4,371,725   7,143,078 
Mortgage loans held for investment, at fair value – $394,942,512 and $415,814,067 pledged as collateral, respectively  397,678,140   415,959,838 
Mortgage loans held for investment, at cost  1,886,642   1,338,935 
Mortgage loans held for sale, at fair value - $115,942,230 and $97,690,960 pledged as collateral, respectively  115,942,230   97,690,960 
Real estate securities, at fair value – $95,627,850 and $135,779,193 pledged as collateral, respectively  109,339,281   148,585,733 
Other Investment Securities, at fair value – $1,989,174 and $2,040,532 pledged as collateral, respectively  12,804,196   2,040,532 
Loans eligible for repurchase from Ginnie Mae  34,745,103   21,710,284 
Mortgage servicing rights, at fair value  48,209,016   33,378,978 
Derivative assets, at fair value  2,376,187   2,485,100 
Other assets  7,928,878   6,092,863 
Goodwill  14,183,537   16,512,680 
Intangible Assets  4,880,270   5,668,611 
Total assets $775,138,921  $792,398,605 
Liabilities        
Warehouse lines of credit $100,768,428  $89,417,564 
Loan repurchase facilities  296,789,330   300,092,293 
Securities repurchase agreements  73,300,159   103,014,105 
Exchangeable Senior Notes  56,509,046   55,474,741 
Contingent consideration  11,285,100   11,430,413 
Derivative liabilities, at fair value  1,831,967   2,585,184 
Dividends and distributions payable  3,559,120   3,559,120 
Accounts payable and other liabilities  18,572,613   11,731,089 
Liability for loans eligible for repurchase from Ginnie Mae  34,745,103   21,710,284 
Total liabilities  597,360,866   599,014,793 
         
Commitments and Contingencies (Note 22)        
         
Equity        
12.5% Series A cumulative non-voting preferred stock, $0.0001 par value; 50,000,000 shares authorized; zero shares issued and outstanding      
Common stock, $0.0001 par value; 500,000,000 shares authorized; 7,970,886 shares issued and outstanding  798   798 
Additional paid-in capital  164,207,617   164,207,617 
(Accumulated deficit)/retained earnings  (4,984,178)  9,029,947 
Total ZAIS Financial Corp. stockholders’ equity  159,224,237   173,238,362 
Non-controlling interests in operating partnership  18,553,818   20,145,450 
Total equity  177,778,055   193,383,812 
Total liabilities and equity $775,138,921  $792,398,605 

 

 

 

 

 

 

 

(In Thousands)

    

December 31, 2017

    

December 31, 2016

Assets

 

 

 

 

 

 

Cash and cash equivalents

 

$

63,425

 

$

59,566

Restricted cash

 

 

11,666

 

 

20,190

Short-term investments

 

 

 —

 

 

319,984

Loans, net (including $188,150 and $81,592 held at fair value)

 

 

1,017,920

 

 

1,011,121

Loans, held for sale, at fair value

 

 

216,022

 

 

181,797

Mortgage backed securities, at fair value

 

 

39,922

 

 

32,391

Loans eligible for repurchase from Ginnie Mae

 

 

95,158

 

 

137,986

Investment in unconsolidated joint venture

 

 

55,369

 

 

 —

Derivative instruments

 

 

4,725

 

 

5,785

Servicing rights (including $72,295 and $61,376 held at fair value)

 

 

94,038

 

 

83,854

Receivable from third parties

 

 

6,756

 

 

7,220

Other assets

 

 

56,840

 

 

54,277

Assets of consolidated VIEs

 

 

861,662

 

 

691,096

Total Assets

 

$

2,523,503

 

$

2,605,267

Liabilities

 

 

 

 

 

 

Secured borrowings

 

 

631,286

 

 

927,462

Promissory note

 

 

6,107

 

 

7,378

Securitized debt obligations of consolidated VIEs, net

 

 

598,148

 

 

492,942

Convertible notes, net

 

 

108,991

 

 

 —

Senior secured notes, net

 

 

138,078

 

 

 —

Guaranteed loan financing

 

 

293,045

 

 

390,555

Contingent consideration

 

 

10,016

 

 

14,487

Liabilities for loans eligible for repurchase from Ginnie Mae

 

 

95,158

 

 

137,986

Derivative instruments

 

 

282

 

 

643

Dividends payable

 

 

12,289

 

 

11,505

Accounts payable and other accrued liabilities

 

 

74,636

 

 

70,207

Total Liabilities

 

$

1,968,036

 

$

2,053,165

Stockholders’ Equity

 

 

 

 

 

 

Common stock, $0.0001 par value, 500,000,000 shares authorized, 31,996,440 and 30,549,084 shares issued and outstanding, respectively

 

 

 3

 

 

 3

Additional paid-in capital

 

 

539,455

 

 

513,295

Deficit

 

 

(3,385)

 

 

(201)

Total Sutherland Asset Management Corporation equity

 

 

536,073

 

 

513,097

Non-controlling interests

 

 

19,394

 

 

39,005

Total Stockholders’ Equity

 

$

555,467

 

$

552,102

Total Liabilities and Stockholders’ Equity

 

$

2,523,503

 

$

2,605,267

 

The accompanying notes are an integral partSee Notes To Consolidated Financial Statements

114


SUTHERLAND ASSET MANAGEMENT CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

 

82

 

 

 

 

 

 

 

 

 

 

 

 

For the Year Ended December 31, 

(In Thousands, except share data)

 

2017

    

2016

    

2015

Interest income

 

$

138,305

 

$

137,023

 

$

148,955

Interest expense

 

 

(74,646)

 

 

(57,772)

 

 

(47,806)

Net interest income before provision for loan losses

 

$

63,659

 

$

79,251

 

$

101,149

Provision for loan losses

 

 

(2,363)

 

 

(7,819)

 

 

(19,643)

Net interest income after provision for loan losses

 

$

61,296

 

$

71,432

 

$

81,506

Non-interest income

 

 

 

 

 

 

 

 

 

Gains on residential mortgage banking activities, net of variable loan expenses

 

$

41,700

 

$

7,033

 

$

 —

Other income

 

 

8,458

 

 

9,161

 

 

14,431

Servicing income, net of amortization and impairment of $6,020, $7,732 and $10,499

 

 

22,994

 

 

8,658

 

 

5,133

Gain on bargain purchase

 

 

 —

 

 

15,218

 

 

 —

Total non-interest income

 

$

73,152

 

$

40,070

 

$

19,564

Non-interest expense

 

 

 

 

 

 

 

 

 

Employee compensation and benefits

 

$

(55,039)

 

$

(24,827)

 

$

(18,949)

Allocated employee compensation and benefits from related party

 

 

(3,843)

 

 

(3,668)

 

 

(3,323)

Professional fees

 

 

(8,921)

 

 

(13,420)

 

 

(6,954)

Management fees – related party

 

 

(8,059)

 

 

(7,432)

 

 

(7,260)

Incentive fees – related party

 

 

 —

 

 

 —

 

 

(965)

Loan servicing expense

 

 

(10,323)

 

 

(4,611)

 

 

(4,347)

Other operating expenses

 

 

(26,939)

 

 

(17,180)

 

 

(11,954)

Total non-interest expense

 

$

(113,124)

 

$

(71,138)

 

$

(53,752)

Net realized gain on financial instruments

 

 

19,329

 

 

6,914

 

 

181

Net unrealized gain on financial instruments

 

 

7,000

 

 

17,937

 

 

5,732

Income from continuing operations before provision for income taxes

 

$

47,653

 

$

65,215

 

$

53,231

Provision for income taxes

 

 

(1,839)

 

 

(9,651)

 

 

(7,810)

Net income from continuing operations

 

$

45,814

 

$

55,564

 

$

45,421

Discontinued operations

 

 

 

 

 

 

 

 

 

Loss from discontinued operations (including loss on disposal of $2,695 in 2016)

 

$

 —

 

$

(3,538)

 

$

(5,103)

Income tax benefit

 

 

 —

 

 

1,380

 

 

4,450

Loss from discontinued operations

 

$

 —

 

$

(2,158)

 

$

(653)

Net income

 

$

45,814

 

$

53,406

 

$

44,768

Less: Net income attributable to non-controlling interest

 

 

2,524

 

 

4,237

 

 

4,385

Net income attributable to Sutherland Asset Management Corporation

 

$

43,290

 

$

49,169

 

$

40,383

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per basic common share

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

1.38

 

$

1.93

 

$

1.62

Discontinued operations

 

$

 —

 

$

(0.08)

 

$

(0.03)

Earnings per basic common share

 

$

1.38

 

$

1.85

 

$

1.59

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per diluted common share

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

1.38

 

$

1.93

 

$

1.62

Discontinued operations

 

$

 —

 

$

(0.08)

 

$

(0.03)

Earnings per diluted common share

 

$

1.38

 

$

1.85

 

$

1.59

 

 

 

 

 

 

 

 

 

 

Weighted-average shares outstanding

 

 

 

 

 

 

 

 

 

Basic

 

 

31,350,102

 

 

26,647,981

 

 

25,287,277

Diluted

 

 

31,351,611

 

 

26,647,981

 

 

25,287,277

 

 

 

 

 

 

 

 

 

 

Dividends declared per share of common stock

 

$

1.48

 

$

1.61

 

$

1.78

 

See Notes To Consolidated Financial Statements

115


SUTHERLAND ASSET MANAGEMENT CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN EQUITYZAIS Financial Corp. and Subsidiaries
Consolidated Statements of Operations

 

  Year Ended
December 31, 2015
  Year Ended
December 31, 2014
  Year Ended
December 31, 2013
 
  (Expressed in United States Dollars, except share data) 
Interest income            
Mortgage loans held for investment $25,930,901  $26,140,679  $10,470,435 
Mortgage loans held for sale  3,144,345   594,217    
Real estate securities  8,166,961   14,313,293   15,947,892 
Other investment securities  560,349   544,558    
Total interest income  37,802,556   41,592,747   26,418,327 
Interest expense            
Warehouse lines of credit  2,151,690   121,194    
Loan repurchase facilities  9,432,335   8,906,849   3,612,167 
Securities repurchase agreements  1,480,616   2,544,838   2,918,813 
Exchangeable Senior Notes  5,785,264   5,686,664   563,539 
Total interest expense  18,849,905   17,259,545   7,094,519 
Net interest income  18,952,651   24,333,202   19,323,808 
             
Non-interest income            
Mortgage banking activities, net  45,857,462   5,439,006    
Loan servicing fee income, net of direct costs  7,092,431   929,718    
Change in fair value of mortgage servicing rights  (4,128,476)  (1,684,373)   
Other income  54,857   45,861    
    Total non-interest income  48,876,274   4,730,212    
Other (losses)/gains            
Change in unrealized gain or loss on mortgage loans held for investment  (9,368,719)  22,814,340   7,136,482 
Change in unrealized gain or loss on real estate securities  (4,851,240)  (2,993,640)  (7,170,706)
Change in unrealized gain or loss on Other Investment Securities  (334,167)  (226,224)   
Change in unrealized gain or loss on real estate owned  (435,282)  (503,956)   
Realized gain on mortgage loans held for investment  1,479,145   1,838,800   1,298,844 
Realized gain/(loss) on real estate securities  18,833   3,694,256   (9,045,689)
Realized (loss)/gain on Other Investment Securities  (154,554)  226,743    
Realized (loss)/gain on real estate owned  (160,341)  2,455    
(Loss)/gain on derivative instruments related to investment portfolio  (171,859)  (5,921,725)  5,614,815 
Total other (losses)/gains  (13,978,184)  18,931,049   (2,166,254)
Expenses            
Advisory fee - related party  2,953,115   2,853,896   2,629,815 
Salaries, commissions and benefits  30,934,727   3,765,784    
Operating expenses  12,294,334   7,862,308   5,473,915 
Other expenses  4,672,368   4,511,741   1,500,359 
Total expenses  50,854,544   18,993,729   9,604,089 
             
Net income before income taxes  2,996,197   29,000,734   7,553,465 
             
Income tax expense/(benefit)  4,415,474   (850,996)   
Net (loss)/income after income taxes  (1,419,277)  29,851,730   7,553,465 
             
Net (loss)/income allocated to non-controlling interests  (158,568)  3,109,760   880,358 
Preferred dividends        15,379 
Net (loss)/income attributable to ZAIS Financial Corp. common stockholders $(1,260,709) $26,741,970  $6,657,728 
Net (loss)/income per share applicable to common stockholders:            
Basic $(0.16) $3.35  $0.92 
Diluted $(0.16) $3.08  $0.92 
Weighted average number of shares of common stock:            
Basic  7,970,886   7,970,886   7,273,366 
Diluted  8,897,800   10,677,360   8,200,280 

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

83

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Retained

 

Total Sutherland

 

 

 

 

 

 

 

 

Common Stock

 

Preferred Stock

 

Additional Paid-

 

Earnings

 

Asset Management

 

Non-controlling

 

 

 

(In thousands, except share data)

    

Shares

    

Par Value

    

Shares

    

Par Value

    

In Capital

    

(Deficit)

    

Corporation equity

    

Interests

    

Total

Balance at January 1, 2015

 

24,595,200

 

$

 2

 

125

 

$

125

 

$

426,271

 

$

(838)

 

$

425,560

 

$

49,131

 

$

474,691

Dividend declared on common stock ($1.78 per share)

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

(45,444)

 

 

(45,444)

 

 

 —

 

 

(45,444)

Dividend reinvestment in common stock

 

418,942

 

 

 —

 

 —

 

 

 —

 

 

7,448

 

 

 —

 

 

7,448

 

 

 —

 

 

7,448

Conversion of OP units into REIT shares

 

725,705

 

 

 —

 

 —

 

 

 —

 

 

13,484

 

 

 —

 

 

13,484

 

 

(13,484)

 

 

 —

Offering costs allocated to Additional Paid-In Capital

 

 —

 

 

 —

 

 —

 

 

 —

 

 

(110)

 

 

 —

 

 

(110)

 

 

(11)

 

 

(121)

Dividend declared on OP units

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

(3,869)

 

 

(3,869)

Dividend reinvestment in OP units

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

2,740

 

 

2,740

Net Income

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

40,383

 

 

40,383

 

 

4,385

 

 

44,768

Balance at December 31, 2015

 

25,739,847

 

$

 2

 

125

 

$

125

 

$

447,093

 

$

(5,899)

 

$

441,321

 

$

38,892

 

$

480,213

  Shares issued pursuant to reverse merger transaction

 

4,651,424

 

 

 1

 

 —

 

 

 —

 

 

62,328

 

 

 —

 

 

62,329

 

 

 —

 

 

62,329

Shares redeemed pursuant to reverse merger transaction

 

(66)

 

 

 —

 

 —

 

 

 —

 

 

(1)

 

 

 —

 

 

(1)

 

 

 —

 

 

(1)

Dividend declared on common stock ($1.61 per share)

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

(43,463)

 

 

(43,463)

 

 

 —

 

 

(43,463)

Dividend reinvestment in common stock

 

103,440

 

 

 —

 

 —

 

 

 —

 

 

1,806

 

 

 —

 

 

1,806

 

 

 —

 

 

1,806

Incentive shares issued

 

27,199

 

 

 —

 

 —

 

 

 —

 

 

482

 

 

 —

 

 

482

 

 

 —

 

 

482

Conversion of OP units into common stock

 

27,240

 

 

 —

 

 —

 

 

 —

 

 

458

 

 

 —

 

 

458

 

 

(458)

 

 

 —

Transfer of Additional Paid-In Capital

 

 —

 

 

 —

 

 —

 

 

 —

 

 

1,134

 

 

 —

 

 

1,134

 

 

(1,134)

 

 

 —

Dividend declared on preferred stock

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

(8)

 

 

(8)

 

 

 —

 

 

(8)

Redemption of preferred stock

 

 —

 

 

 —

 

(125)

 

 

(125)

 

 

(5)

 

 

 —

 

 

(130)

 

 

 —

 

 

(130)

OP units issued pursuant to reverse merger transaction

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

816

 

 

816

Dividend declared on OP units

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

(3,707)

 

 

(3,707)

Dividend reinvestment in OP units

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

359

 

 

359

Net Income

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

49,169

 

 

49,169

 

 

4,237

 

 

53,406

Balance at December 31, 2016

 

30,549,084

 

$

 3

 

 —

 

$

 —

 

$

513,295

 

$

(201)

 

$

513,097

 

$

39,005

 

$

552,102

Dividend declared on common stock ($1.48 per share)

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

(46,474)

 

 

(46,474)

 

 

 —

 

 

(46,474)

Dividend declared on OP units

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

(2,570)

 

 

(2,570)

Shares issued in exchange of litigation settlement

 

275,862

 

 

 —

 

 —

 

 

 —

 

 

4,000

 

 

 —

 

 

4,000

 

 

 —

 

 

4,000

Equity component of 2017 convertible note issuance

 

 —

 

 

 —

 

 —

 

 

 —

 

 

2,065

 

 

 —

 

 

2,065

 

 

74

 

 

2,139

Offering costs allocated to Additional Paid-In Capital

 

 —

 

 

 —

 

 —

 

 

 —

 

 

(68)

 

 

 —

 

 

(68)

 

 

(2)

 

 

(70)

Distributions, net

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

(56)

 

 

(56)

Stock-based compensation

 

 —

 

 

 —

 

 —

 

 

 —

 

 

582

 

 

 —

 

 

582

 

 

 —

 

 

582

Conversion of OP units into common stock

 

1,171,494

 

 

 —

 

 —

 

 

 —

 

 

19,581

 

 

 —

 

 

19,581

 

 

(19,581)

 

 

 —

Net Income

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

43,290

 

 

43,290

 

 

2,524

 

 

45,814

Balance at December 31, 2017

 

31,996,440

 

$

 3

 

 —

 

$

 —

 

$

539,455

 

$

(3,385)

 

$

536,073

 

$

19,394

 

$

555,467

 

ZAIS Financial Corp. and Subsidiaries
Consolidated Statements of Equity

(Expressed in United States Dollars, except share data)

 

  Preferred Stock  Common Stock        Total ZAIS  Non-    
  Shares of
Preferred
Stock
  Preferred
Stock at
Par
  Shares of
Common
Stock
  Common
Stock at
Par
  Additional
Paid-in
Capital
  

Retained
Earnings/

(Accumulated
Deficit)

  Financial
Corp.
Stockholders’
Equity
  controlling
Interests in
Operating
Partnership
  Total Equity 
Balance at December 31, 2012  133  $   2,071,096  $207  $39,759,770  $5,281,941  $45,041,918  $20,098,877  $65,140,795 
                                     
Reversal of common stock repurchase liability        249,790   25   5,440,150      5,440,175      5,440,175 
Repurchase of preferred shares  (133)           (133,000)     (133,000)     (133,000)
Net proceeds from initial public offering        5,650,000   566   118,861,934      118,862,500      118,862,500 
Equity raise payments              (216,658)     (216,658)     (216,658)
Distributions on OP units                       (1,965,060)  (1,965,060)
Dividends on common stock                 (16,898,276)  (16,898,276)     (16,898,276)
Rebalancing of ownership percentage between the Company and operating partnership              495,421      495,421   (495,421)   
Net income                 6,657,728   6,657,728   880,358   7,538,086 
Balance at December 31, 2013    $   7,970,886  $798  $164,207,617  $(4,958,607) $159,249,808  $18,518,754  $177,768,562 
                                     
Distributions on OP units                       (1,483,064)  (1,483,064)
Dividends on common stock                 (12,753,416)  (12,753,416)     (12,753,416)
Net income                 26,741,970   26,741,970   3,109,760   29,851,730 
Balance at December 31, 2014    $   7,970,886  $798  $164,207,617  $9,029,947  $173,238,362  $20,145,450  $193,383,812 
                                     
Distributions on OP units                       (1,483,064)  (1,483,064)
Dividends on common stock                 (12,753,416)  (12,753,416)     (12,753,416)
Contributions                       50,000   50,000 
Net loss                 (1,260,709)  (1,260,709)  (158,568)  (1,419,277)
Balance at December 31, 2015    $   7,970,886  $798  $164,207,617  $(4,984,178) $159,224,237  $18,553,818  $177,778,055 

 

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

See Notes To Consolidated Financial Statements

 

84

116


SUTHERLAND ASSET MANAGEMENT CORPORATION

CONSOLIDATED STATEMENT OF CASH FLOWS

 

 

 

 

 

 

 

 

 

 

 

 

For the Year Ended December 31,

(In Thousands, except share information)

 

2017

    

2016

    

2015

Cash Flows From Operating Activities:

 

 

 

 

 

 

 

 

 

Net income

 

$

45,814

 

$

53,406

 

$

44,768

Less: Loss from discontinued operations

 

 

 —

 

 

(2,158)

 

 

(653)

Net income from continuing operations

 

 

45,814

 

 

55,564

 

 

45,421

Adjustments to reconcile net income to net cash provided  (used in) operating activities:

 

 

 

 

 

 

 

 

 

Discount accretion and premium amortization of financial instruments, net

 

 

(7,553)

 

 

(17,978)

 

 

(22,195)

Amortization of guaranteed loan financing, deferred financing costs, and intangible assets

 

 

22,078

 

 

19,457

 

 

9,782

Provision for loan losses

 

 

2,363

 

 

7,819

 

 

19,643

Charge off of real estate acquired in settlement of loans

 

 

756

 

 

1,833

 

 

849

Purchase of short-term investments and trading securities

 

 

(839,425)

 

 

(1,569,614)

 

 

(253,752)

Proceeds from sale or maturity of short-term investments and trading securities

 

 

1,159,819

 

 

1,569,992

 

 

255,087

Net settlement of derivative instruments

 

 

(1,256)

 

 

(2,058)

 

 

(4,621)

Purchase of loans, held for sale, at fair value

 

 

(11,195)

 

 

 —

 

 

 —

Origination of loans, held for sale, at fair value

 

 

(2,508,153)

 

 

(621,343)

 

 

 —

Proceeds from disposition and principal payments of loans, held for sale, at fair value

 

 

2,571,583

 

 

645,954

 

 

 —

Income on unconsolidated joint venture

 

 

(1,048)

 

 

 —

 

 

 —

Gain on sale of mortgages held for sale included in Gains on residential mortgage banking activities, net of variable loan expenses

 

 

(63,024)

 

 

(2,943)

 

 

 —

Gain (loss) on derivatives included in Gains on residential mortgage banking activities, net of variable loan expenses

 

 

2,699

 

 

(126)

 

 

 —

Creation of servicing rights, net of payoffs

 

 

(14,919)

 

 

(3,157)

 

 

 —

Gain on bargain purchase

 

 

 —

 

 

(15,218)

 

 

 —

Net realized gains on financial instruments

 

 

(19,329)

 

 

(6,914)

 

 

(181)

Net unrealized gains on financial instruments

 

 

(7,000)

 

 

(17,937)

 

 

(5,732)

Net changes in operating assets and liabilities

 

 

 

 

 

 

 

 

 

Assets of consolidated VIEs (excluding loans, net), accrued interest and due from servicers

 

 

24,319

 

 

(21,817)

 

 

(1,983)

Receivable from third parties

 

 

464

 

 

(2,328)

 

 

(608)

Other assets

 

 

(13,898)

 

 

(12,284)

 

 

(4,887)

Accounts payable and other accrued liabilities

 

 

9,394

 

 

9,580

 

 

(8,322)

Net cash provided by operating activities

 

 

352,489

 

 

16,482

 

 

28,501

Net cash (used in) provided by operating activities of discontinued operations

 

 

 —

 

 

(1,719)

 

 

428

Cash Flow From Investing Activities:

 

 

 

 

 

 

 

 

 

Origination of loans

 

 

(454,975)

 

 

(315,339)

 

 

(452,280)

Purchase of loans

 

 

(147,327)

 

 

(98,683)

 

 

(172,097)

Purchase of mortgage backed securities, at fair value

 

 

(14,448)

 

 

(17,388)

 

 

(77,918)

Funding of unconsolidated joint venture

 

 

(54,321)

 

 

 —

 

 

 —

Payment of liability under participation agreements, net of proceeds received

 

 

(1,100)

 

 

(2,318)

 

 

(3,729)

Proceeds from disposition and principal payment of loans

 

 

422,064

 

 

479,965

 

 

488,610

Proceeds from sale and principal payment of mortgage backed securities, at fair value

 

 

9,577

 

 

297,250

 

 

17,908

Proceeds from sale of real estate

 

 

4,802

 

 

6,633

 

 

7,565

Proceeds from sale of intangible assets

 

 

 —

 

 

 —

 

 

2,500

(Increase) Decrease in restricted cash

 

 

(6,506)

 

 

(357)

 

 

2,016

Cash acquired in connection with the reverse merger with ZFC

 

 

 —

 

 

34,932

 

 

 —

Net cash (used in) provided by investing activities

 

 

(242,234)

 

 

384,695

 

 

(187,425)

Net cash used in investing activities of discontinued operations

 

 

 —

 

 

 —

 

 

(1,264)

Cash Flows From Financing Activities:

 

 

 

 

 

 

 

 

 

Proceeds from secured borrowings

 

 

4,555,957

 

 

4,460,652

 

 

9,014,674

Proceeds from issuance of securitized debt obligations of consolidated VIEs

 

 

338,043

 

 

150,367

 

 

374,818

Proceeds from promissory note

 

 

 —

 

 

9,164

 

 

 —

Proceeds from senior secured note offering

 

 

141,917

 

 

 —

 

 

 —

Proceeds from convertible note issuance

 

 

115,000

 

 

 —

 

 

 —

Payment of secured borrowings

 

 

(4,852,132)

 

 

(4,648,201)

 

 

(9,029,152)

Payment of securitized debt obligations of consolidated VIEs

 

 

(227,694)

 

 

(123,093)

 

 

(91,407)

Payment of guaranteed loan financing

 

 

(110,945)

 

 

(122,603)

 

 

(86,039)

Payment of promissory note

 

 

(1,271)

 

 

(1,786)

 

 

 —

Payment of senior exchangeable note

 

 

 —

 

 

(57,500)

 

 

 —

Payment of deferred financing costs

 

 

(16,885)

 

 

(1,456)

 

 

(2,575)

Payment of offering costs

 

 

(70)

 

 

 —

 

 

(121)

Redemption of preferred stock

 

 

 —

 

 

(130)

 

 

 —

Dividend payments

 

 

(48,260)

 

 

(46,874)

 

 

(35,609)

Distributions

 

 

(56)

 

 

 —

 

 

 —

Shares redeemed pursuant to reverse merger transaction

 

 

 —

 

 

(1)

 

 

 —

Net cash (used in) provided by financing activities

 

 

(106,396)

 

 

(381,461)

 

 

144,589

Net increase (decrease) in cash and cash equivalents

 

 

3,859

 

 

17,997

 

 

(15,171)

Cash and cash equivalents at beginning of period

 

 

59,566

 

 

41,569

 

 

56,740

Cash and cash equivalents at end of period

 

$

63,425

 

$

59,566

 

$

41,569

 

 

 

 

 

 

 

 

 

 

Supplemental disclosure of operating cash flow

 

 

 

 

 

 

 

 

 

Cash paid for interest

 

$

62,106

 

$

54,686

 

$

45,334

Cash paid for income taxes

 

 

3,773

 

 

6,161

 

 

6,995

Stock-based compensation

 

 

582

 

 

 —

 

 

 

Supplemental disclosure of non-cash investing activities

 

 

 

 

 

 

 

 

 

Loans, net and borrowings brought on books as a result of the ReadyCap Lending Small Business Trust 2015-1 securitization

 

$

 —

 

$

 —

 

$

474,198

Loans transferred from Loans, held for sale, at fair value to Loans, net

 

 

366

 

 

482

 

 

 —

Loans transferred from Loans, net to Loans, held for sale, at fair value

 

 

4,493

 

 

11,499

 

 

 —

Supplemental disclosure of non-cash financing activities

 

 

 

 

 

 

 

 

 

Shares issued in exchange of litigation settlement

 

$

4,000

 

$

 —

 

$

 —

Dividend reinvestment in common stock

 

 

 —

 

 

1,806

 

 

7,448

Dividend reinvestment in operating partnership units

 

 

 —

 

 

359

 

 

2,740

Common stock issued in connection with the reverse merger with ZAIS Financial Corp

 

 

 —

 

 

62,329

 

 

 —

Incentive shares issued to investment manager pursuant to management agreement

 

 

 —

 

 

482

 

 

 —

 

117


SUTHERLAND ASSET MANAGEMENT CORPORATION

NOTES TO the CONSOLIDATED FINANCIAL STATEMENTS ZAIS Financial Corp. and Subsidiaries
Consolidated Statements of Cash Flows

 

  Year Ended
December 31, 2015
  Year Ended
December 31, 2014
  Year Ended
December 31, 2013
 
  (Expressed in United States Dollars) 
Cash flows from operating activities            
Net (loss) income $(1,419,277) $29,851,730  $7,553,465 
Adjustments to reconcile net (loss)/income to net cash (used in)/provided by operating activities            
Net (accretion)/amortization of (discounts) premiums related to mortgage loans held for investment  (7,761,432)  (7,497,341)  (3,059,231)
Net (accretion)/amortization of (discounts)/premiums related to real estate securities  (3,882,887)  (5,528,538)  (2,932,089)
Net (accretion)/amortization of (discounts)/premiums related to other investment securities  (192,476)  (180,438)   
Change in unrealized gain or loss on mortgage loans held for investment  9,368,719   (22,814,340)  (7,136,482)
Change in unrealized gain or loss on real estate securities  4,851,240   2,993,640   7,170,706 
Change in unrealized gain or loss on other investment securities  334,167   226,224    
Change in unrealized gain or loss on real estate owned  435,282   503,956    
Change in fair value of mortgage servicing rights  4,128,476   1,684,373    
Realized gain on mortgage loans held for investment  (1,479,145)  (1,838,800)  (1,298,844)
Realized (gain)/ loss on real estate securities  (18,833)  (3,694,256)  9,045,689 
Realized loss/(gain) on other investment securities  154,554   (226,743)   
Realized loss/(gain) on real estate owned  160,341   (2,455)   
Change in unrealized gain or loss on derivative instruments related to investment portfolio  (644,304)  5,306,841   (1,281,997)
Amortization of Exchangeable Senior Notes discount  1,034,305   935,690   88,457 
Depreciation and amortization expense  933,812   154,010    
Proceeds from sale and principal payments on mortgages held for sale  1,893,833,985   245,140,671    
Originations and purchases of mortgage loans held for sale  (1,851,206,995)  (253,934,598)   
Gain on sale of mortgages held for sale  (61,322,192)  3,615,357    
Capitalization of originated mortgage servicing rights  (18,958,514)  (2,763,014)   
Changes in operating assets and liabilities:            
   (Increase) /decrease in other assets  1,614,564   559,791   (1,321,134)
   Increase /(decrease) in accounts payable and other liabilities  7,100,795   2,818,360   1,302,727 
   Decrease in contingent consideration  (145,313)      
Net cash (used in)/ provided by operating activities  (23,081,128)  (4,689,880)  8,131,267 
Cash flows from investing activities            
Cash paid for the acquisition of GMFS, net of cash acquired     (49,542,840)   
Origination of mortgage loans held for investment  (6,201,147)      
Acquisitions of mortgage loans held for investment  (16,353,410)  (85,579,169)  (334,162,044)
Proceeds from sales and principal repayments on mortgage loans held for investment  36,798,274   31,519,288   13,871,059 
Acquisitions of real estate securities, net of change in payable for real estate securities purchased  (6,362,138)  (47,034,327)  (406,263,789)
Proceeds from principal repayments on real estate securities  17,888,188   28,197,740   46,752,670 
Proceeds from sales of real estate securities, net of changes in receivable for real estate securities sold  26,770,882   102,635,229   291,348,906 
Acquisitions of Other Investment Securities  (17,031,330)  (12,926,953)   
Proceeds from sales of Other Investment Securities  5,961,506   11,067,378    
Proceeds from principal repayments on other investment securities  9,915       
Purchase of swaption     (4,803,750)   
Proceeds received for the final reconciliation of purchase price relating to the acquisition of GMFS  1,684,263       
Restricted cash provided by/(used) in investment activities  2,771,353   (5,014,842)  1,639,915 
Net cash provided by /(used in) investing activities  45,936,356   (31,482,246)  (386,813,283)
Cash flows from financing activities            
Proceeds from issuance of common stock, net         118,862,500 
Payment of common stock repurchase liability         (5,750,512)
Net borrowings under warehouse lines of credit  11,350,864   3,576,859    
Net (repayments)/borrowings under loan repurchase facilities  (3,302,963)  64,033,317   236,058,976 
Borrowings from securities repurchase agreements  5,243,481   138,210,170   366,103,785 
Repayments of securities repurchase agreements  (34,957,427)  (173,787,743)  (343,592,574)
Proceeds from issuance of Exchangeable Senior Notes        54,450,594 
Allocation of proceeds to conversion option on Exchangeable Senior Notes        1,324,406 
Dividends on common stock and distributions on OP units (net of dividends and distributions payable)  (14,236,480)  (19,130,270)  (10,410,426)
Repurchase of preferred stock including dividend        (148,379)
Equity raise payments        (216,658)
Contributions from non-controlling interests  50,000       
Net cash (used in)/provided by financing activities  (35,852,525)  12,902,333   416,681,712 
Net (decrease)/ increase in cash  (12,997,297)  (23,269,793)  37,999,696 
Cash            
Beginning of year  33,791,013   57,060,806   19,061,110 
End of year $20,793,716  $33,791,013  $57,060,806 
Supplemental disclosure of cash flow information            
Interest paid on warehouse lines of credit, loan repurchase facilities, securities repurchase agreements and Exchangeable Senior Notes $17,536,164  $18,666,057  $5,696,619 
Taxes paid $  $  $ 
Supplemental disclosure of noncash investing and financing activities            
Accrued dividends and distributions payable $3,559,120  $3,559,120  $8,452,910 
Conversion of mortgage loans held for investment to real estate owned $3,806,064  $  $ 

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

85

ZAIS FINANCIAL CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Formation andNote 1 – Organization

 

ZAIS Financial Corp.Sutherland Asset Management Corporation (the “Company” or “Sutherland” and together with its subsidiaries (the "Company"“we,” “us” and “our”) is a Maryland corporation invests in residential mortgage loans. GMFS, LLCcorporation. On October 31, 2016, we completed our path to becoming a publicly traded company through our merger with and into a subsidiary of ZAIS Financial Corp. (“GMFS”), a mortgage banking platform the Company acquired in October 2014, originates, sells and services mortgage loans and the Company acquires performing, re-performing and newly originated loans through other channels. The Company also invests in, finances and manages residential mortgage-backed securities ("RMBS") that are not issued or guaranteed by a federally chartered corporation, such as the Federal National Mortgage Association ("Fannie Mae"), the Federal Home Loan Mortgage Corporation ("Freddie Mac"), or an agency of the U.S. Government, such as Government National Mortgage Association ("Ginnie Mae") ("non-Agency RMBS"ZAIS Financial”), with an emphasisZAIS Financial legally surviving the merger and changing its name to Sutherland Asset Management Corporation. On November 1, 2016, our common stock began trading on securities that, when originally issued, were ratedthe New York Stock Exchange (“NYSE”) under ticker symbol “SLD”. See further discussion in the highest rating category by one or more of the nationally recognized statistical rating organizations. The Company also has the discretion to invest in RMBS that are issued or guaranteed by a federally chartered corporation or a U.S. Government agency ("Agency RMBS"), including through To-Be-Announced ("TBA") contracts, and in other real estate-related and financial assets.

As announced on November 4, 2015, the Company has engaged a financial advisor to assist it in evaluating potential strategic alternatives to enhance stockholder value. The continuing strategic review includes the exploration of merger or sale transactions involving the Company or a liquidation of Company's assets. In light of the strategic review and in order to reduce current market risk in its investment portfolio, the Company has recently begun the process of selling its seasoned, re-performing mortgage loans from its residential mortgage investments segment. A sale of these assets is expected to be completed early in the second quarter of 2016. Additionally, as part of the strategic review, the Company has made the recent decision to cease the purchase of newly originated residential mortgage loans as part of its mortgage conduit purchase program and will begin the unwinding of the Company’s mortgage conduit business.Note 5, Business Combinations.

 

The Company is externally managed and its financialadvised by Waterfall Asset Management, LLC (“Waterfall” or the “Manager”), an investment advisor have engaged in preliminary discussionsregistered with several potential counterparties. Whilethe United States Securities and Exchange Commission under the Investment Advisors Act of 1940, as amended.

Sutherland Partners, LP (the “Operating Partnership”) holds substantially all of our assets and conducts substantially all of our business. As of December 31, 2017 and 2016, the Company is currently engagedowned approximately 96.5% and 92.9%, respectively, of the operating partnership units (“OP units”) of the Operating Partnership. The Company, as sole general partner of the Operating Partnership, has responsibility and discretion in discussions with a potential counterparty about a potential mergerthe management and control of the Operating Partnership, and the limited partners of the Operating Partnership, in such capacity, have no authority to transact business for, or sale transaction, there is no assurance thatparticipate in the discussions will lead to a definitive merger or sale transaction, which would be subject to approval bymanagement activities of the Company’s board of directors and its stockholders. In the event thatOperating Partnership. Therefore, the Company does not reach a definitive agreement with respect to a merger or sale transaction, management ofconsolidates the Company intends to present to the Company’s board of directors for its consideration a plan of liquidation. There is no assurance that the Company’s board of directors will approve any plan of liquidation and recommend its acceptance by the Company’s stockholders.

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.Operating Partnership.

 

The Company, was incorporated in Maryland on May 24, 2011,together with its consolidated subsidiaries and has elected to be taxedvariable interest entities (“VIEs”), is a specialty-finance company which acquires, originates, manages, services and finances small balance commercial (“SBC”) loans, Small Business Administration (“SBA”) loans, residential mortgage loans, and to qualifya lesser extent, mortgage backed securities (“MBS”) collateralized primarily by SBC loans, or other real estate-related investments.

SBC loans represent a special category of commercial loans, sharing both commercial and residential loan characteristics. SBC loans are generally secured by first mortgages on commercial properties, but because SBC loans are also often accompanied by collateralization of personal assets and subordinate lien positions, aspects of residential mortgage credit analysis are utilized in the underwriting process.

The Company reports its results of operations through the following four business segments: i) Loan Acquisitions, ii) SBC Originations, iii) SBA Originations, Acquisitions and Servicing, and iv) Residential Mortgage Banking, with the remaining amounts recorded in Corporate-Other. Our acquisition and origination platforms consist of the following four operating segments:

·

Loan Acquisitions.  We acquire performing and non-performing SBC loans and intend to continue to acquire these loans as part of our business strategy. We hold performing SBC loans to term, and we seek to maximize the value of the non-performing SBC loans acquired by us through proprietary loan modification programs. We typically acquire non-performing loans at a discount to their unpaid principal balance (“UPB”) when we believe that resolution of the loans will provide attractive risk-adjusted returns.

·

SBC Originations. We originate SBC loans secured by stabilized or transitional investor properties using multiple loan origination channels through our wholly-owned subsidiary, ReadyCap Commercial, LLC (“RCC”), a wholly-owned subsidiary of ReadyCap Holdings, LLC (collectively, “ReadyCap”). Additionally, as part of this segment, we originate and service multi-family loan products under the newly launched small balance loan program of the Federal Home Loan Mortgage Corporation (“Freddie Mac” and the “Freddie Mac program”). These originated loans are generally held-for-investment or placed into securitization structures.

·

SBA Originations, Acquisitions, and Servicing. We acquire, originate and service owner-occupied loans guaranteed by the SBA under its Section 7(a) loan program (the “SBA Section 7(a) Program”) through our wholly-owned subsidiary, ReadyCap Lending (“RCL”). We hold an SBA license as one of only 14 non-bank Small Business Lending Companies and have been granted preferred lender status by the SBA. In the future, we may originate SBC loans for real estate under the SBA 504 loan program, under which the SBA guarantees

118


subordinated, long-term financing. These originated loans are either held-for-investment, placed into securitization structures, or sold.

·

Residential Mortgage Banking. In connection with our merger with ZAIS Financial on October 31, 2016, as described in greater detail below, we added a residential mortgage loan origination segment through our wholly-owned subsidiary, GMFS, LLC ("GMFS"). GMFS originates residential mortgage loans eligible to be purchased, guaranteed or insured by the Federal National Mortgage Association (“Fannie Mae”), Freddie Mac, Federal Housing Administration (“FHA”), U.S. Department of Agriculture (“USDA”) and U.S. Department of Veterans Affairs (“VA”) through retail, correspondent and broker channels. These originated loans are then sold to third parties.

The Company qualifies as a REIT under the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”), commencing with its first taxable year ended December 31, 2011. To maintain its tax status as a real estate investment trust ("REIT"(“REIT”) beginning with the taxable year ended December 31, 2011. The Company completed its formation transaction and commenced operations on July 29, 2011. On February 13, 2013,, the Company completed its initial public offering ("IPO"), pursuant to which the Company sold 5,650,000 sharesdistributes at least 90% of its common stock at a pricetaxable income in the form of $21.25 per share for gross proceeds of $120.1 million. Net proceeds, after the payment of offering costs of $1.2 million, were $118.9 million.distributions to shareholders.

 

The Company's charter authorizesIn the issuancefourth quarter of up2015, Silverthread Falls, LLC (“Silverthread”), a brokerage subsidiary, was classified as held-for-sale due to 500,000,000 shares of common stock with a par value of $0.0001 per share,management’s intent to sell the business, 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 included Silverthread in discontinued operations. The trade date of the authority to issue.Silverthread sale was February 28, 2016 and the closing occurred in May of 2016.

 

The Company is the sole general partner

Note 2 – Basis of and conducts substantially all of its business through, ZAIS Financial Partners, L.P., the Company's consolidated operating partnership subsidiary (the "Operating Partnership"). The Company is externally managed by ZAIS REIT Management, LLC (the "Advisor"), a subsidiary of ZAIS Group, LLC ("ZAIS"), and has no employees except for those employed by GMFS. GMFS had 246 employees at December 31, 2015.Presentation

 

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordanceconformity with U.S.accounting principles generally accepted accounting principlesin the United States of America (“U.S. GAAP”)as contained withinprescribed by the Financial Accounting Standards BoardBoard’s (“FASB”) Accounting Standards Codification (“ASC”) and the rules and regulations of the U.S. Securities and Exchange Commission.

86

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

 

Per ASC 805-40-45-1, we were designated as the accounting acquirer (accounting survivor) because of our larger pre-merger size relative to ZAIS Financial, the relative voting interests of our stockholders after consummation of the merger, and our senior management and board continuing on after the consummation of the merger. As the accounting acquirer, our historical financial statements (and not those of ZAIS Financial) are the historical financial statements following the consummation of the merger and are included in this annual report on Form 10-K.

Historical stockholders’ equity of the Company prior to the reverse acquisition has been retrospectively adjusted (a recapitalization) for the equivalent number of shares received by the Company after giving effect to any difference in par value of ZAIS Financial and the Company’s stock with any such difference recognized in equity. Retained earnings of the Company have been carried forward after the acquisition. Operations prior to the merger are those of the Company. Under the terms of the merger agreement: (1) stockholders of ZAIS Financial and unitholders in the ZAIS Financial operating partnership retained their existing shares and partnership units following the merger, (2) each outstanding share of Sutherland common stock was converted into 0.8356 of ZAIS Financial common stock and (3) each outstanding partnership unit of Sutherland operating partnership was converted into 0.8356 units of limited partnership interests in the operating partnership.

Note 3 – Summary of Significant Accounting Policies

Use of Estimates

 

The preparation of the Company’s consolidated financial statements in conformity with U.S. GAAP requires managementus to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosuredisclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenuesincome and expenses during the reporting period. Actual results may ultimatelycould differ from those estimates.

 

Principles

119


Basis of Consolidation

 

The accompanying consolidated financial statements of the Company include the accounts and results of operations of the Operating Partnership and other consolidated subsidiaries and VIEs in which we are the primary beneficiary. The consolidated financial statements includeare prepared in accordance with ASC 810, Consolidations. Intercompany accounts and transactions have been eliminated.

Reclassifications

Certain amounts reported for the accountsprior periods in the accompanying consolidated financial statements have been reclassified in order to conform to the current period’s presentation.

Loans, held-for-investment and loans, held at fair value are now presented on the consolidated balance sheets as Loans, net. These amounts have been presented by loan program type and accounting category, within Note 6.

Servicing rights and residential mortgage servicing rights, at fair value, are now included on the consolidated balance sheets as Servicing rights. These amounts have been presented by loan servicing program and accounting category, within Note 9. The amounts reported for the prior periods have been reclassified in order to conform to the current period’s presentation.

Borrowings under repurchase agreements and borrowings under credit facilities are now included on the consolidated balance sheets as Secured borrowings. The amounts reported for the prior periods have been reclassified in order to conform to the current period’s presentation.

As described in Note 10, the historical results of our Residential mortgage banking segment has been reclassified in the consolidated statements of income to conform to our current period’s presentation of Gains on residential mortgage banking activities, net of variable loan expenses.

As described in Note 26, effective at the beginning of the third quarter of 2017, the Company the Operating Partnership, allimplemented organizational changes to align its segment financial reporting more closely with its current business practices. These organizational changes resulted in securitization activities on originated SBC and SBA loans being transferred out of the wholly owned subsidiariesLoan Acquisitions segment and into either the SBC originations or SBA originations, acquisitions, and servicing segment, based on the loan type. These organizational changes also resulted in the Company presenting Corporate- Other amounts separately and no longer reflecting these amounts as part of the Operating Partnership, including its taxable REIT subsidiaries (“TRS”),four business segments. Prior period numbers were revised to conform to the new segment alignment and a joint ventureto be consistent with our current period’s presentation.

As described in whichNote 27, the historical results of Silverthread has been reflected in the accompanying consolidated statements of income for the years ended December 31, 2016 and 2015 as discontinued operations and financial information related to discontinued operations has been excluded from the notes to consolidated financial statements for all periods presented.

Cash and Cash Equivalents

The Company has accounted for cash and cash equivalents in accordance with ASC 305, Cash and Cash Equivalents.The Company defines cash and cash equivalents as cash, demand deposits, and short-term, highly liquid investments with original maturities of 90 days or less when purchased. Cash and cash equivalents are exposed to concentrations of credit risk. We deposit our cash with institutions that we believe to have highly valuable and defensible business franchises, strong financial fundamentals, and predictable and stable operating environments.

As of December 31, 2017 and 2016, the Company has a controlling financial interest. All intercompany balances have been eliminatedhad $0.6 million and $0.6 million, respectively, in consolidation.

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

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

Variable Interest Entities

A variable interest entity ("VIE") is an entity that lacks one or more of the characteristics of a voting interest entity. The Company evaluates each of its investments to determine whether it is a VIE based on: (1) the sufficiency of the entity's equity investment at risk to finance its activities without additional subordinated financial support provided by any parties, including the equity holders; (2) whether as a group the holders of the equity investment at risk have (a) the power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impacts the entity's economic performance, (b) the obligation to absorb the expected losses of the legal entity or the right to receive the expected residual returns of the legal entity; and (3) whether the voting rights of these investors are proportional to their obligations to absorb the expected losses of the entity, their rights to receive the expected returns of their equity, or both, and whether substantially all of the entity's activities involve orCompany’s cash and cash equivalents not held in money market funds were comprised of cash balances with banks that are conducted on behalf of an investor that has disproportionately fewer voting rights. An investment that lacks one or morein excess 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.Federal Deposit Insurance Corporation insurance limits.

 

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 December 31, 2015 or December 31, 2014. The maximum exposure of the Company to VIEs is limited to the fair value of its investments in real estate securities and MSRs as disclosed in the Company's consolidated balance sheets.

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.

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Restricted Cash

 

Restricted cash represents the Company's cash held by counterpartiesthe Company as collateral against the Company'sits derivatives, and/or securitiesborrowings under repurchase agreements. Cash agreements, borrowings under credit facilities with counterparties, construction and mortgage escrows, as well as cash

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held by counterparties as collateralfor remittance on loans serviced for third parties. Restricted cash is not available to the Company for general corporate purposes, but may be applied against amounts due to derivative or securitiescounterparties under existing swaps and repurchase agreement counterpartiesborrowings, or returned to the Company when the collateralrestriction requirements are exceededno longer exist or at the maturity of the derivativesswap or securities repurchase agreements.agreement.

 

Other InvestmentShort term investments

The Company accounts for short-term investments as trading securities under ASC 320, Investments-Debt and Equity Securities. Short-term investments consist of U.S. Treasury Bills with original maturities of less than a year but greater than three months. The Company holds short-term investments at fair value. Interest received and accrued as well as the accretion of purchase discount in connection with short-term investments is recorded as interest income on the consolidated statements of income. Changes in the fair value of short-term investments are recorded as net unrealized gain (loss) on the consolidated statements of income.

Loans, net

Loans, net consists of loans, held-for-investment, net of allowance for loan losses, and loans, held at fair value.

Loans, held-for-investment

Loans, held-for-investment are loans acquired from third parties (“acquired loans”), loans originated by ReadyCap that we do not intend to securitize or sell, or securitized loans that were previously originated by ReadyCap. Securitized loans remain on the Company’s balance sheet because the securitization vehicles are consolidated under ASC 810.

Acquired loans are recorded at cost at the time they are acquired. Acquired loans are accounted for in accordance with ASC 310-30, Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310-30”) and referred to as “purchased credit impaired loans” (PCI loans) if both of the following conditions are met as of the acquisition date: (i) there is evidence of deterioration in credit quality of the loan since its origination and (ii) it is probable that we will not collect all contractual cash flows on the loan.

Acquired loans without evidence of these conditions, securitized loans, and loans originated by ReadyCap that we do not intend to securitize are accounted for under ASC 310-10, Receivables-Overall, (“ASC 310-10”) and are referred to as “Non-purchased credit impaired loans” (non-PCI loans).

Purchased Credit Impaired (PCI) Loans

The estimated cash flow expected for each loan is estimated at the time the loan is acquired. The excess of the cash flows expected to be collected on PCI loans, measured as of the acquisition date, over the initial investment is referred to as the accretable yield and is recognized in interest income over the remaining life of the loan using the interest method of accretion. The difference between contractually required payments as of the acquisition date and the cash flows expected to be collected is referred to as the non-accretable difference and is not accreted over time.

 

The Company held Freddie Mac Structured Agency Credit Risk Notes at December 31, 2015 and December 31, 2014 and Fannie Mae's Risk Transfer Notes at December 31, 2015 (collectively, the “Other Investment Securities”). The Other Investment Securities represent unsecured general obligations of Fannie Mae and Freddie Mac and are structuredestimates expected cash flows to be subjectcollected over the life of individual PCI loans on a quarterly basis. If the Company determines that discounted expected cash flows have decreased, the PCI loans would be considered impaired, which would result in a provision for loan loss and a corresponding increase in the allowance for loan losses.

If discounted expected cash flows have increased, or improved, in subsequent evaluations, the increase in cash flows is first used to reverse the amount of any related allowance for loan losses before the yield is adjusted. Additionally, the Company will increase the accretable yield to account for the increase in expected cash flows.

The estimate of the amount and timing of cash flows for our PCI loans is based on historical information available and expected future performance of the loans, and may include the timing of expected future cash flows, prepayment speed, default rates, loss severities, delinquency rates, percentage of non-performing loans, extent of credit support available, Fair Isaac Corporation scores at loan origination, year of origination, loan-to-value ratios, geographic concentrations, as well as reports by credit rating agencies, such as Moody’s, Standard & Poor’s Corporation, or Fitch, general market assessments and dialogue with market participants. As a result, substantial judgment is used in the analysis to determine the expected cash flows.

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Non-PCI Loans

The Company uses the interest method to recognize, as a constant effective yield adjustment, the difference between the initial recorded investment in the loan and the principal amount of the loan. The calculation of the constant effective yield necessary to apply the interest method uses the payment terms required by the loan contract, and prepayments of principal are not anticipated to shorten the loan term.

For non-PCI loans, recognition of interest income is suspended when any loans are placed on non-accrual status. Generally, all classes of loans are placed on non-accrual status when principal or interest has been delinquent for 90 days or when full collection is determined not to be probable. Interest income accrued, but not collected, at the date loans are placed on non-accrual status is reversed and subsequently recognized only to the performanceextent it is received in cash or until it qualifies for return to accrual status. However, where there is doubt regarding the ultimate collectability of a certain poolloan principal, all cash received is applied to reduce the carrying value of residential mortgagesuch loans. Loans are restored to accrual status only when contractually current and the collection of future payments is reasonably assured.

 

Mortgage Loans, Held for Investment, Mortgage Loans Held for Sale, Real Estate Securities, Other Investment Securities and MSRs — Fair Value Electionheld at fair value

 

U.S. GAAP permits entities to choose to measure certain eligible financial instrumentsLoans, held at fair value.value are loans originated by ReadyCap. The Company has elected the fair value option for somebecause of its mortgage loans held for investment, and each of its real estate securities, Other Investment Securities and MSRs at the date of purchase. The fair value option electionintent to transfer to securitizations in the near term. Interest is irrevocable and requires the Company to measure these mortgage loans, real estate securities, Other Investment Securities and MSRs at estimated fair value with the change in estimated fair value recognized through earnings. The Company has established a policy for its mortgage loans held for investment, real estate securities and Other Investment Securities to separateas interest income from the full change in fair value inon the consolidated statements of operations. The interest income component is presented as interest income on mortgage loans held for investment, mortgage loans held for sale, real estate securitieswhen earned and Other Investment Securities and the remainder of the change in fair value is presented separately as change in unrealized gain or loss in the Company's consolidated statements of operations.

Determination of Fair Value Measurement

The "Fair Value Measurements and Disclosures" Topic of the FASB ASC defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurements under U.S. GAAP. Specifically, this guidance defines fair value based on exit price, or the price that would be received upon the sale of an asset or the transfer of a liability in an orderly transaction between market participants at the measurement date. Fair value under U.S. GAAP represents an exit price in the normal course of business, not a forced liquidation price. If the Company was forced to sell assets in a short period to meet liquidity needs, the prices it receives could be substantially less than their recorded fair values.

The Company follows the fair value measurement and disclosure guidance under U.S. GAAP, which establishes a hierarchical disclosure framework. This framework prioritizes and ranks the level of market price observability used in measuring investments at fair value. Market price observability is affected by a number of factors, including the type of investment, the characteristics specific to the investment and the state of the marketplace including the existence and transparency of transactions between market participants. Investments with readily available active quoted prices or for which fair value can be measured from actively quoted prices in an orderly market generally will have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value. In all cases, an instrument's level within the hierarchy is based upon the market pricing transparency of the instrument and does not necessarily correspond to the Company's perceived risk or liquidity of the instrument.

The Company considers observable data to be market data which is readily available, regularly distributed or updated, reliable and verifiable, not proprietary, and provided by independent sources that are actively involved in the relevant market. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the determination of which category within the fair value hierarchy is appropriate for any given investment is based on the lowest level of input that is significant to the fair value measurement. The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires significant judgment and considers factors specific to the investment.

Assets and liabilities that are measured and reported at fair value are classified and disclosed in one of the following categories:

Level 1 — Fair value is determined based on quoted prices for identical assets or liabilities in an active market. Assets and liabilities included in Level 1 include listed securities. As required in the fair value measurement and disclosure guidance under U.S. GAAP, the Company does not adjust the quoted price for these investments. The hierarchy gives highest priority to Level 1.

Level 2 — Fair value is determined based on inputs other than quoted prices that are observable for the asset or liability either directly or indirectly as of the reporting date. Assets and liabilities which are generally included in this category include corporate bonds and loans, less liquid and restricted equity securities and certain over-the-counter derivatives, including foreign exchange forward contracts whose values are based on the following:

·Quoted prices for similar assets or liabilities in active markets.

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·Quoted prices for identical or similar assets or liabilities in nonactive markets.

·Pricing models whose inputs are observable for substantially the full term of the asset or liability.

·Pricing models whose inputs are derived principally from or corroborated by observable market data for substantially the full term of the asset or liability.

Level 3 — Fair value is determined based on inputs that are unobservable for the investment and includes situations where there is little, if any, market activity for the asset or liability. The inputs into the determination of fair value require significant management judgment or estimation and the Company may use models or other valuation methodologies to arrive at fair value. Investments that are included in this category generally include MSRs, distressed debt, less liquid corporate debt securities, non-investment grade residual interests in securitizations, collateralized debt obligations and certain derivative contracts. The hierarchy gives the lowest priority to Level 3.

ZAIS has established a valuation process that applies for all levels of investments in the valuation hierarchy to ensure that the valuation techniques are consistent and verifiable. The valuation process includes discussions between the valuation team, portfolio management team and the valuation committee (the “Valuation Committee”). The Valuation Committee consists of senior members of ZAIS Group and is co-chaired by the Chief Risk Officer and Chief Financial Officer of ZAIS. The Valuation Committee meets to review and approve the results of the valuation process which are used in connection with the preparation of quarterly and annual financial statements. The Valuation Committee is responsible for oversight and review of the written valuation policies and procedures and ensuring that they are applied consistently.

The lack of an established, liquid secondary market for some of the Company’s holdings may have an adverse effect on the market value of those holdings and on the Company’s ability to dispose of them. Additionally, the public markets for the Company’s holdings may experience periods of volatility and periods of reduced liquidity and the Company’s holdings may be subject to certain other transfer restrictions that may further contribute to illiquidity. Such illiquidity may adversely affect the price and timing of liquidations of the Company’s holdings.

The following is a description of the valuation techniques used to measure fair value and the classification of these instruments pursuant to the fair value hierarchy:

Mortgage Loans Held for Investment, at Fair Value

The fair value of the Company's mortgage loans held for investment considers data such as loan origination information and additional updated borrower and loan servicing data, as available, forward interest rates, general economic conditions, home price index forecasts and valuations of the underlying properties. The variables considered most significant to the determination of the fair value of the Company's mortgage loans held for investment include market-implied discount rates, projections of default rates, delinquency rates, loss severity (considering mortgage insurance) and prepayment rates. ZAIS uses loan level data, macro-economic inputs and forward interest rates to generate loss adjusted cash flows and other information in determining the fair value of its mortgage loans. Because of the inherent uncertainty of such valuation, the fair values established for mortgage loans held for investment by the Company may differ from the fair values that would have been established if a ready market existed for these mortgage loans held for investment. Accordingly, mortgage loans held for investment are classified as Level 3 in the fair value hierarchy.

Mortgage Loans Held for Sale, at Fair Value

The fair value of mortgage loans held for sale is determined, when possible, using quoted 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 sale are classified as Level 2 in the fair value hierarchy.

Real Estate Securities and Other Investment Securities, at Fair Value

ZAIS determines the fair value of the Company’s investments in RMBS generally using third party valuation services. ZAIS verifies that the quotes received from the valuation services are reflective of fair value as defined in U.S. GAAP, generally by comparing to trading activity for similar asset classes, pricing research provided by banks and brokers, the indicative broker quotes and results from ZAIS’ proprietary models.

If the values from the third party valuation services are insufficient or unavailable, fair value is determined using observable market data, indicative broker quotes or proprietary models that incorporate market based inputs but also include unobservable inputs. Some of the significant unobservable inputs used are constant prepayment rates, constant default rates, delinquency rates, security ratings, discount rates, credit spreads, and yields. The proprietary models convert future projected cash flows to a single discounted present value. ZAIS’ assessment of the significance of a particular input to the fair value measurement in its entirety requires significant judgment and considers factors specific to the investment.

The Company's Agency RMBS, if any, are valued using the market data described above, which includes inputs determined to be observable or whose significant fair value drivers are observable. Accordingly, Agency RMBS securities are classified as Level 2 in the fair value hierarchy.

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MSRs, at Fair Value

The Company uses a third party vendor to assist management in estimating the fair value of MSRs. The third party vendor uses a discounted cash flow approach which consists of projecting servicing cash flows discounted at a rate that management believes market participants would use in their determinations of fair value. The key assumptions used in the estimation of the fair value of MSRs include prepayment speeds, discount rates, default rates, cost to service, contractual servicing fees, escrow earnings and ancillary income. MSRs are classified as Level 3 in the fair value hierarchy. 

Derivative Instruments

Interest Rate Swaption Agreements

An interest rate swaption agreement represents an option that gives the Company the right, but not the obligation, to enter into a previously agreed upon interest rate swap agreement on a future date. If exercised the Company will enter into an interest rate swap agreement and is obligated to pay a fixed rate of interest and receive a floating rate of interest. The Company utilizes proprietary modeling analysis or industry standard third party analytics to support the counterparty valuations received for interest rate swaption agreements. These counterparty valuations are generally based on models with observable market inputs such as interest rates and contractual cash flows, and, as such, are classified as Level 2 on the fair value hierarchy. The Company's interest rate swaption agreements are governed by International Swap and Derivative Association trading agreements, which are separately negotiated agreements with dealer counterparties.

Interest Rate Swap Agreements

An interest rate swap is an agreement between two counterparties to exchange periodic interest payments where one party to the contract makes a fixed rate payment in exchange for a floating rate payment from the other party. The dollar amount each party pays is an agreed-upon periodic interest rate multiplied by some predetermined dollar principal (notional amount). No principal (notional amount) is exchanged between the two parties at trade initiation date. Only interest payments are exchanged. ZAIS utilize proprietary modeling analysis or industry standard third party analytics to support the counterparty valuations received for interest rate swap agreements. These counterparty valuations are generally based on models with observable market inputs such as interest rates and contractual cash flows, and, as such, are classified as Level 2 on the fair value hierarchy. The Company’s interest rate swap agreements are governed by International Swap and Derivative Association trading agreements, which are separately negotiated agreements with dealer counterparties. At December 31, 2015 and December 31, 2014, no credit valuation adjustment was made in determining the fair value of the derivative. Changes in the value of the contract are reported in gain (loss) on derivative instruments related to investment portfolio in the consolidated statements of operations.

Loan Purchase Commitments ("LPCs")

LPCs are agreements with approved third-party residential loan originators to purchase residential loans at a future date. LPCs that qualify as derivatives are recorded at their estimated fair values in the Company's consolidated balance sheets. The fair value of the Company's LPCs are based on the prices the underlying loans can be purchased for in the secondary market, adjusted for an estimated pull through rate.deemed collectible. Changes in fair value are recurring and are reported inas net unrealized gain (loss) on the consolidated statements of operations. LPCs are classified as Level 3income.

The Company transfers loans held at fair value to loans, held-for-investment upon the completion of securitization.

Allowance for loan losses

The allowance for loan losses is intended to provide for credit losses inherent in the fair value hierarchy.loans, held-for-investment portfolio and is reviewed quarterly for adequacy considering credit quality indicators, including probable and historical losses, collateral values, loan-to-value ratio and economic conditions. The allowance for loan losses is increased through provisions for loan losses charged to earnings and reduced by charge-offs, net of recoveries.

 

Interest Rate Lock Commitments ("IRLCs")

IRLCs are agreements under whichWe determine the Company agrees to extendallowance for loan losses by measuring credit toimpairment on (1) an individual basis for non-accrual status loans, and (2) on a borrower under certain specified terms and conditions in which the interest ratecollective basis for all other loans with similar risk characteristics. The allowance for loan losses on an individual basis is assessed when a loan is on non-accrual and the maximum amountrecoverability of the loan are set prioris less than its carrying value. The Company considers the loans to funding. Unrealized gainsbe collateral dependent and lossesrelies on the IRLCs, reflected as derivative assets and derivative liabilities, respectively, are measured based on the value of the underlying mortgage loan, quoted GSE mortgage backed security ("MBS") prices, estimates of thecurrent fair value of the MSRscollateral as the basis for determining impairment. Loans that are not assessed individually for impairment are assessed on a collective basis. For the acquired loans we perform a historical analysis on both cumulative defaults and severity upon default for all loans that were current as of November 4, 2013 when the probability thatCompany was formed or acquired thereafter. We calculated the mortgagecumulative default and loss severity on the acquired loans with delinquency statuses of 90+ days and applied those factors to the current acquired loan will fund withinpopulation. For the termsoriginated loans, our historical data shows a minimal number of defaults, therefore we used an analysis performed on the IRLC, netlatest ReadyCap securitization to determine the likelihood of commission expensedefault and broker fees. IRLCs are classified as Level 3to determine loss severity we stressed collateral value to the current principal balance based on the total valuation decline of SBC properties from the peak valuation in the fair value hierarchy.2007 through their post-crisis low in 2010.

 

MBS Forward Sales ContractsThe determination of allowances for SBA loans is based upon the assignment of a probability of default on a rating scale. Each loan rating is re-evaluated at least annually for loan performance, underlying borrower financial performance or data from third party credit bureaus. The probability of default is compared to the underlying collateral value securing each loan and TBA Securitiescompared to each loan carrying value to calculate a loss estimate. Collectively the estimated probability of default and recovery value is compared to actual portfolio default and recovery rates as well as economic factors and adjusted when needed.

 

MBS forward sales contracts and TBA securities are forward contractsThe determination of whether an allowance for the purchaseloan loss is necessary is based on whether or salenot there is a decrease in cash flows based on consideration of MBS at a predetermined price with a stated face amount, coupon and stated maturity at a agreed upon future date. The specific MBS delivered into the contract upon the settlement date, published each month by the Securities Industry and Financial Markets Association ("SIFMA"), are not knownfactual information available at the time of the transaction. The Companyassessment as well as management’s estimates the fair value of MBS forward sales contracts and TBA securities based on third party vendor prices and quoted MBS prices. MBS forward sales contracts and TBA securities are classified as Level 2 in the fair value hierarchy.

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Mortgage Loans Held for Investment, at Cost

Mortgage loans held for investment related to the Company's mortgage banking activities includes loans which, due to various reasons, are unable to be sold to a third party. Such loans are performing loans which the Company carries at amortized cost, less a valuation allowance for estimated credit losses, if applicable. 

Revenue Recognition

Mortgage Loans Held for Investment, at Fair Value

Pursuant to the Company's policy for separately presenting interest income on mortgage loans, the Company follows acceptable methods under U.S. GAAP for allocating a portion of the change in fair valuefuture performance and projected amount and timing of certain mortgage loans held for investment to interest income.

When the Company purchases mortgage loans which are held for investment and which have shown evidence of credit deterioration since origination and management determines that it is probable the Company will not collect all contractual cash flows on those loans, the Company applies the guidance that addresses accounting for differences between contractual cash flows and cash flows expected to be collected if those differences are attributable to, at least in part, credit quality.on the loan.

 

Interest income is recognized on

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While we have a level-yield basis overformal methodology to determine the lifeadequate and appropriate level of the allowance for loan losses, estimates of inherent loan losses involve judgment and assumptions as long as cash flows can be reasonably estimated. The level-yieldto various factors, including current economic conditions. Our determination of adequacy of the allowance for loan losses is based on quarterly evaluations of the above factors. Accordingly, the provision for loan losses will vary from period to period based on management's ongoing assessment of the adequacy of the allowance for loan losses.

Non-accrual loans

Non-accrual loans are the loans for which we are not accruing or accreting interest income. Non-accrual loans include non-PCI loans when principal or interest has been delinquent for 90 days or more or when it is determined by the excess of the Company's initial estimate of undiscounted expected principal, interest, and other cash flows (cash flows expected at acquisition to be collected) over the Company's initial investment in the mortgage loan (accretable yield). The amount of interest income to be recognized cannot result in a carrying amount that exceeds the payoff amount of the loan. The excessfull collection of contractual cash flows over cash flows expected to be collected (nonaccretable difference) willis not be recognized as an adjustment of yield.

On a quarterly basis,probable. Additionally, PCI loans for which the Company updates itsis unable to reasonably estimate of the cash flows expected to be collected. For purposes of interest income recognition, any subsequent increases in cash flows expected to be collected are generally recognized as prospective yield adjustments (which establishes a new level-yield) and any subsequent decreases in cash flows expected to be collected are recognized as an impairment to be recorded through change in unrealized gain or loss in the consolidated statements of operations.

Income recognition is suspended for a loan when cash flows cannot be reasonably estimated.

Interest income on newly originated mortgage loans which are purchased by the Company and held for investment, is accrued based on the effective yield method on the outstanding principal balance and their contractual terms. Premiums and discounts associated with these mortgage loans at the time of purchase are amortized into interest income over the life of such loan using the effective yield method and adjusted for actual prepayments.

Real Estate Securities and Other Investment Securities, at Fair Value

Pursuant to the Company's policy for separately presenting interest income on real estate securities and Other Investment Securities, the Company follows acceptable methods under U.S. GAAP for allocating a portion of the change in fair value of real estate securities and Other Investment Securities to interest income.

Interest income on Agency RMBS, if any, is accrued based on the effective yield method on the outstanding principal balance and their contractual terms. Premiums and discounts associated with Agency RMBS at the time of purchase are amortized into interest income over the life of such securities using the effective yield method and adjusted for actual prepayments.

Interest income on the non-Agency RMBS and Other Investment Securities, which were purchased at a discount to par value and/or were rated below AA at the time of purchase, is recognized based on the effective yield method. The effective yield on these securities is based on the projected cash flows from each security, which are estimated based on the Company's observation of current information and events and include assumptions related to interest rates, prepayment rates and the timing and amount of credit losses. On a monthly basis, the Company reviews and, if appropriate, makes adjustments to its cash flow projections based on input and analysis received from external sources, internal models and its judgment about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. Changes inexpected cash flows from those originally projected, or from those estimated at the last evaluation, may result in a prospective change in the yield/interest income recognized on such securities. Actual maturities of the securities are affected by the contractual lives of the associated mortgage collateral, periodic payments of principal, prepayments of principal and credit losses. Therefore, actual maturities of the securities are generally shorter than stated contractual maturities.

Based on the projected cash flows from the Company's non-Agency RMBS purchased at a discount to par value, a portion of the purchase discount may be designated as credit protection against future credit losses and, therefore, not accreted into interest income. The amount designated as credit discount is determined, and may be adjusted over time, based on the actual performance of the security, its underlying collateral, actual and projected cash flow from such collateral, economic conditions and other factors. If the performance of a security with a credit discount is more favorable than forecasted, a portion of the amount designated as credit discount may be accreted into interest income prospectively.

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RMBS and Other Investment Securities are evaluated for other-than-temporary impairment ("OTTI") each quarter. A security with a fair value that is less than amortized cost is considered impaired. Impairment of a security is considered to be other-than-temporary when: (i)non-accrual loans.

Troubled Debt Restructurings

In situations where, for economic or legal reasons related to the holder hasborrower’s financial difficulties, we grant concessions for a period of time to the intentborrower that we would not otherwise consider, the related loans are classified as troubled debt restructurings (“TDR”). These modified terms may include interest rate reductions, principal forgiveness, term extensions, payment forbearance and other actions intended to sellminimize our economic loss and to avoid foreclosure or repossession of collateral. For modifications where we forgive principal, the entire amount of such principal forgiveness is immediately charged off. Loans classified as TDRs, are considered impaired security; (ii) itloans. Other than resolutions such as foreclosures and sales, we may remove loans held-for-investment from TDR classification, but only if they have been refinanced or restructured at market terms and qualify as a new loan.

Generally, all loans modified in a TDR are placed or remain on non-accrual status at the time of the restructuring. However, certain accruing loans modified in a TDR that are current at the time of restructuring may remain on accrual status if payment in full under the restructured terms is more likely than notexpected.

Impaired loans

The Company considers a loan to be impaired when the holder will be required to sell the security; or (iii) the holderCompany does not expect to recover the entire amortized costcollect all of the security. When a security has been deemedcontractual interest and principal payments as scheduled in the loan agreements. This includes certain non-PCI loans where we do not expect to collect all of the contractual interest and principal payments, as well as PCI loans, which experienced credit deterioration prior to acquisition.

Loans, held for sale, at fair value

Loans, held for sale, at fair value are loans that are expected to be other-than-temporarily impaired,sold to third parties in the amount of OTTI is bifurcated into: (i) the amount related to expected credit losses; and (ii) the amount related to fair value adjustments in excess of expected credit losses. The portion of OTTI related to expected credit lossesnear term. Interest is recognized inas interest income on the consolidated statements of operationsincome when earned and deemed collectible. For loans originated by our SBC originations and SBA originations segments, changes in fair value are recurring and are reported as a realized loss on real estate securities and realized loss on Other Investment Securities. The remaining OTTI related to the valuation adjustment is recognized as a component of change innet unrealized gain or loss in(loss) on the consolidated statements of operations. Realizedincome. For originated SBA loans, the guaranteed portion is held for sale, at fair value. For loans originated by GMFS, changes in fair value are reported as gains and losses on residential mortgage banking activities, net of variable loan expenses, on the consolidated statements of income.

The Company transfers loans held for sale, of real estateat fair value to loans, held-for-investment when the Company no longer intends to sell the loans.

Mortgage backed securities, at fair value

The Company accounts for MBS as trading securities and Other Investment Securities are determined using the specific identification method. Real estatecarried at fair value under ASC 320, Investments-Debt and Equity Securities. Our MBS portfolio is comprised of asset-backed securities collateralized by interest in or obligations backed by pools of SBC loans.

Purchases and Other Investment Securities transactionssales of MBS are recorded on the trade date.

Mortgage Loans Held for Investment, at Cost and Mortgage Loans Held for Sale, at Fair Value

Interest income on mortgage loans is accrued to income based upon the principal amount outstanding and contractual interest rates and is included in interest income on mortgage loans held for sale in the consolidated statements of operations. Income recognition is discontinued when loans become 90 days delinquent or when in management's opinion, the collectability of principal and income becomes doubtful and the mortgage loans held for sale or investment are put on nonaccrual status.

Mortgage Banking Activities, net

Gain on Sale of Mortgage Loans Held for Sale, net of direct costs

Mortgage loans held for sale are considered sold when the Company surrenders control over the financial assets. Control is considered to have been surrendered when the transferred assets have been isolated from the Company, beyond the reach of the Company and its creditors; the purchaser obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets; and the Company does not maintain effective control over the transferred assets through an agreement that both entitles and obligates the Company to Our MBS securities pledged as collateral against borrowings under repurchase or redeem the transferred assets before their maturity or the ability to unilaterally cause the holder to return specific assets. Such transfers may involve securitizations, participation agreements or repurchase agreements. If the criteria above are not met, such transfers are accounted for as secured borrowings, in which the assets remain on the consolidated balance sheets, the proceeds from the transaction are recognized as a liability and no MSRs are recorded for the transferred loans.

Gains and losses from the sale of mortgage loans held for sale are recognized based upon the difference between the sales proceeds and carrying value of the related loans upon sale and is included in mortgage banking activities, net in the consolidated statements of operations. The sales proceeds reflect the cash received and the initial fair value of the separately recognized MSRs. Gains and losses also includes the unrealized gains and losses associated with the mortgage loans held for sale and the realized and unrealized gains and losses from MBS forward sales contracts and IRLCs. Loan origination costs directly attributable to the processing, underwriting, and closing of a loan are offset against gain on sale of mortgage loans held for sale when loans are sold.

Loan Expenses, including Provision for Loan Indemnification

Loan expenses include indirect costs related to loan origination activities and are expensed as incurred and are included in mortgage banking activities, net in the Company’s consolidated statements of operations. The provision for loan indemnification includes the fair value of the incurred liability for mortgage repurchases and indemnifications recognized at the time of loan sale and any other provisions recorded against the loan indemnification reserve and are included in mortgage banking activities, net in the Company’s consolidated statements of operations.

Loan Origination Fee Income

Loan origination fee income represents revenue earned from originating mortgage loans and is included in mortgage banking activities, net in the Company's consolidated statements of operations. Loan origination fees relating to mortgage loans held for sale are reflected in mortgage banking activities, net when loans are sold.

Loan Servicing Fee Income, Net of Direct Costs

Loan servicing fee income represents revenue earned for servicing loans for various investors and is included in the consolidated statements of operations. The servicing fees are based on a contractual percentage of the outstanding principal balance and recognized into revenue as the related mortgage payments are received. Direct costs consist of sub-servicing costs which are offset against loan servicing fee income as incurred.

Expense Recognition

Expenses are recognized when incurred. Expenses include, but are not limited to, loan servicing fees, advisory fees, professional fees for legal, accounting and consulting services, and general and administrative expenses such as insurance, custodial and miscellaneous fees.

Servicing Advances

Servicing advances represent escrow and other advances on behalf of borrowers and investors to cover delinquent balances for property taxes, insurance premiums and other out-of-pocket costs. Advances are made in accordance with the servicing agreements and are recoverable upon liquidation. The Company periodically reviews the advances for collectability and amounts are written off when they are deemed uncollectible.

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Offering Costs

Offering costs are accounted for as a reduction of additional paid-in capital. Offering costs in connection with the Company’s IPO were paid out of the proceeds of the IPO. Costs incurred to organize the Company were expensed as incurred. The Company’s obligation to pay for organization and offering expenses directly related to the IPO was capped at $1.2 million and the Advisor paid for expenses incurred above the cap.

Repurchase Facilities

Loan Repurchase Facilities

The Company finances a portion of its mortgage loans held for investment,backed securities, at fair value through the use of repurchase agreements entered into under master repurchase agreements with certain lenders (the "Loan Repurchase Facilities"). Under the Loan Repurchase Facilities, the Company may sell, and later repurchase trust certificates representing interests in residential mortgage loans (the "Trust Certificates"). The borrowings under the Loan Repurchase Facilities are treated as collateralized financing transactions and are carried at their contractual amounts, including accrued interest, as specified in the respective agreement. The borrowings under the Loan Repurchase Facilities are recorded on the trade date at the contract amount.

Securities Repurchase Agreements

The Company finances a portion of its RMBS portfolio and Other Investment Securities through the use of securities repurchase agreements entered into under master repurchase agreements. The Company has master repurchase agreements with four financial institutions at December 31, 2015. Repurchase agreements are treated as collateralized financing transactions and are carried at their contractual amounts, including accrued interest, as specified in the respective agreements. Repurchase agreements are recorded on trade date at the contract amount.

Derivatives and Hedging Activities

The Company accounts for its derivative financial instruments in accordance with derivative accounting guidance, which requires an entity to recognize all derivatives as either assets or liabilities in the consolidated balance sheets and to measure those instruments at fair value. The Company has not designated any of its derivative agreements as hedging instruments for accounting purposes. As a result, changes in the fair value of derivatives are recorded through current period earnings. 

The Company generally records its derivatives on a gross basis prior to the application of the impact of the fair value and collateral netting in the consolidated balance sheets. Derivative instruments that are subject to an enforceable master netting arrangement or similar agreement are netted in theour consolidated balance sheets.

Real Estate Owned

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The Company records real estate owned ("REO") assets when it is considered to have received physical possession (resulting from an in substance repossession or foreclosure) of residential real estate property collateralizing mortgage loans. The Company is considered to have received physical possession of the property upon the occurrence of either (i) obtaining legal title to the residential real estate property upon completion of a foreclosure (the Company may obtain legal title to the residential real estate property even if the borrower has redemption rights that provide the borrower with a legal right for a period of time after a foreclosure to reclaim the real estate property by paying certain amounts specified by law) or (ii) the borrower conveying all interest in the residential real estate property to the Company to satisfy the loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. The deed in lieu of foreclosure or similar legal agreement is completed when agreed-upon terms and conditions have been satisfied by both the borrower and the creditor.

The Company records its REOMBS are recorded at fair value less costsas determined by market prices provided by independent broker dealers or other independent valuation service providers. The fair values assigned to sell. All legal feesthese investments are based upon available information and direct costs relatingmay not reflect amounts that may be realized. We generally intend to real estate owned are expensedhold our investment in MBS to generate interest income; however, we have and may continue to sell certain of our investment securities as incurred. The excesspart of the Company's investment in the mortgage loan satisfied over the fair valueoverall management of the foreclosed property (less cost to sell) is reported as a realized loss in the Company's statements of operations.our assets and liabilities and operating our business.

 

Loans Eligibleeligible for Repurchaserepurchase from Ginnie Mae

 

When the Company has the unilateral right to repurchase Ginnie Mae pool loans it has previously sold (generally loans that are more than 90 days past due), the Company then records the right to repurchase the loan as an asset and liability in its consolidated balance sheets. Such amounts reflect the unpaid principal balance of the loans.

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8% Exchangeable Senior Notes Due 2016

 

On November 25, 2013, the Operating Partnership issued $57.5 million aggregate principal amountDerivative instruments, at fair value

Subject to maintaining our qualification as a REIT for U.S. federal income tax purposes, we utilize derivative financial instruments, currently comprised of unsecured 8.0% Exchangeable Senior Notes due 2016 (the "Exchangeable Senior Notes"credit default swaps (“CDSs”)., interest rate swaps, and interest rate lock commitments (“IRLCs”) as part of our risk management. The Exchangeable Senior NotesCompany accounts for derivative instruments under ASC 815, Derivatives and Hedges.

All derivatives are carried at amortized cost. Interest expensereported as either assets or liabilities on the Exchangeable Senior Notes is computed using the effective interest method. The conversion features of the Exchangeable Senior Notes are deemed to be an embedded derivative. Accordingly, the Company is required to bifurcate the embedded derivative related to the conversion features of the Exchangeable Senior Notes. The Company recognized the embedded derivative as a liability in its consolidated balance sheets and measured it at itsthe estimated fair value and recognizedwith the changes in its estimatedthe fair value recorded in gain/(loss) onearnings.

Although permitted under certain circumstances, generally the Company does not offset cash collateral receivable or payables against our gross derivative positions. As of December 31, 2017 and 2016, the cash collateral receivable held for derivative instruments in the Company's consolidated statements of operations.

Liability for Loan Repurchasesis $0.8 million and Indemnifications

Loans sold to investors by the Company$1.7 million, respectively, and which met investor and agency underwriting guidelines at the time of sale may be subject to repurchase or indemnification in the event of specific default by the borrower or subsequent discovery that underwriting standards were not met. The Company may, upon mutual agreement, agree to repurchase the loans or indemnify the investor against future losses on such loans. In such cases, the Company bears any subsequent credit loss on the loans. The Company has established a liability for potential losses related to these representations and warranties with a corresponding provision recorded for loan indemnification losses. The liability is included in accounts payable and other liabilities inrestricted cash on the Company's consolidated balance sheets and the provision for loan indemnification 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 demands, historical rescission rates and economic trends and conditions in the industry. Actual losses incurred are reflected as charge-offs against the reserve liability.

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.

Loss Contingencies

Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company’s management and its legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company’s legal counsel evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief available, sought or expected to be sought therein.

If the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be reasonably estimated, then the estimated liability would be accrued in the Company’s financial statements. If the assessment indicates that a potentially material loss contingency is not probable, but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss if determinable, would be disclosed.

Legal costs are recorded on an accrual basis as incurred.

Escrow and Fiduciary Funds

The Company maintains segregated bank accounts in trust for mortgagor escrow balances. Such amounts are excluded from the Company's consolidated balance sheets.

 

Net Income (Loss) Per ShareInterest Rate Swap Agreements

An interest rate swap is an agreement between two counterparties to exchange periodic interest payments where one party to the contract makes a fixed-rate payment in exchange for a floating-rate payment from the other party. The dollar amount each party pays is an agreed-upon periodic interest rate multiplied by some pre-determined dollar principal (notional amount). No principal (notional amount) is exchanged between the two parties at trade initiation date. Only interest payments are exchanged. Interest rate swaps are classified as Level 2 in the fair value hierarchy. The fair value adjustments, along with the related interest income or interest expense, are reported as net gain/(loss) on financial instruments.

Interest Rate Lock Commitments (“IRLCs”)

IRLCs are agreements under which GMFS agrees to extend credit to a borrower under certain specified terms and conditions in which the interest rate and the maximum amount of the loan are set prior to funding. Unrealized gains and losses on the IRLCs, reflected as derivative assets and derivative liabilities, respectively, are measured based on the value of the underlying mortgage loan, quoted government-sponsored enterprise (Fannie Mae, Freddie Mac, and the Government National Mortgage Association (“Ginnie Mae”), collectively, “GSEs”) or MBS prices, estimates of the fair value of the mortgage servicing rights (“MSRs”) and the probability that the mortgage loan will fund within the terms of the IRLC, net of commission expense and broker fees. The realized and unrealized gains or losses are reported on the consolidated statements of income as gains on residential mortgage banking activities, net of variable loan expenses. IRLCs are classified as Level 3 in the fair value hierarchy.

CDS

CDS are contracts between two parties, a protection buyer who makes fixed periodic payments, and a protection seller, who collects the premium in exchange for making the protection buyer whole in the case of default. The fair value adjustments, along with the related interest income or interest expense, are reported as net gain/(loss) on financial instruments. CDS are classified as Level 2 in the fair value hierarchy.

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Servicing rights

Servicing rights initially represent the fair value of expected future cash flows for performing servicing activities for others. The fair value considers estimated future servicing fees and ancillary revenue, offset by estimated costs to service the loans, and generally declines over time as net servicing cash flows are received, effectively amortizing the servicing right asset against contractual servicing and ancillary fee income.

Servicing rights are recognized upon sale or securitization of loans if servicing is retained. For servicing rights, gains related to servicing rights retained is included in net realized gain/(loss) on the consolidated statements of income. For residential mortgage servicing rights, gains on servicing rights retained upon sale of a loan are included in gains on residential mortgage banking activities, net of variable loan expenses, on the consolidated statements of income.

The Company treats its servicing rights and residential mortgage servicing rights as two separate classes of servicing assets based on the class of the underlying mortgages and it treats these assets as two separate pools for risk management purposes. Servicing rights relating to the Company’s servicing of loans guaranteed by the SBA under its Section 7(a) loan program and servicing rights related to the Freddie Mac program are accounted for under ASC 860, Transfers and Servicing, while the Company’s residential mortgage servicing rights are accounted for under the fair value option under ASC 825, Financial Instruments.

Servicing rights – SBA and Freddie Mac

SBA and Freddie Mac servicing rights are initially recorded at fair value and subsequently carried at amortized cost. We capitalize the value expected to be realized from performing specified servicing activities for others. Servicing rights are amortized in proportion to and over the period of estimated servicing income, and are evaluated for potential impairment quarterly.

For purposes of testing our servicing rights for impairment, we first determine whether facts and circumstances exist that would suggest the carrying value of the servicing asset is not recoverable. If so, we then compare the net present value of servicing cash flow with its carrying value. The estimated net present value of servicing cash flows is determined using discounted cash flow modeling techniques, which require management to make estimates regarding future net servicing cash flows, taking into consideration historical and forecasted loan prepayment rates, delinquency rates and anticipated maturity defaults. If the carrying value of the servicing rights exceeds the net present value of servicing cash flows, the servicing rights are considered impaired and an impairment loss is recognized in earnings for the amount by which carrying value exceeds the net present value of servicing cash flows.

We leverage all available relevant market data to determine the fair value of our recognized servicing assets. Since quoted market prices for servicing rights are not readily available, we estimate the fair value of servicing rights by determining the present value of future expected servicing cash flows using modeling techniques that incorporate management's best estimates of key variables including estimates regarding future net servicing cash flows, forecasted loan prepayment rates, delinquency rates, and return requirements commensurate with the risks involved. Cash flow assumptions are modeled using our internally forecasted revenue and expenses, and where possible, the reasonableness of assumptions is periodically validated through comparisons to market data. Prepayment speed estimates are determined from historical prepayment rates or obtained from third-party industry data. Return requirement assumptions are determined using data obtained from market participants, where available, or based on current relevant interest rates plus a risk-adjusted spread. We also consider other factors that can impact the value of the servicing rights, such as surety provider termination clauses and servicer terminations that could result if we failed to materially comply with the covenants or conditions of our servicing agreements and did not remedy the failure. Since many factors can affect the estimate of the fair value of servicing rights, we regularly evaluate the major assumptions and modeling techniques used in our estimate and review these assumptions against market comparables, if available. We monitor the actual performance of our servicing rights by regularly comparing actual cash flow, credit, and prepayment experience to modeled estimates.

Servicing rights - Residential (carried at fair value)

 

The Company's basic earnings per share ("EPS") is computed by dividing net incomeCompany’s residential mortgage servicing rights consist of conforming conventional residential loans sold to Fannie Mae and Freddie Mac or loss attributable to common stockholdersloans securitized in Ginnie Mae securities. Government insured loans serviced by the weighted average numberCompany are securitized through Ginnie Mae, whereby the Company is insured against loss by the Federal Housing Administration or partially guaranteed against loss by the Department of sharesVeterans Affairs.

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Income Taxes

 

The Company has elected to be taxed as a REIT under the Internal Revenue Codeaccount for its portfolio of 1986, as amended (the "Code"residential mortgage servicing rights (“MSRs”), 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, at fair value. For these assets, the Company must meet certain organizational and operational requirements, includinguses a requirementthird-party vendor to distributeassist management in estimating the fair value. The third-party vendor uses a discounted cash flow approach which consists of projecting servicing cash flows discounted at least 90%a rate that management believes market participants would use in their determinations of fair value. The key assumptions used in 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 majorityestimation of States also recognize the Company's REIT status. If the Company fails to qualify as a REIT in any taxable year, it will be subject to federal income tax on its taxable income at regular corporate income tax rates and generally will not be permitted to qualify for treatment as a REIT for federal income tax purposes for the four taxable years following the year during which qualification is lost unless the Internal Revenue Service ("IRS") grants the Company relief under certain statutory provisions. Such an event could materially adversely affect the Company's net income under U.S. GAAP and net cash available for distribution to stockholders. However, it is assumed that the Company will retain its REIT status and will incur no REIT level taxation as it intends to comply with the REIT regulations and annual distribution requirements.

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

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

Goodwill and Intangible Assets

The purchase price of GMFS was allocated to the assets acquired, including identifiable intangible assets (trade name, customer relationships, licenses and favorable leases), and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of purchase price over the fair value of MSRs include prepayment rates, discount rates, and cost of servicing rates. Residential MSRs are classified as Level 3 in the net assets acquired was recognized as goodwill. Goodwill is carried at cost, net of impairment charges, and reflected on the Company's consolidated balance sheets.fair value hierarchy.

 

Intangible assets

Intangible assets are accounted for under ASC 350, Intangibles-Goodwill and Other. As of December 31, 2017 and 2016, the Company’s identifiable intangible assets include SBA license for our lending operations as well as a trade name, a favorable lease, and other licenses relating to our residential mortgage banking segment, obtained as part of the ZAIS Financial merger transaction. The Company does not amortize intangible assets withdetermined that its SBA license has an indefinite lives.life, while the other intangibles acquired as part of the ZAIS Financial merger transaction are finite-lived. The Company amortizes intangible assets with identified estimated useful lives on a straight-line basis over their estimated useful lives.

Goodwill is not amortized but is tested The Company initially records its intangible assets at cost and subsequently tests for impairment on October 31stan annual basis. Intangible assets are included within other assets on the consolidated balance sheets.

Investment in unconsolidated joint venture

In November of each calendar year,2017, the Company acquired an interest in an SBC loan pool through a joint venture, WFLLA, LLC, which the Company has a 50% interest. According to ASC 323, Equity Method and Joint Ventures, investors in unincorporated entities such as partnerships and unincorporated joint ventures generally shall account for their investments using the equity method of accounting if the investor has the ability to exercise significant influence over the investee. Under the equity method, we recognize our share of the earnings or more frequently if eventslosses of the investment monthly in earnings and adjust the carrying amount for our share of the earnings or changes in circumstances indicate that a potential impairment may have occurred. The testing of goodwill for impairment is initiallylosses based on our equity ownership.

Pursuant to the consolidation guidance, we determined our interest in the entity is a qualitative assessmentVIE, however, we do not consolidate the entity as we determined that we are not the primary beneficiary. The Company is determined to determine ifbe the primary beneficiary only when it has a controlling financial interest in the VIE, which is more likely than notdefined as possessing both (i) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (ii) the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.

Deferred financing costs

Costs incurred in connection with our secured borrowings are accounted for under ASC 340, Other Assets and Deferred Costs. Deferred costs are capitalized and amortized using the effective interest method over the respective financing term with such amortization reflected on our consolidated statements of income as a component of interest expense. Our deferred financing costs may include legal, accounting and other related fees. Unamortized deferred financing costs are expensed when the associated debt is refinanced or repaid before maturity. Pursuant to the adoption of ASU 2015-03, unamortized deferred financing costs related to securitizations and note issuances are presented on the consolidated balance sheets as a direct deduction from the associated liability.

Due from Servicers

The loan-servicing activities of the Company’s SBC Loan Acquisitions and SBC Originations reportable segments are performed primarily by third-party servicers. SBA loans originated by and held at RCL are internally serviced. Residential mortgage loans originated by and held at GMFS are both serviced by third-party servicers and internally serviced. The Company’s servicers hold substantially all of the cash owned by the Company related to loan servicing activities. These amounts include principal and interest payments made by borrowers, net of advances and servicing fees. Cash is generally received within thirty days of recording the receivable.

The Company is subject to credit risk to the extent any servicer with whom the Company conducts business is unable to deliver cash balances or process loan-related transactions on the Company’s behalf. The Company monitors the financial

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condition of the servicers with whom the Company conducts business and believes the likelihood of loss under the aforementioned circumstances is remote.

Secured borrowings

Secured borrowings include borrowings under credit facilities and borrowings under repurchase agreements.

Borrowings under credit facilities

The Company accounts for borrowings under credit facilities under ASC 470, Debt. The Company partially finances its loans, net through credit agreements with various counterparties. These borrowings are collateralized by loans, held-for-investment, and loans, held for sale, at fair value and have maturity dates within two years from the consolidated balance sheet date. If the fair value (as determined by the applicable counterparty) of the collateral securing these borrowings decreases, we may be subject to margin calls during the period the borrowings are outstanding. In instances where we do not satisfy the margin calls within the required time frame, the counterparty may retain the collateral and pursue collection of any outstanding debt amount from us. Interest paid and accrued in connection with credit facilities is recorded as interest expense on the consolidated statements of income.

Borrowing under repurchase agreements

Borrowings under repurchase agreements are accounted for under ASC 860, Transfers and Servicing. Investment securities financed under repurchase agreements are treated as collateralized borrowings, unless they meet sale treatment or are deemed to be linked transactions. Through December 31, 2017, none of our repurchase agreements have been accounted for as components of linked transactions. All securities financed through a reporting unitrepurchase agreement have remained on our consolidated balance sheets as an asset and cash received from the lender was recorded on our consolidated balance sheets as a liability. Interest paid and accrued in connection with our repurchase agreements is less than itsrecorded as interest expense on the consolidated statements of income.

Promissory note

The Company accounts for promissory notes under ASC 470, Debt. There are no debt issuance costs associated with the outstanding note. The note is collateralized by loans, held-for-investment and have maturity dates within five years from the consolidated balance sheet date. Interest paid and accrued in connection with the promissory note is recorded as interest expense on the consolidated statements of income.

Securitized debt obligations of consolidated VIEs, net

Since 2011, we have engaged in several securitization transactions, which the Company accounts for under ASC 810. Securitization involves transferring assets to an SPE, or securitization trust, to convert all or a portion of those assets into cash before they would have been realized in the normal course of business, through the SPE’s issuance of debt instruments. The entity that has a controlling financial interest in a VIE is referred to as the primary beneficiary and is required to consolidate the VIE. The consolidation of the SPE includes the issuance of senior securities to third parties, which are shown as securitized debt obligations of consolidated VIEs on the consolidated balance sheets.

Debt issuance costs related to securitizations are presented as a direct deduction from the carrying value including goodwill. Ifof the facts indicaterelated debt. Debt issuance costs are amortized using the effective interest method and are included in interest expense from securitized debt obligations on the consolidated financial statements.

Convertible note, net

ASC 470, Debt, requires the liability and equity components of convertible debt instruments that itmay be settled in cash upon conversion to be separately accounted for in a manner that reflects the issuer’s nonconvertible debt borrowing rate. ASC 470-20 requires that the initial proceeds from the sale of these convertible debt instruments be allocated between a liability component and an equity component in a manner that reflects interest expense at the interest rate of similar nonconvertible debt that could have been issued by the Company at such time. We measured the estimated fair value of

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the debt component of our convertible notes as of the issuance date based primarily on our nonconvertible debt borrowing rate. The equity components of the convertible notes have been reflected within additional paid-in capital in our consolidated balance sheet, and the resulting debt discount is more likely than not that that an impairment may exist, a two-step quantitative assessment is conductedamortized over the period during which the convertible notes are expected to (a) calculatebe outstanding (through the maturity date) as additional non-cash interest expense.

Upon repurchase of convertible debt instruments, ASC 470-20 requires the issuer to allocate total settlement consideration, inclusive of transaction costs, amongst the liability and equity components of the instrument based on the fair value of the reporting unit and compareliability component immediately prior to its carrying value including goodwill and (b) ifrepurchase. The difference between the carrying value of a reporting unit exceeds its fair value, goodwill is considered impaired with the impairment loss equalsettlement consideration allocated to the amount by whichliability component and the net carrying value of the goodwill exceeds the implied fair value of that goodwill. The impairment isliability component, including unamortized debt issuance costs, would be recognized as gain (loss) on extinguishment of debt in our consolidated statements of income. The remaining settlement consideration allocated to the equity component would be recognized as a reduction of additional paid-in capital in our consolidated balance sheets.

Senior secured note, net

The Company accounts for secured debt offerings under ASC 470, Debt. Pursuant to the adoption of ASU 2015-03, the Company’s senior secured note is presented net of debt issuance costs. These senior secured notes are collateralized by loans, MBS, and retained interests of consolidated VIE’s. Interest paid and accrued in connection with senior secured notes is recorded as interest expense on the consolidated statements of income.

Guaranteed loan financing

Certain partial loan sales do not qualify for sale accounting under ASC 860, Transfers and Servicing because these sales do not meet the definition of a “participating interest,” as defined in the guidance, in order for sale treatment to be allowed. Participations or other partial loan sales which do not meet the definition of a participating interest remain as an investment on the consolidated balance sheets and the proceeds from the portion sold is recorded as guaranteed loan financing in the liabilities section of the consolidated balance sheets. For these partial loan sales, the interest earned on the entire loan balance is recorded as interest income and the interest earned by the buyer in the partial loan sale is recorded within interest expense in the period in which the impairment occurs.accompanying consolidated statements of income.

 

The Company periodically reviews the carrying amounts of its finite-lived intangible assets to determine whether current events or circumstances indicate that such carrying amounts may not be recoverable. The assessment of recoverability is based on management’s estimates by comparing the sum of the estimated undiscounted cash flows generated by the underlying asset, or other appropriate grouping of assets, to its carrying value to determine whether an impairment existed at its lowest level of identifiable cash flows. If the carrying amount of the asset is greater than the expected undiscounted cash flows to be generated by such asset, an impairment is recognized to the extent the carrying value of such asset exceeds its fair value.

Contingent Considerationconsideration

 

Contingent consideration representrepresents future payments of cash or equity interests to the former owners of GMFS, which was acquired on October 31, 2014.2016. The contingent consideration was initially recorded on the date of acquisition at fair value in the consolidated balance sheet and is subsequently remeasured each reporting period at fair value with the change in the fair value recorded in earnings in the accompanying consolidated statements of income.

Repair and denial reserve

The repair and denial reserve represents the potential liability to the SBA in the event that we are required to make whole the SBA for reimbursement of the guaranteed portion of SBA loans. We may be responsible for the guaranteed portion of SBA loans if there are lien and collateral issues, unauthorized use of proceeds, liquidation deficiencies, undocumented servicing actions or denial of SBA eligibility. This reserve is calculated using an estimated frequency of a repair and denial event upon default, as well as an estimate of the severity of the repair and denial as a percentage of the guaranteed balance.

Variable Interest Entities

VIEs are entities that, by design, either (i) lack sufficient equity to permit the entity to finance its activities without additional subordinated financial support from other parties; or (ii) have equity investors that do not have the ability to make significant decisions relating to the entity’s operations through voting rights, or do not have the obligation to absorb the expected losses, or do not have the right to receive the residual returns of the entity. The entity that has a controlling financial interest in a VIE is referred to as the primary beneficiary and is required to consolidate the VIE. An entity is deemed to be the primary beneficiary of a VIE if that entity has both (i) the power to direct the activities that most

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significantly impact the VIE’s economic performance and (ii) the right to receive benefits from the VIE or the obligation to absorb losses of the VIE that could be significant to the VIE.

In determining whether we are the primary beneficiary of a VIE, we consider both qualitative and quantitative factors regarding the nature, size and form of our involvement with the VIE, such as our role establishing the VIE and our ongoing rights and responsibilities, the design of the VIE, our economic interests, servicing fees and servicing responsibilities, and other factors.

We perform ongoing reassessments to evaluate whether changes in the entity’s capital structure or changes in the nature of our involvement with the entity result in a change to the VIE designation or a change to our consolidation conclusion.

Non-controlling Interests

Non-controlling interests, which are presented on the consolidated balance sheets and the consolidated statements of income, represent direct investment in the Operating Partnership by Sutherland OP Holdings II, Ltd. and third parties.

Fair Value Option

The guidance in ASC 825, Financial Instruments, provides a fair value option election that allows entities to make an irrevocable election of fair value as the initial and subsequent measurement attribute for certain eligible financial assets and liabilities. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. The decision to elect the fair value option is determined on an instrument by instrument basis and must be applied to an entire instrument and is irrevocable once elected. Assets and liabilities measured at fair value pursuant to this guidance are required to be reported separately in our consolidated balance sheets from those instruments using another accounting method.

We have elected the fair value option for certain loans held-for-sale originated by ReadyCap that the Company intends to securitize or sell in the near term. The fair value elections for loans, held at fair value originated by ReadyCap were made due to the short-term nature of these instruments.

We have elected the fair value option for loans held-for-sale originated by GMFS that the Company intends to sell in the near term. We have elected the fair value option for certain residential mortgage servicing rights acquired as part of the merger transaction.

Earnings per Share

We present both basic and diluted earnings per share (“EPS”) amounts in our consolidated financial statements. Basic EPS excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Diluted EPS reflects the maximum potential dilution that could occur from our share-based compensation, consisting of unvested restricted stock units (“RSUs”), unvested restricted stock awards (“RSAs”), as well as “in-the-money” conversion options associated with our outstanding convertible senior notes. Potential dilutive shares are excluded from the calculation if they have an anti-dilutive effect in the period. The Company’s earnings per share has been updated retroactively as a result of the reverse merger.

All of the Company’s unvested RSUs and unvested RSAs contain rights to receive non-forfeitable dividends and, thus, are participating securities. Due to the existence of these participating securities, the two-class method of computing EPS is required, unless another method is determined to be more dilutive. Under the two-class method, undistributed earnings are reallocated between shares of common stock and participating securities.

Income Taxes

GAAP establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current period and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s consolidated financial statements or tax returns. We assess the recoverability of deferred tax assets through evaluation of carryback availability, projected taxable income and other factors as applicable. Significant judgment is required in assessing the

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future tax consequences of events that have been recognized in our consolidated financial statements or tax returns as well as the recoverability of amounts we record, including deferred tax assets.

We provide for exposure in connection with uncertain tax positions, which requires significant judgment by management including determination, based on the weight of the tax law and available evidence, that it is more-likely-than-not that a tax result will be realized. Our policy is to recognize interest and/or penalties related to income tax matters in income tax expense on our consolidated statements of income. As of December 31, 2017 and 2016, we accrued no taxes, interest or penalties related to uncertain tax positions. In addition, we do not anticipate a change in this position in the next 12 months.

Revenue Recognition

Revenue is accounted for under ASC 605, Revenue Recognition, which provides among other things that revenue be recognized when there is persuasive evidence an arrangement exists, delivery and services have been rendered, price is fixed and determinable and collectability is reasonably assured.

Interest Income

Interest income on non-PCI loans, held-for-investment, loans, held at fair value, loans, held for sale, at fair value, and MBS, at fair value is accrued based on the outstanding principal amount and contractual terms of the instrument. Discounts or premiums associated with the loans and investment securities are amortized or accreted into interest income as a yield adjustment on the effective interest method, based on contractual cash flows through the maturity date of the investment. On at least a quarterly basis, we review and, if appropriate, make adjustments to the accrual status of the asset. If the asset has been delinquent for the previous 90 days, the asset status will turn to non-accrual, and recognition of interest income will be suspended until the asset resumes contractual payments for three consecutive months.

Realized Gains (Losses)

Upon the sale or disposition (not including the prepayment of outstanding principal balance) of loans or securities, the excess (or deficiency) of net proceeds over the net carrying value or cost basis of such loans or securities is recognized as a realized gain/loss.

Origination Income and Expense

Origination income represents fees received for origination of either loans, held at fair value, loans, held for sale, at fair value, or loans, held-for-investment. For loans held, at fair value, and loans, held for sale, at fair value, pursuant to ASC 825, the Company reports origination fee income as revenue and fees charged and costs incurred as expenses. These fees and costs are excluded from the fair value. For originated loans, held-for-investment, under ASC 310-10, the Company defers these origination fees and costs at origination and amortizes them under the effective interest method over the life of the loan. Origination fees and expenses for ReadyCap loans, held at fair value and loans, held for sale, at fair value, are presented in the consolidated statements of income in other income and operating expenses. Origination fees and expenses for residential mortgage loans originated by GMFS are presented in the consolidated statements of income in gains of residential mortgage banking activities, net of variable loan expenses. The amortization of net origination fees and expenses for loans, held-for-investment are presented in the consolidated statements of income in interest income.

Gains on Residential Mortgage Banking Activities, net of variable loan expenses

Gains on residential mortgage banking activities, net of variable loan expenses, reflects variable revenue and expense within our residential mortgage banking business directly related to loan origination and sale activity. This primarily consists of the realized gains on sales of residential loans held for sale and loan origination fee income, offset by direct costs, such as correspondent fee expenses and other direct expenses relating to these loans, which vary based on loan origination volumes. Gains on residential mortgage banking activities, net of variable loan expenses, also consists of unrealized gains and losses associated with the changes in fair value of the loans held for sale, the fair value of retained MSR additions, and the realized and unrealized gains and losses from derivative instruments.

Gains and losses from the sale of mortgage loans held for sale are recognized based upon the difference between the sales proceeds and carrying value of the related loans upon sale and is included in gains on residential mortgage banking

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activities, net of variable loan expenses in the consolidated statements of income. Sales proceeds reflect the cash received from investors from the sale of a loan plus the servicing release premium if the related MSR is sold. Gains and losses also includes the unrealized gains and losses associated with the mortgage loans held for sale and the realized and unrealized gains and losses from IRLCs.

Loan origination costs directly attributable to the processing, underwriting, and closing of a loan are included in the gain on sale of mortgage loans held for sale when loans are sold. Loan expenses include indirect costs related to loan origination activities, such as correspondent fees, and are expensed as incurred and are included in gains on residential mortgage banking activities, net of variable loan expenses, in the Company’s consolidated statements of operations.

Recently Issued Accounting Pronouncements

In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers" ("ASU 2014-09").income. The objective of the guidance is to clarify the principlesprovision 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.

95

In February 2015, the FASB issued ASU 2015-02, "Consolidation: Amendments to the Consolidation Analysis" ("ASU 2015-02"). ASU 2015-02 makes changes to both the variable interest model and the voting model. The guidance is effective for annual and interim periods beginning after December 15, 2015. Early adoption is permitted, including adoption in an interim period. Adoption of ASU 2015-02 on January 1, 2016 is not expected to have a material effect on the Company’s consolidated financial statements.

In April 2015 the FASB issued ASU 2015-03, "Interest- Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs" ("ASU 2015-03"). ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The guidance is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted for financial statements that have not been previously issued. Adoption of ASU 2015-03 on January 1, 2016 is not expected to have a material effect on the Company's consolidated financial statements.

In September 2015, the FASB issued ASU 2015-16, “Business Combinations (Topic 805)” (“ASU 2015-16”). The amendments in ASU 2015-16 require that an acquirer recognize adjustments to estimated amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The amendments require that the acquirer record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the estimated amounts, calculated as if the accounting had been completed at the acquisition date. The amendments also require an entity to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the estimated amounts had been recognized as of the acquisition date. ASU 2015-16 is effective for public business entities for fiscal years beginning after December 15, 2015, including interim periods within those fiscal years. The amendments should be applied prospectively to adjustments to provisional amounts that occur after the effective date with earlier application permitted for financial statements that have not been issued. Adoption of ASU 2015-16 on January 1, 2016 is not expected to have a material effect on the Company’s consolidated financial statements.

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 measuringloan indemnification includes the fair value of financial instrumentsthe incurred liability for disclosure purposes; (iii) requires separate presentation of financial assetsmortgage repurchases 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

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

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

The preliminary purchase price was approximately $62.8 million at closing which was comprised of (i) the estimated fair market value of GMFS's MSR portfolio, (ii) the estimated value of GMFS's net tangible assets at October 31, 2014 and (iii) a purchase price premium. In addition to cash paid at closing, two contingent $1 million deferred premium payments payable in cash over two years, plus potential additional consideration based on future loan production and profits will be payable over a four-year period if certain conditions are met (the “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,indemnifications recognized at the Company's option. The Company fundedtime of loan sale and any other provisions recorded against the closing cash payment through a combination of available cashloan indemnification reserve and the liquidation of a portion of its non-Agency RMBS portfolio.

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Total consideration at closing was as follows:

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

Contingent consideration represents the estimated present value of deferred premiums and the 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 year ended December 31, 2015, the Company recorded a decrease in the contingent consideration liability of $145,313. The net decrease in the estimated liability resulted from (i) an increase due to the impact of the passage of time and (ii) a decrease due to the impact of the refinement of the expected case estimate to incorporate market based volatility assumptions and changes to the market discount rates. The change in the contingent consideration liability is included in operating expenses in the consolidated statements of operations.

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

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

For the years ended December 31, 2015 and December 31, 2014, the Company incurred acquisition related costs of $120,852 and $2,177,617, respectively related to the acquisition of GMFS. Such amounts are included in othergains on residential mortgage banking activities, net of variable loan expenses, in the Company’s consolidated statements of operations.

Goodwillincome.

 

GoodwillLoan origination fee income represents the excessrevenue earned from originating mortgage loans held for sale and are reflected in gains on residential mortgage banking activities, net of the purchase price over the fair value of the net assets acquired and liabilities. The determination of goodwill at the time of closing was as follows:variable loan expenses, when loans are sold.

 

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

 

Pursuant

Note 4 – Recently Issued Accounting Pronouncements

Financial Accounting Standards Board (“FASB”) Standards adopted during 2017

Standard

Summary of guidance

Effects on financial statements

ASU 2016-09, Compensation—Stock Compensation (Topic 718) – Improvements to Employee Share-Based Payment Accounting

Simplifies the accounting for employee share-based payment transactions, including the accounting for associated income taxes and forfeitures.

The adoption of this standard did not have an impact on our consolidated financial statements.

Issued March 2016

ASU 2016-17, Consolidation (Topic 810) – Interests Held through Related Parties That Are under Common Control

When assessing which party is the primary beneficiary in a VIE requires that the decision maker considers interests held by entities under common control on a proportionate basis instead of treating those interests as if they were that of the decision maker itself, as current GAAP requires.

The adoption of this standard did not have an impact on our consolidated financial statements.

Issued October 2016

FASB Standards issued, but not yet adopted

Standard

Summary of guidance

Effects on financial statements

ASU 2014-09, Revenue from Contracts with Customers (Topic 606)

Outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance.

Required effective date: Annual reporting periods beginning after December 15, 2017

Issued May 2014



The standard clarifies the required factors that

an entity must consider when recognizing revenue and also requires additional disclosures.

Since the guidance does not apply to revenue associated with financial instruments, including loans and securities that are accounted for under other U.S. GAAP, the Company does not expect the new revenue recognition guidance to have a material impact on the elements of its consolidated statements of income most closely associated with financial instruments, including interest income, gains and losses on financial instruments, residential mortgage banking activities, servicing and origination income.



May be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption.



The Company has evaluated the impact of this standard and we do not anticipate that the adoption will have a material impact on our consolidated financial statements. To the extent an adjustment is warranted, we will adjust for the cumulative effect recognized as of the date of adoption.

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ASU 2016-13, Financial Instruments—Credit Losses (Topic 326) – Measurement of Credit Losses on Financial Instruments

Requires the use of an “expected loss” credit model for estimating future credit losses of certain financial instruments instead of the “incurred loss” credit model that existing GAAP currently requires.

Required effective date: Annual reporting periods, and interim periods therein, beginning after December 15, 2019. Early adoption is permitted for periods beginning after December 15, 2018.

Issued June 2016



The “expected loss” model requires the consideration of possible credit losses over the life of an instrument compared to only estimating credit losses upon the occurrence of a discrete loss event in accordance with the current “incurred loss” methodology.



The Company is evaluating the impact ASU 2016-13 will have on our consolidated financial statements.

ASU 2016-15, Statement of Cash Flows (Topic 230) – Classification of Certain Cash Receipts and Cash Payments

Provides guidance on the disclosure and classification of certain items within the statement of cash flows, including beneficial interests obtained in a securitization of financial assets, debt prepayment or extinguishment costs, and distributions received from equity-method investees.

Required effective date: Annual reporting periods, and interim periods therein, beginning after December 15, 2017. Early adoption is permitted.

Issued August 2016



Required to be applied retrospectively to all periods presented beginning in the year of adoption.

The Company is evaluating the impact this standard will have on our consolidated statement of cash flows.

ASU 2016-16, Income Taxes (Topic 740) – Intra-Entity Transfers of Assets Other Than Inventory

Requires that an entity recognize the income tax consequences of intra-entity transfers of assets other than inventory at the time of the transfer instead of deferring the tax consequences until the asset has been sold to an outside party, as current GAAP requires.

Required effective date: Annual reporting periods, and interim periods therein, beginning after December 15, 2017. Early adoption is permitted.

Issued October 2016

The Company is evaluating the impact this standard will have on our consolidated financial statements.

ASU 2016-18, Statement of Cash Flows (Topic 230) - Restricted Cash

Requires that restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows.

Required effective date: Annual reporting periods, and interim periods therein, beginning after December 15, 2017. Early adoption is permitted.

Issued November 2016

��

The Company is evaluating the impact this standard will have on our consolidated financial statements.

ASU 2017-01, Business Combinations (Topic 805) – Clarifying the Definition of a Business

Amends the definition of a business to exclude acquisitions of groups of assets where substantially all of the fair value of the assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets.

Required effective date: Annual reporting periods, and interim periods therein, beginning after December 15, 2017. Early adoption is permitted.

Issued January 2017

This ASU results in most real estate acquisitions no longer being considered business combinations and instead being accounted for as asset acquisitions.

The Company is evaluating the impact this standard will have on our consolidated financial statements.

ASU 2017-05, Other Income – Gains and Losses from the De-recognition of Nonfinancial Assets

Requires that all entities account for the de-recognition of a business in accordance with ASC 810, including instances in which the business is considered in substance real estate.

Required effective date: Annual reporting periods, and interim periods therein, beginning after December 15, 2017. Early adoption is permitted.

Issued February 2017

The Company is evaluating the impact this standard will have on our consolidated financial statements.

ASU 2017-09, Compensation—Stock Compensation (Topic 718) Scope of Modification Accounting

Provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Topic 718.

Required effective date: Annual reporting periods, and interim periods therein, beginning after December 15, 2017. Early adoption is permitted.

Issued May 2017

There is currently no impact as there have been no modifications to share-based compensation.

ASU 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815)—Accounting for Certain Financial Instruments with Down Round Features

Issued July 2017

Provides guidance which changes the classification analysis of certain equity-linked financial instruments (or embedded features) with down round features.

Required effective date: Annual reporting periods, and interim periods therein, beginning after December 15, 2018. Early adoption is permitted.

When determining whether certain financial instruments should be classified as liabilities or equity instruments, a down round feature no longer precludes equity classification when assessing whether the instrument is indexed to an entity's own stock.

This standard currently would not have an impact on our consolidated financial statements. None of our issued equity or debt (in particular our convertible notes), contain down round features.

ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities

Provides guidance on simplifying the accounting and presentation for hedging activities.

This standard currently would not have an impact on our consolidated financial statements. We do not apply hedge accounting to any of our derivative instruments.

Issued August 2017

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Note 5 – Business Combinations

On October 31, 2016, Sutherland merged with and into a subsidiary of ZAIS Financial Corp. (“ZAIS Financial”), with ZAIS Financial legally surviving the merger and changing its name to Sutherland Asset Management Corporation (the “Combined Company”). Per the terms of the GMFSAgreement and Plan of Merger Agreement, based on(“Merger Agreement”), dated as of April 6, 2016, as amended as of May 9, 2016 and August 4, 2016, (i) Sutherland merged with and into ZAIS Merger Sub, LLC, with ZAIS Merger Sub, LLC surviving the final reconciliationmerger transaction and continuing as a wholly-owned subsidiary of ZAIS and (ii) Sutherland Partners, L.P. merged with and into ZAIS Financial Partners, L.P., with ZAIS Financial Partners, L.P. legally surviving the merger transaction, continuing as a wholly-owned subsidiary of ZAIS Financial, and changing its name to Sutherland Partners, L.P. ZAIS Financial was re-named Sutherland Asset Management Corporation as part of the October 31, 2014 values,merger transaction (as a whole, the Company received“Merger Transaction” or “merger”).

Prior to and as a net settlementcondition to the merger, ZAIS Financial disposed of $1,684,263 in June 2015 from an escrow account established atits seasoned re-performing mortgage loan portfolio, such that upon the timecompletion of the closingmerger, ZAIS Financial’s assets largely consisted of its GMFS origination subsidiary, cash, conduit loans and updated its allocation of the purchase priceresidential mortgage backed securities. Additionally, prior to the assets and liabilities acquired. The finalclosing, ZAIS Financial completed a tender offer, purchasing 4,185,478 shares of common stock from existing ZAIS Financial stockholders at a purchase price of the acquisition (before contingent consideration) was $61,163,189 as a result of this net settlement. The updated allocation, combined$15.37 per share. In connection with the receiptmerger, 25,870,420 shares of escrow funds resulted in a reduction of goodwill of $1,943,533common stock were issued to our pre-merger common stockholders, and a reduction of accrued expenses of $259,269. Additionally, goodwill was reduced by $385,610 relating to the reversal of a liability existing as of the date of the acquisition. These adjustments were recorded based on information obtained subsequent to the acquisition date that related to information that existed as of the acquisition date.

The changes2,288,663 units in the carrying amountoperating partnership subsidiary (“OP units”) were issued to our pre-merger OP unit holders. Our pre-merger stockholders held approximately 86% of the goodwill for the period from October 31, 2014 through December 31, 2014 and the year ended December 31, 2015 is as follows:

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

Goodwill has been allocated to the Company's residential mortgage banking segment and was establishedour stockholders’ equity as a result of the acquisitionmerger, with continuing ZAIS Financial stockholders holding approximately 14% of GMFSour stockholders’ equity, on Octobera fully diluted basis.

Under the terms of the Merger Agreement, in connection with the Merger Transaction, each outstanding share of the Company and each outstanding unit of Sutherland Partners, L.P. was converted into the right to receive 0.8356 (the “Exchange Ratio”) shares of common stock in ZAIS Financial or units in ZAIS Financial Partners, L.P., respectively. The Exchange Ratio was determined by dividing the Company’s adjusted book value per share on July 31, 2014. Goodwill is not amortized but is tested for impairment2016 (the “Determination Date”) by the ZAIS Financial adjusted book on the anniversary dateDetermination Date.

Additionally, the Merger Agreement provided for a cash tender offer to existing ZAIS Financial shareholders for cash proceeds up to $64.3 million. The tender offer was completed at a price of $15.37 equal to 95% of ZAIS Financial’s adjusted book value per share, as further adjusted by ZAIS Financial’s pro-rata share of (i) an $8.0 million payment to ZAIS REIT Management, LLC relating to the termination of ZAIS Financial’s existing advisory agreement, and (ii) approximately $4.0 million related to intangible assets. The tender offer resulted in the tender of 4,185,478 shares of ZAIS Financial common stock.

The primary purpose of the acquisition or more frequently if events or changesmerger was to increase the Combined Company’s scale, with a stockholders’ equity base in circumstances indicateexcess of $550 million, which was expected to enhance operational efficiencies, substantially increase the liquidity in the combined company common stock and reduce operating costs. Sutherland management believes that a potential impairment may have occurred. Asstockholders of the combined company benefit from lower base management fees and that the incentive distribution fee structure further aligns stakeholder interests.

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The following table summarizes the fair value of assets acquired and liabilities assumed from the merger:

 

 

 

 

(In Thousands)

    

October 31, 2016

Assets:

 

 

 

Cash and cash equivalents

 

$

34,932

Short term investments

 

 

69,992

Restricted cash

 

 

4,522

Loans, held-for-investment, at cost

 

 

1,496

Loans, held for sale, at fair value

 

 

189,197

Mortgage backed securities, at fair value

 

 

97,936

Loans eligible for repurchase from GNMA

 

 

79,530

Residential mortgage servicing rights, at fair value

 

 

51,302

Derivative assets, at fair value

 

 

2,699

Other assets

 

 

7,741

Identifiable Intangibles

 

 

2,703

Total assets

 

 

542,050

Liabilities:

 

 

 

Borrowings under credit facilities

 

 

142,463

Borrowings under repurchase agreements

 

 

153,105

Exchangeable senior notes

 

 

57,500

Contingent consideration

 

 

14,422

Accounts payable and other liabilities

 

 

16,667

Liability for loans eligible for repurchase from GNMA

 

 

79,530

Total liabilities

 

 

463,687

Fair Value of Net Assets Acquired

 

$

78,363

The Company determined that the most identifiable value for consideration transferred was the share price of ZAIS Financial common shares as of the market close of October 31, 2015,2016. To determine the Company’stotal consideration transferred, the Company multiplied the total remaining ZAIS Financial common stock had been trading below its book value for several quarters which is an indicator of potential impairmentshares and ZAIS Partners, L.P. OP units, after the completion of the goodwill.tender offer, times the closing price. The aggregate consideration transferred, net assets acquired, and related bargain purchase gain was as follows (in thousands, except share and per share amounts):

 

 

 

 

ZAIS Financial closing share price on October 31, 2016

 

$

13.40

ZAIS Financial common shares and OP units acquired

 

 

4,712,322

Fair value of consideration transferred

 

$

63,145

Fair Value of Net Asset Acquired

 

$

78,363

Bargain purchase gain

 

$

15,218

Based on the calculation, the Company therefore, conductedhas determined the transaction resulted in a valuation analysisbargain purchase gain. The Company’s Valuation Committee reviewed the results of the mortgage banking unit using bothidentified net assets acquired, liabilities assumed, and the calculation and conclusion of consideration transferred and determined that it was appropriate to recognize a discounted cash flow analysis and market comparables.bargain purchase gain of $15.2 million. This valuation analysis supportedbargain purchase gain is reflected separately within the current carrying valueconsolidated statements of the mortgage banking segment, and indicated that the discount in the Company’s stock price wasincome under gain on bargain purchase.

Acquisition-related costs directly attributable to the residential mortgage investmentsSutherland Merger, including legal, accounting, valuation, and corporate segments. No impairment losses relating to goodwillother professional or consulting fees, among other general and administrative expenses, were recorded$4.2 million for the period from October 31, 2014 to December 31, 2014 or the yeartwelve months ended December 31, 2015.2016 were expensed as incurred and are reflected within professional fees and operating expenses within the consolidated statements of income.

 

Additionally, goodwill

134


The following table summarizes income and earnings from the net assets acquired as part of the reverse merger with ZFC. These net assets include those of GMFS and are for two months of activity following the reverse merger. This activity is expected to be deductible for tax purposes over a 15-year life.included in the consolidated statements of income:

 

Other Intangible Assets

 

 

 

 

 

 

 

For the year ended

(In Thousands)

 

 

December 31, 2016

Interest income

 

$

1,054

Interest expense

 

 

(681)

Other income (expense)

 

 

(4,482)

Realized gain (loss)

 

 

6,036

Unrealized gain (loss)

 

 

4,902

Net income

 

$

6,829

 

The following table presents information aboutpro-forma income and earnings (unaudited) of the intangible assets acquired byCombined Company are presented as if the Company:merger had occurred on January 1, 2015:

 

Estimated Fair
Value
Estimated Useful
Life
Trade name$2.0 million10 years
Customer relationships1.3 million10 years
Licenses1.0 million3 years
Favorable lease1.5 million12 years
Total Intangible assets$5.8 million

 

 

 

 

 

 

 

 

 

 

For the year ended December 31,

(In Thousands)

 

 

2016

 

 

2015

Selected Financial Data

 

 

 

 

 

 

Interest income

 

$

145,767

 

$

161,174

Interest expense

 

$

(66,372)

 

$

(57,551)

Provision for loan losses

 

$

(7,713)

 

$

(19,643)

Other income (expense)

 

$

(37,641)

 

$

(27,760)

Realized gain (loss)

 

$

14,030

 

$

46

Unrealized gain (loss)

 

$

5,772

 

$

(3,817)

Net income from continuing operations before income taxes

 

$

53,843

 

$

52,449

 

Amortization expense relatedNon-recurring pro forma transaction costs directly attributable to the intangible assets acquiredmerger were $4.6 million for the year ended December 31, 20152016 and periodhave been deducted from October 31, 2014the other income (expense) amount above. The Company excluded the bargain purchase gain of $15.2 million from the other income (expense) amount above.

Note 6 – Loans and Allowance for Loan Losses

The accounting for a loan depends on management’s strategy for the loan, and on whether the loan was credit-impaired at the date of acquisition. The Company accounts for loans based on the following loan program categories:

·

Originated or purchased loans held-for-investment, other than PCI loans – originated transitional loans, originated conventional SBC and SBA loans that have been securitized, or acquired loans with no signs of credit deterioration at time of purchase.

·

Loans at fair value – originated conventional SBC and SBA loans that we intend to securitize

·

Loans held-for-sale, at fair value – originated or acquired that we intend to sell in the near term

·

PCI loans held-for-investment – acquired loans with signs of credit deterioration at time of purchase

135


Loan Portfolio

The following table summarizes the classification, unpaid principal balance (“UPB”), and carrying value of loans held by the Company including loans of consolidated VIEs:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

 

 

December 31, 2016

Loans (In Thousands)

 

Carrying Value

 

UPB

 

 

Carrying Value

 

UPB

Loans

 

 

 

 

 

 

 

 

 

 

 

 

 

   Acquired SBA 7(a) loans

 

$

331,083

 

$

353,556

 

 

$

440,731

 

$

471,189

   Acquired loans

 

 

191,327

 

 

209,694

 

 

 

310,286

 

 

355,660

   Originated Transitional loans

 

 

246,076

 

 

248,190

 

 

 

163,155

 

 

162,270

   Originated Transitional loans, at fair value

 

 

 —

 

 

 —

 

 

 

14,505

 

 

13,958

   Originated SBC loans, at fair value

 

 

188,150

 

 

182,045

 

 

 

67,087

 

 

65,131

   Originated SBC loans

 

 

27,610

 

 

27,349

 

 

 

10,426

 

 

10,749

   Originated SBA 7(a) loans

 

 

41,208

 

 

43,439

 

 

 

15,414

 

 

16,112

   Originated Residential Agency loans

 

 

2,013

 

 

2,014

 

 

 

2,238

 

 

2,413

Total Loans, before allowance for loan losses

 

$

1,027,467

 

$

1,066,287

 

 

$

1,023,842

 

$

1,097,482

Allowance for loan losses

 

$

(9,547)

 

 

 —

 

 

$

(12,721)

 

 

 —

Total Loans, net

 

$

1,017,920

 

$

1,066,287

 

 

$

1,011,121

 

$

1,097,482

Loans in consolidated VIEs

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans

 

 

 

 

 

 

 

 

 

 

 

 

 

   Originated SBC loans

 

$

382,873

 

$

373,996

 

 

$

448,722

 

$

436,220

   Acquired loans

 

 

189,545

 

 

204,497

 

 

 

92,844

 

 

101,481

   Acquired SBA 7(a) loans

 

 

69,523

 

 

95,605

 

 

 

91,978

 

 

127,963

   Originated Transitional loans

 

 

196,438

 

 

196,070

 

 

 

25,424

 

 

24,486

Total Loans, in consolidated VIEs, before allowance for loan losses

 

$

838,379

 

$

870,168

 

 

$

658,968

 

$

690,150

Allowance for loan losses on loans in consolidated VIEs

 

$

(2,199)

 

 

 —

 

 

$

(3,409)

 

 

 —

Total Loans, net, in consolidated VIEs

 

$

836,180

 

$

870,168

 

 

$

655,559

 

$

690,150

Total Loans, net, and Loans, net in consolidated VIEs

 

$

1,854,100

 

$

1,936,455

 

 

$

1,666,680

 

$

1,787,632

Held for sale, at fair value, loans

 

 

 

 

 

 

 

 

 

 

 

 

 

   Originated Residential Agency loans

 

$

129,096

 

$

124,758

 

 

$

127,773

 

$

125,012

   Originated Freddie Mac loans

 

 

67,591

 

 

66,642

 

 

 

17,311

 

 

17,161

   Originated SBA 7(a) loans

 

 

16,791

 

 

15,472

 

 

 

 —

 

 

 —

   Acquired loans

 

 

2,544

 

 

2,662

 

 

 

36,713

 

 

36,734

Total Loans, held for sale, at fair value

 

$

216,022

 

$

209,534

 

 

$

181,797

 

$

178,907

Total Loan portfolio

 

$

2,070,122

 

$

2,145,989

 

 

$

1,848,477

 

$

1,966,539

 

 

 

 

 

 

 

 

 

 

 

 

 

 

136


Credit Quality Indicators

The Company monitors credit quality of our loan portfolio based on primary credit quality indicators. Delinquency rates are a primary credit quality indicator for our types of loans. Loans that are more than 30 days past due provide an early warning of borrowers who may be experiencing financial difficulties and/or who may be unable or unwilling to repay the loan. As the loan continues to age, it becomes more clear that the borrower is likely either unable or unwilling to pay.

The following tables display delinquency information on loans, net as of the consolidated balance sheet dates:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

Loans (In Thousands)

Current and
less than 30 days
past due

30-89 Days
Past Due

90+ Days
Past Due

Total Loans Carrying Value

 

Non-Accrual
Loans

 

90+ Days Past Due but Accruing

Loans(1)(2)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Acquired SBA 7(a) loans

$

376,102

$

15,953

$

5,542

$

397,597

 

$

16,782

 

$

176

   Acquired loans

 

348,271

 

6,891

 

19,263

 

374,425

 

 

16,405

 

 

4,090

   Originated Transitional loans

 

435,252

 

7,263

 

 —

 

442,515

 

 

 —

 

 

 —

   Originated SBC loans, at fair value

 

188,150

 

 —

 

 —

 

188,150

 

 

 —

 

 

 —

   Originated SBC loans

 

402,004

 

7,702

 

608

 

410,314

 

 

608

 

 

 —

   Originated SBA 7(a) loans

 

40,871

 

311

 

 —

 

41,182

 

 

671

 

 

 —

   Originated Residential Agency loans

 

1,226

 

 —

 

787

 

2,013

 

 

289

 

 

498

Total Loans, before general allowance for loans losses

$

1,791,876

$

38,120

$

26,200

$

1,856,196

 

$

34,755

 

$

4,764

General allowance for loan losses

 

 

 

 

 

 

$

(2,096)

 

 

 

 

 

 

Total Loans, net

 

 

 

 

 

 

$

1,854,100

 

 

 

 

 

 

 Percentage of outstandings

 

96.5%

 

2.1%

 

1.4%

 

100%

 

 

1.9%

 

 

0.3%

(1) Loan balances include specific allowance for loan losses.

(2) Includes Loans, net in consolidated VIEs

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2016

Loans (In Thousands)

Current and
less than 30 days
past due

30-89 Days
Past Due

90+ Days
Past Due

Total Loans Carrying Value

 

Non-Accrual
Loans

 

90+ Days Past Due but Accruing

Loans(1)(2)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Acquired SBA 7(a) loans

$

501,651

$

15,715

$

10,590

$

527,956

 

$

20,673

 

$

2,127

   Acquired loans

 

354,123

 

7,230

 

32,476

 

393,829

 

 

25,669

 

 

9,677

   Originated Transitional loans, at fair value

 

14,505

 

 —

 

 —

 

14,505

 

 

 —

 

 

 —

   Originated Transitional loans

 

179,700

 

8,879

 

 —

 

188,579

 

 

 —

 

 

 —

   Originated SBC loans, at fair value

 

67,087

 

 —

 

 —

 

67,087

 

 

 —

 

 

 —

   Originated SBC loans

 

458,371

 

 —

 

712

 

459,083

 

 

712

 

 

 —

   Originated SBA 7(a) loans

 

15,192

 

 —

 

222

 

15,414

 

 

222

 

 

 —

   Originated Residential Agency loans

 

931

 

744

 

563

 

2,238

 

 

387

 

 

176

Total Loans, before allowance for loans losses

$

1,591,560

$

32,568

$

44,563

$

1,668,691

 

$

47,663

 

$

11,980

General allowance for loan losses

 

 

 

 

 

 

$

(2,011)

 

 

 

 

 

 

Total Loans, net

 

 

 

 

 

 

$

1,666,680

 

 

 

 

 

 

 Percentage of outstandings

 

95.4%

 

2.0%

 

2.7%

 

100%

 

 

2.9%

 

 

0.7%

(1) Loan balances include specific allowance for loan losses.

(2) Includes Loans, net in consolidated VIEs

      In addition to delinquency rates, the current estimated LTV ratio is another indicator that can provide insight into a borrower’s continued willingness to pay, as the delinquency rate of high LTV loans tends to be greater than that for loans where the borrower has equity in the collateral. The geographic distribution of the loan collateral also provides insight as to the credit quality of the portfolio, as factors such as the regional economy, property price changes and specific events such as natural disasters, will affect credit quality. The Company monitors the loan-to-value ratio and associated risks on a monthly basis.

137


      The following tables presents quantitative information on the credit quality of loans, net as of December 31, 2014 was as follows:

  Year Ended 
December 31, 2015
  October 31, 2014 to
December 31, 2014
 
Amortization expense $788,341  $131,389 

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

At December 31, 20152017 and December 31, 2014, accumulated amortization2016:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    

Loan-to-Value  (a)

 

(In Thousands)

    

0.0 – 20.0%

20.1 – 40.0%

40.1 – 60.0%

60.1 – 80.0%

80.1 – 100.0%

Greater than 100.0%

Total

December 31, 2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans(1) (2)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Acquired SBA 7(a) loans

 

$

8,978

$

37,880

$

125,234

$

106,199

$

56,676

$

62,630

$

397,597

   Acquired loans

 

 

54,463

 

102,498

 

114,010

 

67,037

 

18,745

 

17,672

 

374,425

   Originated Transitional loans

 

 

 —

 

26,735

 

171,227

 

212,830

 

21,639

 

10,084

 

442,515

   Originated SBC loans, at fair value

 

 

 —

 

17,294

 

31,245

 

115,653

 

21,245

 

2,713

 

188,150

   Originated SBC loans

 

 

2,661

 

49,281

 

192,796

 

158,047

 

7,529

 

 —

 

410,314

   Originated SBA 7(a) loans

 

 

52

 

954

 

5,227

 

15,583

 

5,766

 

13,600

 

41,182

   Originated Residential Agency loans

 

 

 —

 

60

 

166

 

609

 

823

 

355

 

2,013

Total Loans, before general allowance for loans losses

 

$

66,154

$

234,702

$

639,905

$

675,958

$

132,423

$

107,054

$

1,856,196

General allowance for loan losses

 

 

 

 

 

 

 

 

 

 

 

 

 

$

(2,096)

Total Loans, net

 

 

 

 

 

 

 

 

 

 

 

 

 

$

1,854,100

December 31, 2016

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans(1) (2)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   Acquired SBA 7(a) loans

 

$

9,301

$

42,617

$

153,710

$

141,586

$

86,085

$

94,657

$

527,956

   Acquired loans

 

 

46,776

 

90,574

 

109,330

 

106,432

 

20,335

 

20,382

 

393,829

   Originated Transitional loans, at fair value

 

 

 —

 

 —

 

1,475

 

13,030

 

 —

 

 —

 

14,505

   Originated Transitional loans

 

 

 —

 

17,187

 

78,219

 

44,730

 

32,967

 

15,476

 

188,579

   Originated SBC loans, at fair value

 

 

 —

 

11,303

 

5,728

 

34,150

 

15,906

 

 —

 

67,087

   Originated SBC loans

 

 

2,709

 

56,050

 

187,823

 

190,473

 

20,258

 

1,770

 

459,083

   Originated SBA 7(a) loans

 

 

145

 

375

 

2,995

 

3,351

 

2,456

 

6,092

 

15,414

   Originated Residential Agency loans

 

 

 —

 

 —

 

217

 

434

 

1,399

 

188

 

2,238

Total Loans, before allowance for loans losses

 

$

58,931

$

218,106

$

539,497

$

534,186

$

179,406

$

138,565

$

1,668,691

General allowance for loan losses

 

 

 

 

 

 

 

 

 

 

 

 

 

$

(2,011)

Total Loans, net

 

 

 

 

 

 

 

 

 

 

 

 

 

$

1,666,680

(a) Loan-to-value is calculated as carrying amount as a percentage of current collateral value.

(1) Loan balances include specific allowance for loan loss reserves.

(2) Includes Loans, net in consolidated VIEs.

As of December 31, 2017 and 2016, the Company’s total carrying amount of loans in the foreclosure process was $0.4 million and $2.3 million, respectively.

The following table displays the geographic concentration of the Company’s loans, net, secured by real estate recorded on our consolidated balance sheets.

 

 

 

 

 

 

 

Geographic Concentration (Unpaid Principal Balance)

    

December 31, 2017

    

 

December 31, 2016

 

California

 

13.5

%  

 

13.6

%

Texas

 

12.4

 

 

14.0

 

Florida

 

11.7

 

 

9.9

 

New York

 

6.8

 

 

6.9

 

Georgia

 

6.2

 

 

5.9

 

Arizona

 

5.1

 

 

5.2

 

Illinois

 

3.9

 

 

2.8

 

North Carolina

 

3.7

 

 

3.7

 

Ohio

 

2.7

 

 

2.9

 

Virginia

 

2.6

 

 

2.9

 

Other

 

31.4

 

 

32.2

 

Total

 

100.0

%  

 

100.0

%

138


The following table displays the collateral type concentration of the Company’s loans, net, on our consolidated balance sheets.

 

 

 

 

 

 

 

Collateral Concentration (Unpaid Principal Balance)

    

December 31, 2017

    

 

December 31, 2016

 

SBA(1) 

    

25.4

%  

 

34.4

%

Multi-family

 

21.1

 

 

13.8

 

Retail

 

17.6

 

 

14.3

 

Office

 

15.6

 

 

14.9

 

Industrial

 

6.9

 

 

6.9

 

Mixed Use

 

6.3

 

 

5.0

 

Lodging/Residential

 

2.9

 

 

4.8

 

Other

 

4.2

 

 

5.9

 

Total

 

100.0

%  

 

100.0

%

(1) Further detail provided on SBA collateral concentration is included in table below.

 

 

 

 

 

 

The following table displays the collateral type concentration of the Company’s SBA loans within loans, net, on our consolidated balance sheets.

 

 

 

 

 

 

 

Collateral Concentration (Unpaid Principal Balance)

    

December 31, 2017

    

 

December 31, 2016

 

Offices of Physicians

 

16.0

%  

 

15.8

%

Child Day Care Services

    

12.3

 

 

14.3

 

Lodging

 

10.5

 

 

11.4

 

Veterinarians

 

7.0

 

 

6.7

 

Eating Places

 

5.5

 

 

6.3

 

Grocery Stores

 

4.7

 

 

4.3

 

Auto

 

3.2

 

 

3.2

 

Funeral Service & Crematories

 

2.2

 

 

1.7

 

Accounting Auditing & Bookkeeping

 

2.1

 

 

2.4

 

Gasoline Service Stations

 

1.9

 

 

1.8

 

Other

 

34.6

 

 

32.1

 

Total

 

100.0

%  

 

100.0

%

Allowance for Loan Losses

The allowance for loan losses represents the Company’s estimate of probable credit losses inherent in the Company’s held-for-investment loan portfolio. This is assessed by considering credit quality indicators, including probable and historical losses, collateral values, loan-to-value (“LTV”) ratios, and economic conditions. The allowance for loan losses includes an asset-specific component, a general formula-based component, and a component related to PCI loans.

The following tables detail the allowance for loan losses by loan product and impairment methodology as of the consolidated balance sheet dates:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

(In Thousands)

Originated
SBC loans

Originated Transitional loans

Acquired
loans

Acquired
SBA 7(a) loans

Originated
SBA 7(a) loans

Total Allowance for
loan losses

General

$

468

$

 -

$

819

$

518

$

291

$

2,096

Specific

 

169

 

 -

 

586

 

1,564

 

27

 

2,346

PCI

 

 -

 

 -

 

5,859

 

1,445

 

 -

 

7,304

Ending balance

$

637

$

 -

$

7,264

$

3,527

$

318

$

11,746

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2016

(In Thousands)

Originated
SBC loans

Originated Transitional loans

Acquired
loans

Acquired
SBA 7(a) loans

Originated
SBA 7(a) loans

Total Allowance for
loan losses

General

$

739

$

 -

$

847

$

253

$

172

$

2,011

Specific

 

65

 

 -

 

1,110

 

2,489

 

 -

 

3,664

PCI

 

 -

 

 -

 

8,193

 

2,262

 

 -

 

10,455

Ending balance

$

804

$

 -

$

10,150

$

5,004

$

172

$

16,130

139


The following tables detail the activity of the allowance for loan losses for loans:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year ended December 31, 2017

(In Thousands)

Originated
SBC loans

Originated Transitional loans

Acquired
loans

Acquired
SBA 7(a) loans

Originated
SBA 7(a) loans

Total Allowance for
loan losses

Beginning balance

$

804

$

 -

$

10,150

$

5,004

$

172

$

16,130

Provision for (Recoveries of) loan losses

 

(166)

 

 -

 

2,387

 

(4)

 

146

 

2,363

Charge-offs and sales

 

 -

 

 -

 

(1,356)

 

(1,473)

 

 -

 

(2,829)

Recoveries

 

(1)

 

 -

 

(3,917)

 

 -

 

 -

 

(3,918)

Ending balance

$

637

$

 -

$

7,264

$

3,527

$

318

$

11,746

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year ended December 31, 2016

(In Thousands)

Originated
SBC loans

Originated Transitional loans

Acquired
loans

Acquired
SBA 7(a) loans

Originated
SBA 7(a) loans

Total Allowance for
loan losses

Beginning balance

$

 -

$

 -

$

10,967

$

6,155

$

 -

$

17,122

Provision for loan losses

 

804

 

 -

 

5,702

 

1,141

 

172

 

7,819

Charge-offs and sales

 

 -

 

 -

 

(685)

 

(2,292)

 

 -

 

(2,977)

Recoveries

 

 -

 

 -

 

(5,834)

 

 -

 

 -

 

(5,834)

Ending balance

$

804

$

 -

$

10,150

$

5,004

$

172

$

16,130

Impaired Loans - Non-PCI loans

The Company considers a loan to be impaired when the Company does not expect to collect all the contractual and principal payments as scheduled in the loan agreements. Impaired loans include loans that have been modified in a TDR or loans that are placed on non-accrual status. All impaired loans are evaluated for an asset-specific allowance as described in Note 3.

 

 

 

 

 

 

(In Thousands)

December 31, 2017

 

December 31, 2016

Impaired loans

 

 

 

 

 

  With an allowance

$

9,222

 

$

14,772

  Without an allowance

 

12,659

 

 

17,653

Total recorded carrying value of impaired loans

$

21,881

 

$

32,425

Allowance for loan losses related to impaired loans

$

(2,346)

 

$

(3,664)

Unpaid principal balance of impaired loans

$

29,853

 

$

33,185

Impaired loans on non-accrual status

$

21,881

 

$

32,425

 

 

 

 

 

 

Average carrying value of impaired loans(1)

$

28,693

 

$

28,891

 

 

 

 

 

 

 

December 31, 2017

 

December 31, 2016

Interest income on impaired loans for the year ended

$

610

 

$

1,165

 

 

 

 

 

 

(1) Average for the year ended December 31, 2017 and 2016.

 

 

 

 

 

Troubled Debt Restructurings

If the borrower is determined to be in financial difficulty, then the Company will determine whether a financial concession has been granted to the borrower by analyzing the value of the loan as compared to the recorded investment, modifications of the interest rate as compared to market rates, modification of the stated maturity date, modification of the timing of principal and interest payments and the partial forgiveness of the loan. Modified loans that are classified as TDRs are individually evaluated and measured for impairment.

140


The following table summarizes the recorded investment of TDRs on the consolidated balance sheet dates by loan type.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

 

December 31, 2016

(In Thousands)

SBC

 

SBA

 

Total

 

SBC

 

SBA

 

Total

Recorded carrying value modified loans classified as TDRs

$

3,727

 

$

12,398

 

$

16,125

 

$

7,918

 

$

11,135

 

$

19,053

Allowance for loan losses on loans classified as TDRs

$

883

 

$

695

 

$

1,578

 

$

656

 

$

1,544

 

$

2,200

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Carrying value of modified loans classified as TDRs

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Carrying value of modified loans classified as TDRs on accrual status

$

1,804

 

$

4,791

 

$

6,595

 

$

5,196

 

$

359

 

$

5,555

Carrying value of modified loans classified as TDRs on non-accrual status

 

1,923

 

 

7,607

 

 

9,530

 

 

2,722

 

 

10,776

 

 

13,498

  Total carrying value of modified loans classified as TDRs

$

3,727

 

$

12,398

 

$

16,125

 

$

7,918

 

$

11,135

 

$

19,053

The following table summarizes the TDR activity that occurred during the years ended December 31, 2017 and 2016 and the financial effects of these modifications.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31, 2017

 

Year Ended December 31, 2016

(In Thousands, except number of loans)

SBC

 

SBA

 

Total

 

SBC

 

SBA

 

Total

Number of loans permanently modified

 

14

 

 

47

 

 

61

 

 

 9

 

 

40

 

 

49

Pre-modification recorded balance (a)

$

3,518

 

$

6,187

 

$

9,705

 

$

9,041

 

$

4,387

 

$

13,428

Post-modification recorded balance (a)

 

3,041

 

 

6,132

 

 

9,173

 

 

7,532

 

 

1,740

 

 

9,272

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Number of loans that remain in default as of December 31, 2017 (b)

 

10

 

 

18

 

 

28

 

 

 3

 

 

15

 

 

18

Balance of loans that remain in default as of December 31, 2017 (b)

$

1,590

 

$

672

 

$

2,262

 

$

359

 

$

362

 

$

721

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Concession granted (a):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Term extension

$

413

 

$

4,931

 

$

5,344

 

$

930

 

$

8,748

 

$

9,678

Interest rate reduction

 

100

 

 

239

 

 

339

 

 

307

 

 

49

 

 

356

Principal reduction

 

601

 

 

286

 

 

887

 

 

 -

 

 

90

 

 

90

Foreclosure

 

920

 

 

554

 

 

1,474

 

 

961

 

 

412

 

 

1,373

  Total

$

2,034

 

$

6,010

 

$

8,044

 

$

2,198

 

$

9,299

 

$

11,497

(a) Represents carrying value.

(b) Represents the December 31, 2017 carrying values of the TDRs that occurred during the year ended December 31, 2017 and 2016 that remained in default as of December 31, 2017. Generally, all loans modified in a TDR are placed or remain on non-accrual status at the time of the restructuring. However, certain accruing loans modified in a TDR that are current at the time of restructuring may remain on accrual status if payment in full under the restructured terms is expected.  For purposes of this schedule, a loan is considered in default if it is 30 or more days past due.

The Company does not believe the financial impact of the presented TDRs to be material. The other elements of the Company’s modification programs do not have a significant impact on financial results given their relative size, or do not have a direct financial impact as in the case of covenant changes.

Loans, held-for-investment are accounted for under ASC 310-10 or ASC 310-30 depending on whether there is evidence of credit deterioration at the time of acquisition. The outstanding carrying amount of our held-for-investment loan portfolio broken down by ASC 310-10 (non-PCI loans) and ASC 310-30 (PCI loans) is as follows:

 

  December 31,
2015
  December 31
2014
 
Trade name $233,338  $33,333 
Customer relationships  151,662   21,666 
Licenses  388,892   55,556 
Favorable lease  145,838   20,834 
Total accumulated amortization $919,730  $131,389 

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

2016  $788,340 
2017  $732,776 
2018  $455,004 
2019  $455,004 
2020  $455,004 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

 

December 31, 2016

 

    

Non-PCI

    

PCI

    

Non-PCI

    

PCI

(In Thousands)

 

Loans

 

Loans

 

Loans

 

Loans

Unpaid principal balance

 

$

1,624,395

 

$

130,015

 

$

1,536,245

 

$

172,298

Non-accretable discount

 

 

 —

 

 

(8,336)

 

 

 —

 

 

(24,784)

Accretable discount

 

 

(44,629)

 

 

(23,749)

 

 

(55,563)

 

 

(26,978)

Loans, held-for-investment

 

 

1,579,766

 

 

97,930

 

 

1,480,682

 

 

120,536

Allowance for loan losses

 

 

(4,442)

 

 

(7,304)

 

 

(5,675)

 

 

(10,455)

Loans, held-for-investment

 

$

1,575,324

 

$

90,626

 

$

1,475,007

 

$

110,081

 

 

 

 

 

 

 

 

 

 

 

 

 

 

98

141


PCI Loans

The following table details the activity of the accretable yield on PCI loans, held-for-investment. The amount of accretable yield is affected by changes in credit outlooks, including metrics such as default and loss severities, prepayment speeds, which can change the amount and period of time over which interest payments are expected to be received, and the interest rates on variable loans.

 

 

 

 

 

 

 

 

 

Year Ended December 31, 

(In Thousands)

 

2017

 

2016

Beginning accretable discount- PCI loans

 

$

26,978

 

$

42,031

Purchases/Originations

 

 

1,234

 

 

676

Sales

 

 

(2,835)

 

 

(7,655)

Accretion

 

 

(4,735)

 

 

(6,635)

Other

 

 

1,466

 

 

4,459

Transfers

 

 

1,641

 

 

(5,898)

Ending accretable discount- PCI loans

 

$

23,749

 

$

26,978

 

No impairment losses relatingIn 2016, the Company acquired credit impaired loans with contractually required principal and interest payments receivable of $2.3 million; expected cash flows of $1.8 million; and a fair value (initial carrying amount) of $1.1 million. In 2017, the Company acquired credit impaired loans with contractually required principal and interest payments receivable of $12.5 million; expected cash flows of $8.9 million; and a fair value (initial carrying amount) of $6.2 million.

Note 7 – Fair Value Measurements

The Company adopted the provisions of ASC 820 Fair Value Measurement, which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. ASC 820 established a fair value hierarchy that prioritizes and ranks the level of market price observability used in measuring investments at fair value. Market price observability is impacted by a number of factors, including the type of investment, the characteristics specific to intangiblethe investment, and the state of the marketplace (including the existence and transparency of transactions between market participants). Investments with readily available, actively quoted prices or for which fair value can be measured from actively quoted prices in an orderly market will generally have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets were recordedor liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Investments measured and reported at fair value are classified and disclosed into one of the following categories based on the inputs as follows:

Level 1 — Quoted prices (unadjusted) in active markets for identical assets and liabilities that the Company has the ability to access.

Level 2 — Pricing inputs are other than quoted prices in active markets, including, but not limited to, quoted prices for similar assets and liabilities in markets that are active, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the period from October 31, 2014assets or liabilities (such as interest rates, yield curves, volatilities, prepayment speeds, loss severities, credit risks and default rates) or other market corroborated inputs.

Level 3 — Significant unobservable inputs are based on the best information available in the circumstances, to December 31, 2014 or the year ended December 31, 2015. The Company didextent observable inputs are not have any intangible assets prioravailable, including the Company’s own assumptions used in determining the fair value of investments. Fair value for these investments are determined using valuation methodologies that consider a range of factors, including but not limited to the price at which the investment was acquired, the nature of the investment, local market conditions, trading values on public exchanges for comparable securities, current and projected operating performance, and financing transactions subsequent to the acquisition of GMFS on October 31, 2014.

Resultsthe investment. The inputs into the determination of Operations and Pro-Forma Resultsfair value require significant management judgment.

 

The Company has recognizedIn certain cases, the following revenues and earnings relatedinputs used to its investment in GMFS for the period from October 31, 2014 (the date of acquisition) to December 31, 2014 which are reflected in the Company’s consolidated statements of operations:

Interest income – mortgage loans held for sale $594,217 
     
Mortgage banking activities, net:    
Gain on sale of mortgage loans, net of direct costs  5,344,361 
Loan origination fee income  213,540 
Provision for loan indemnification  (118,895)
   5,439,006 
Loan servicing fee income, net of direct costs  929,718 
Change in fair value of mortgage servicing rights  (1,684,373)
Other income  45,861 
Total non-interest income  4,730,212 
     
Net income before expenses and taxes relating to Honeybee TRS  583,073 
Expenses of Honeybee TRS  (2,710,564)(1)
Net loss after expenses of Honeybee TRS, before tax  (2,127,491)
Tax benefit  850,996 
Net loss after expenses of Honeybee TRS, after tax $(1,276,495)

(1) These expenses are included in other expenses in the Company’s consolidated statements of operations.

The results of GMFS are included in the Company’s results beginning October 31, 2014. The unaudited pro forma revenues and net incomemeasure fair value may fall into different levels of the consolidated entity for the year ended December 31, 2014, assuming the business combination was consummated on January 1, 2013, are as follows:

  Year Ended
December 31, 2014
  Year Ended
December 31, 2013
 
Net interest income $21,623,473  $15,737,131 
         
Non-interest Income        
Mortgage banking activities, net  41,047,510   46,354,596 
         
Loan servicing fees, net of direct costs  5,239,010   3,022,447 
         
Other income  673,270   709,369 
         
Net income  35,213,626   11,465,008 

The pro forma results are presented for illustrative purposes only and are not intended to represent or be indicative of the actual consolidated results of operations of the Company that would have been achieved had the business combination occurred on January 1, 2013, nor are they intended to represent or be indicative of future results of operations.

4. Fair Value

Fair Value Measurement

Financial assets and liabilities recorded at fair value on a recurring basis are classified in their entiretyhierarchy. In such cases, an investment’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the investment.

 

99

142


 

The following tables presenttable presents the Company’s financial instruments that were accounted forcarried at fair value on a recurring basis atas of December 31, 2015 and December 31, 2014, by level within the fair value hierarchy:2017:

 

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 

December 31, 2014

  Assets and Liabilities at Fair Value 
  Level 1  Level 2  Level 3  Total 
Assets                
Mortgage loans held for investment $  $  $415,959,838  $415,959,838 
Mortgage loans held for sale     97,690,960      97,690,960 
Non-Agency RMBS        148,585,733   148,585,733 
Other Investment Securities        2,040,532   2,040,532 
MSRs        33,378,978   33,378,978 
Derivative assets        2,485,100   2,485,100 
Total $  $97,690,960  $602,450,181  $700,141,141 
Liabilities                
Contingent consideration $  $  $11,430,413  $11,430,413 
Derivative liabilities     2,585,184      2,585,184 
Total $  $2,585,184  $11,430,413  $14,015,597 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In Thousands)

 

Level 1

 

Level 2

 

Level 3

 

Total

Assets:

 

 

 

 

 

 

 

 

 

 

 

 

Cash held in money market funds

 

$

632

 

$

 —

 

$

 —

 

$

632

Loans, held for sale, at fair value

 

 

 —

 

 

216,022

 

 

 —

 

 

216,022

Loans, net, at fair value

 

 

 —

 

 

 —

 

 

188,150

 

 

188,150

Mortgage backed securities, at fair value

 

 

 —

 

 

31,859

 

 

8,063

 

 

39,922

Derivative instruments, at fair value

 

 

 —

 

 

2,898

 

 

1,827

 

 

4,725

Residential mortgage servicing rights, at fair value

 

 

 —

 

 

 —

 

 

72,295

 

 

72,295

Total assets

 

$

632

 

$

250,779

 

$

270,335

 

$

521,746

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

Derivative instruments, at fair value

 

$

 —

 

$

282

 

$

 —

 

$

282

Contingent consideration

 

 

 —

 

 

 —

 

 

10,016

 

 

10,016

Total liabilities

 

$

 —

 

$

282

 

$

10,016

 

$

10,298

 

The following table presents additional information about the Company’s financial instruments which are measuredcarried at fair value on a recurring basis for whichas of December 31, 2016:

 

 

 

 

 

 

 

 

 

 

 

 

 

(In Thousands)

 

Level 1

 

Level 2

 

Level 3

 

Total

Assets:

 

 

 

 

 

 

 

 

 

 

 

 

Cash held in money market funds

 

$

632

 

$

 —

 

$

 —

 

$

632

Short term investments

 

 

319,984

 

 

 —

 

 

 —

 

 

319,984

Loans, held for sale, at fair value

 

 

 —

 

 

164,485

 

 

17,312

 

 

181,797

Loans, net, at fair value

 

 

 —

 

 

 —

 

 

81,592

 

 

81,592

Mortgage backed securities, at fair value

 

 

 —

 

 

 —

 

 

32,391

 

 

32,391

Derivative instruments, at fair value

 

 

 —

 

 

3,095

 

 

2,690

 

 

5,785

Residential mortgage servicing rights, at fair value

 

 

 —

 

 

 —

 

 

61,376

 

 

61,376

Total assets

 

$

320,616

 

$

167,580

 

$

195,361

 

$

683,557

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

Derivative instruments, at fair value

 

$

 —

 

$

643

 

$

 —

 

$

643

Contingent consideration

 

 

 —

 

 

 —

 

 

14,487

 

 

14,487

Total liabilities

 

$

 —

 

$

643

 

$

14,487

 

$

15,130

The following table presents a summary of changes in the Company has utilizedfair value of loans, held at fair value classified as Level 3:

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

(In Thousands)

    

 

2017

    

2016

Beginning Balance

 

 

$

81,592

 

$

155,134

Realized gains (losses), net

 

 

 

(90)

 

 

 6

Unrealized gains, net

 

 

 

5,328

 

 

4,131

Originations

 

 

 

152,339

 

 

147,823

Sales

 

 

 

 —

 

 

(4,776)

Principal payments

 

 

 

(10,114)

 

 

(34,895)

Transfer to loans, held for sale, at fair value

 

 

 

 —

 

 

(11,499)

Transfer to loans, held-for-investment

 

 

 

(40,905)

 

 

(174,332)

Ending Balance

 

 

$

188,150

 

$

81,592

Unrealized gains on loans, held at fair value held on December 31, 2017 and 2016 and classified as Level 3 inputs to determine fair value:were $6.0 million and $2.5 million, respectively.

 

Mortgage Loans Held

143


The following table presents a summary of changes in the fair value of loans, held for Investment, RMBS and Other Investment Securitiessale, at fair value classified as Level 3:

 

  Year Ended December 31, 2015  Year Ended December 31, 2014 
  Mortgage
Loans Held
for
Investment
  Non-Agency
RMBS
  Other
Investment
Securities
  Mortgage
Loans Held
for
Investment
  Non-Agency
RMBS
  Other
Investment
Securities
 
Beginning balance $415,959,838  $148,585,733  $2,040,532  $331,785,542  $226,155,221  $ 
Originations/acquisitions  21,709,387   6,362,138   17,031,330   85,579,169   47,034,327   12,926,953 
Proceeds from sales     (26,770,882)  (5,961,506)     (102,635,229)  (11,067,378)
Amortization of premiums  (6,422)               
Net accretion of discounts  7,767,854   3,882,887   192,476   7,497,341   5,528,538   180,438 
Proceeds from principal repayments  (36,056,879)  (17,888,188)  (9,915)  (31,759,326)  (28,197,740)   
Conversion of mortgage loans to REO  (3,806,064)        (1,796,028)      
Total losses (realized/unrealized) included in earnings  (19,504,275)  (6,105,642)  (723,638)  (8,250,003)  (6,694,487)  (226,224)
Total gains (realized/unrealized) included in earnings  11,614,701   1,273,235   234,917   32,903,143   7,395,103   226,743 
Ending balance $397,678,140  $109,339,281  $12,804,196  $415,959,838  $148,585,733  $2,040,532 
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 $(9,639,808) $(4,098,040) $(567,589) $22,957,500  $(1,039,499) $(226,224)

100

 

 

 

 

 

 

 

 

 

Year Ended December 31,

(In Thousands)

 

2017

    

2016

Beginning Balance

 

$

17,312

 

$

 —

Realized gains, net

 

 

9,005

 

 

5,260

Unrealized gains, net

 

 

2,595

 

 

 —

Originations

 

 

352,975

 

 

257,993

Sales

 

 

(284,707)

 

 

(257,281)

Principal payments

 

 

(10,429)

 

 

(159)

Transfer from loans, held at fair value

 

 

 —

 

 

11,499

Transfer from loans, held-for-investment, net

 

 

5,937

 

 

 —

Transfer from Level 3

 

 

(92,688)

 

 

 —

Ending Balance

 

$

 —

 

$

17,312

 

Derivative Instruments

  Year Ended 
December 31, 2015
  Year Ended 
December 31, 2014
 
  Loan Purchase
Commitments
  Interest Rate
Lock
Commitments
  Loan Purchase
Commitments
  Interest Rate
Lock
Commitments
 
Beginning balance $4,037  $2,481,063  $  $ 
Acquisition of GMFS           2,702,954 
Change in unrealized gain or loss  (13,908)  (104,876)  4,037   (221,891)
Ending balance $(9,871) $2,376,187  $4,037  $2,481,063 
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 $(13,908) $(104,876) $4.037  $(221,891)

MSRs

See Note 8 – "Mortgage Servicing Rights,Unrealized gains on loans, held for sale at fair value" for additional information about the Company's MSRs.

Contingent Consideration

  Year Ended 
  December 31,
2015
  December 31,
2014
 
Beginning balance $11,430,413  $ 
Acquisition of GMFS     11,430,413 
Change in fair value  (145,313)   
Ending balance $11,285,100  $11,430,413 

value held on December 31, 2016 and classified as Level 3 were $0.1 million. There were no financial assets or liabilities that were accountedloans, held for sale classified as Level 3 on December 31, 2017.

The following table presents a summary of changes in the fair value of MBS, at fair value classified as Level 3:

 

 

 

 

 

 

 

 

 

Year Ended December 31,

(In Thousands)

    

2017

    

2016

Beginning Balance

 

$

32,391

 

$

213,504

Accreted discount, net

 

 

224

 

 

201

Realized gains (losses), net

 

 

522

 

 

(3,068)

Unrealized gains, net

 

 

1,344

 

 

3,680

Purchases

 

 

14,448

 

 

17,388

Acquired in connection with reverse merger

 

 

 —

 

 

97,936

Sales / Principal payments

 

 

(7,785)

 

 

(297,250)

Transfer from Level 3

 

 

(33,081)

 

 

 —

Ending Balance

 

$

8,063

 

$

32,391

Unrealized losses on a nonrecurring basisMBS, at fair value held on December 31, 2015 or2017 and 2016 and classified as Level 3 were $0.6 million and $0.3 million, respectively.

Refer to “Note 9 – Servicing rights” for activity relating to the changes in the fair value of the Company’s residential mortgage servicing rights. Unrealized gains (losses) on residential mortgage servicing rights, at fair value held on December 31, 2014. During2017 and 2016 and classified as Level 3 were $(8.5) million and $6.9 million, respectively.

The following table presents a summary of changes in the years endedfair value of derivatives instruments, at fair value classified as Level 3, or interest rate lock commitments:

 

 

 

 

 

 

 

 

 

Year Ended December 31, 

(In Thousands)

 

2017

    

2016

Beginning Balance

 

$

2,690

 

$

 —

Acquired in connection with reverse merger

 

 

 —

 

 

3,498

Unrealized gains (losses)

 

 

(863)

 

 

(808)

Ending Balance

 

$

1,827

 

$

2,690

Unrealized gains (losses) on derivatives held on December 31, 20152017 and 2016 and classified as Level 3 were $(1.7) million and $0.8 million, respectively.

The following table presents a summary of changes in the fair value of contingent consideration classified as Level 3:

 

 

 

 

 

 

 

 

 

Year Ended December 31, 

(In Thousands)

    

2017

    

2016

Beginning Balance

 

$

14,487

 

$

 —

Acquired in connection with reverse merger

 

 

 —

 

 

14,422

Adjustment for legal settlement

 

 

(5,744)

 

 

 —

Amortization

 

 

1,273

 

 

65

Ending Balance

 

$

10,016

 

$

14,487

 

 

 

 

 

 

 

144


As of December 31, 2014, mortgage loans held for investment were transferred2017 and 2016, there was no unrealized gain (loss) on contingent consideration.

The Company’s policy is to recognize transfers in and transfers out as of the beginning of the period of the event or the change in circumstances that caused the transfer. Transfers between Level 2 and Level 3 whengenerally relate to whether there were changes in the properties were foreclosedsignificant relevant observable and were classified as real estate owned. There were no other transfersunobservable inputs that are available for the fair value measurements of such financial instruments. Transfers into or out of Level 1,3 of the fair value hierarchy are recorded at the end of the reporting period. In December 2017, the Company determined that, based a more liquid market for these financial instruments, a transfer from Level 3 was necessary. Based on this determination, as of December 31, 2017, we have applied Level 2 orclassification to these financial instruments.

Valuation Process for Fair Value Measurements

The Company establishes valuation processes and procedures designed so that fair value measurements are appropriate and reliable, that they are based on observable inputs where possible, and that valuation approaches are consistently applied and the assumptions and inputs are reasonable. The Company has also established processes to provide that the valuation methodologies, techniques and approaches for investments that are categorized within Level 3 duringof the years endedfair value hierarchy are fair, consistent and verifiable. The Company’s processes provide a framework that ensures the oversight of the Company’s fair value methodologies, techniques, validation procedures, and results.

The Company designates a valuation committee (the “Committee”) to oversee the entire valuation process of the Company’s Level 3 investments. The Committee is comprised of various personnel who are responsible for developing the Company’s written valuation policies, processes and procedures, conducting periodic reviews of the valuation policies, and performing validation procedures on the overall fairness and consistent application of the valuation policies and processes and that the assumptions and inputs used in valuation are reasonable.

The validation procedures overseen by the Committee are also intended to provide that the values received from external third-party pricing sources are consistent with the Company’s Valuation Policy and are carried at fair value. To the extent that there are no exchange pricing, vendor marks or broker quotes readily available, the Company may use an internal valuation model or other valuation methodology that may be based on unobservable market inputs to fair value the investment.

The values provided by a third-party pricing service are calculated based on key inputs provided by the Company including collateral values, unpaid principal balances, cash flow velocity, contractual status and anticipated disposition timelines. In addition, the Company performs an internal valuation used to assess and review the reasonableness and validity of the fair values provided by a third party. The Company also performs analytical procedures, which include automated checks consisting of prior-period variance analysis, comparisons of actual prices to internally calculate expected prices based on observable market changes, analysis of changes in pricing ranges, and relative value and yield comparisons using the Company’s proprietary valuation models.

Upon completion of the review process described above, the Company may provide additional quantitative and qualitative data to the third-party pricing service to consider in valuing certain financial assets and liabilities, as applicable. Such data may include deal specific information not included in the data tape provided to the third party, outliers when compared to the unpaid principal balance and collateral value and knowledge of any impending liquidation of an investment. If deemed necessary by the third party and management, the investments are re-valued by the third party to account for the updated information.

145


The following table summarizes the valuation techniques and significant unobservable inputs used for the Company’s financial instruments that are categorized within Level 3 of the fair value hierarchy as of December 31, 2015 or December 31, 2014.2017 using third party information without adjustment:

 

101

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Predominant

 

 

 

 

 

 

Weighted

 

 

 

 

 

 Valuation

 

 

 

 

 

 

Average Price

(In Thousands, except price)

    

Fair Value

    

Technique

    

Type

    

Price Range

    

(a)

Loans, held at fair value

 

$

188,150

 

Single External Source

 

Third Party Mark

 

$

101.05 – 104.00

 

$

103.35

Mortgage backed securities, at fair value

 

 

7,937

 

Broker Quotes

 

Third Party Mark

 

 

70.92 – 70.92

 

 

70.92

Mortgage backed securities, at fair value

 

 

126

 

Transaction Price

 

Transaction Price

 

 

99.00 – 99.00

 

 

99.00

Residential mortgage servicing rights, at fair value

 

 

72,295

 

Single external source

 

Discounted cash flow

 

 

N/A

 

 

N/A

Contingent consideration

 

 

10,016

 

Single external source

 

Discounted cash flow

 

 

N/A

 

 

N/A


(a)Prices are weighted based on the unpaid principal balance of the loans and securities included in the range for each class

 

The following tables present quantitative information abouttable summarizes 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
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%

102

  Fair Value at
December 31,
2014
  Valuation
Technique(s)
 Unobservable Input Min/Max  Weighted
Average
 
Mortgage loans held for investment $415,959,838  Discounted cash flow model Constant voluntary prepayment  1.4%  27.1%  3.9%
        Constant default rate  0.0%  4.0%  2.9%
        Loss severity  0.0%  40.5%  23.8%
        Delinquency  0.1%  13.6%  10.6%
Non-Agency RMBS                    
Alternative – A $61,296,540  Broker quotes/ comparable trades Constant voluntary prepayment  1.6%  24.8%  13.6%
        Constant default rate  0.1%  8.4%  3.1%
        Loss severity  0.0%  81.1%  20.5%
        Delinquency  1.3%  25.9%  10.1%
Pay option adjustable rate $45,541,325  Broker quotes/ comparable trades Constant voluntary prepayment  1.7%  20.1%  8.9%
        Constant default rate  1.6%  19.4%  4.3%
        Loss severity  0.0%  66.2%  38.0%
        Delinquency  6.8%  29.1%  15.2%
Prime $39,065,076  Broker quotes/ comparable trades Constant voluntary prepayment  2.6%  17.3%  9.2%
        Constant default rate  0.2%  9.2%  4.1%
        Loss severity  0.0%  78.3%  28.2%
        Delinquency  5.0%  24.8%  13.0%
Subprime $2,682,792  Broker quotes/ comparable trades Constant voluntary prepayment  2.4%  7.4%  4.7%
        Constant default rate  6.0%  8.0%  7.7%
        Loss severity  65.0%  85.0%  72.0%
        Delinquency  25.5%  27.7%  26.8%
Total Non-Agency RMBS $148,585,733                 
                     
Other Investment Securities $2,040,532  Broker quotes/ comparable trades Constant voluntary prepayment        7.5%
                     
MSRs $33,378,978  Discounted cash flow model Constant prepayment rate  7.6 %  58.2%  10.6%
      Cost of servicing $76  $533  $91 
     Discount rate  9.0%  10.0%  9.4%
Contingent consideration $11,430,413  Discounted cash flow model Cost of equity        6.4%
        Cost of capital        16.9%

The valuation methodology for the contingent consideration changed from 2014 to 2015. The contingent consideration recorded at December 31, 2014 was based on a discount cash flow in connection with the acquisition of GMFS on October 31, 2014. The Company used an option pricing model to reassess the fair value of the contingent consideration at December 31, 2015. 

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 completetechniques 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 infor the Company’s financial instruments that are categorized within Level 3 of the fair value measurementhierarchy as of December 31, 2016 using third-party information without adjustment:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    

 

 

    

Predominant

    

 

    

 

 

    

Weighted

 

 

 

 

 

Valuation

 

 

 

 

 

 

Average Price

(In Thousands, except price)

 

Fair Value

 

Technique

 

Type

 

Price Range

 

(a)

Loans, held at fair value

 

$

81,592

 

Single External Source

 

Third Party Mark

 

$

98.47 – 105.00

 

$

103.16

Loans, held for sale, at fair value

 

 

17,312

 

Single External Source

 

Third Party Mark

 

 

100.04 – 102.97

 

 

100.87

Mortgage backed securities, at fair value (b)

 

 

29,883

 

Broker Quotes

 

Third Party Mark

 

 

17.91 – 101.00

 

 

68.90

Mortgage backed securities, at fair value

 

 

2,508

 

Transaction Price

 

Transaction Price

 

 

99.00 – 99.00

 

 

99.00

Residential mortgage servicing rights, at fair value

 

 

61,376

 

Single external source

 

Discounted cash flow

 

 

N/A

 

 

N/A

Contingent consideration

 

 

14,487

 

Single external source

 

Discounted cash flow

 

 

N/A

 

 

N/A


(a)Prices are weighted based on the unpaid principal balance of the Company's IRLCs are the pull-through rateloans 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 changessecurities included in the pull-through raterange for each class

(b)Price ranges and expected net future cash flows related to servicing the MSR component of the IRLCs, in isolation, may result inweighted averages exclude interest-only strips with 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$1.5 million as of IRLC value, but increase the pull-through rate for loans that have decreased in fair value. 

103

The following is a quantitative summary of key unobservable inputs used in the valuation of IRLCs at December 31, 2015 and December 31, 2014:2016.

Pull-through rate        
Range  62.4% – 100.0%   55.7% - 100.0% 
Weighted average  87.6%  85.0%
MSR value expressed as:        
Servicing fee multiple        
Range  0.8% - 5.9%   0.4% - 6.0% 
Weighted average  4.3%  4.4%
Percentage of unpaid principal balance        
Range  0.3% - 1.7%   0.2% - 1.9% 
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.

 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 December 31, 2015 and December 31, 2014:

104

  December 31, 2015  December 31, 2014 
  Fair Value  Unpaid Principal
and/or Notional
Balance(2)
  Difference  Fair Value  Unpaid Principal
and/or Notional
Balance(2)
  Difference 
Financial instruments, at fair value                  
Mortgage loans held for investment(1) $397,678,140  $444,500,063  $(46,821,923) $415,959,838  $464,877,028  $(48,917,190)
Mortgage loans held for sale  115,942,230   111,393,424   4,548,804   97,690,960   92,917,659   4,773,301 
Non-Agency RMBS  109,339,281   168,925,162   (59,585,881)  148,585,733   226,501,915   (77,916,182)
Other Investment Securities  12,804,196   13,398,851   (594,655)  2,040,532   2,250,000   (209,468)
MSRs  48,209,016   4,173,927,393   N/A(3)  33,378,978   3,078,974,342   N/A(3)

(1)Balance comprised of loans that are (i) distressed and re-performing at the time of purchase and (ii) newly originated at the time of purchase.
(2)Non-Agency RMBS includes an IO with a notional balance of $35.0 million and $48.6 million at December 31, 2015 and December 31, 2014, respectively.
(3)Amounts not presented. Unpaid principal balance of MSRs are 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 recordedinstruments not carried 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 summarizespresents the carrying value and estimated fair value and carrying value for all otherof our financial instruments that are not carried at December 31, 2015 and December 31, 2014:

  December 31, 2015  December 31, 2014 
  Fair Value  Carrying Value  Fair Value  Carrying Value 
Other financial instruments                
Assets                
Cash $20,793,716  $20,793,716  $33,791,013  $33,791,013 
Restricted cash  4,371,725   4,371,725   7,143,078   7,143,078 
Mortgage loans held for investment, at cost  1,886,642   1,886,642   1,310,544   1,338,935 
Liabilities                
Warehouse lines of credit $100,768,428  $100,768,428  $89,417,564  $89,417,564 
Loan repurchase facilities  296,789,330   296,789,330   300,092,293   300,092,293 
Securities repurchase agreements  73,300,159   73,300,159   103,014,105   103,014,105 
Exchangeable Senior Notes  56,775,500   56,509,046   59,933,400   55,474,741 

Cash includes cash on hand for which fair value equals carrying value (a Level 1 measurement). Restricted cash representson the Company's cash held by counterparties as collateral against the Company's derivatives, loan repurchase facilitiesconsolidated balance sheets and securities repurchase agreements. Due to the short-term nature of the restrictions, fair value approximates carrying value (a Level 1 measurement). The fair value of the mortgage loans held for investment is determined, where possible using secondary-market prices. If no such quoted price exists, the fair value of a loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan. Accordingly, mortgage loans held for investment, at cost are classified as Level 2 in the3:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

 

December 31, 2016

(In Thousands)

    

Carrying Value

    

Fair Value

    

Carrying Value

    

Fair Value

Assets:

 

 

 

 

 

 

 

 

 

 

 

 

Loans, net

 

$

1,665,950

 

$

1,737,361

 

$

1,585,088

 

$

1,639,982

Investment in unconsolidated joint venture

 

 

55,369

 

 

55,369

 

 

 —

 

 

 —

Servicing rights

 

 

21,743

 

 

23,432

 

 

22,478

 

 

23,470

Total assets

 

$

1,743,062

 

$

1,816,162

 

$

1,607,566

 

$

1,663,452

Liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

Secured borrowings

 

$

631,286

 

$

631,286

 

$

927,462

 

$

927,462

Promissory note

 

 

6,107

 

 

6,107

 

 

7,378

 

 

7,378

Securitized debt obligations of consolidated VIEs, net

 

 

598,148

 

 

613,676

 

 

492,942

 

 

483,381

Senior secured note, net

 

 

138,078

 

 

144,376

 

 

 —

 

 

 —

Guaranteed loan financing

 

 

293,045

 

 

306,964

 

 

390,555

 

 

409,751

Convertible note, net

 

 

108,991

 

 

108,301

 

 

 —

 

 

 —

Total liabilities

 

$

1,775,655

 

$

1,810,710

 

$

1,818,337

 

$

1,827,972

146


Other assets totaling $16.5 million at December 31, 2017 and $32.6 million at December 31, 2016 are not carried at fair value hierarchy. Theand include Due from servicers and Accrued interest, which are reflected in Note 20. Receivable from third parties totaling $6.8 million at December 31, 2017 and $7.2 million at December 31, 2016 are not carried at fair value. For these instruments, carrying value approximates fair value of the Company's warehouse lines of credit and repurchase agreements related to the GMFS mortgage banking platform, loan repurchase facilitiesare classified as Level 3.

Accounts payable and securities repurchase agreements is based on an expected present value technique using observable market interest rates. As such, the Company considers the estimatedother accrued liabilities totaling $12.4 million at December 31, 2017 and $8.4 million at December 31, 2016 are not carried at fair value and include Payable to be a Level 2 measurement. This method discounts future estimated cash flows using rates the Company determined best reflect current marketrelated parties and Accrued interest rates that would be offered for loans with similar characteristics and credit quality. Thepayable which are included in Note 20. For these instruments, carrying value approximates fair value of the Exchangeable Senior Notes (see and are classified as Level 3.

Note 12) is based on observable market prices (a Level 2 measurement).8 – Mortgage Backed Securities

 

The differences reflected infollowing table presents certain information about the Company’s MBS portfolio, which are classified as trading securities and carried at fair value, as of December 31, 2017.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

 

    

 

    

Weighted

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Weighted

 

Average

 

 

 

 

 

 

 

 

 

 

Gross

 

Gross

 

 

Average

 

Interest

 

Principal

 

Amortized

 

 

 

 

Unrealized

 

Unrealized

(In Thousands)

 

Maturity (a)

 

Rate (a)

 

Balance

 

Cost

 

Fair Value

 

Gains

 

 Losses

MBS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Freddie Mac Loans

 

12/2034

 

5.3

%  

$

49,767

 

$

37,287

 

$

38,568

 

$

2,529

 

$

(1,248)

Commercial Loans

 

06/2043

 

5.5

 

 

4,513

 

 

1,054

 

 

1,228

 

 

174

 

 

 —

Tax Liens

 

09/2026

 

6.0

 

 

127

 

 

127

 

 

126

 

 

 —

 

 

(1)

Total

 

08/2035

 

5.3

%  

$

54,407

 

$

38,468

 

$

39,922

 

$

2,703

 

$

(1,249)


(a)

Weighted based on current principal balance

The following table presents certain information about the Company’s MBS portfolio as of December 31, 2016.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2016

 

 

 

 

Weighted

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted

 

Average

 

 

 

 

 

 

 

 

 

 

Gross

 

Gross

 

 

Average

 

Interest

 

Principal

 

Amortized

 

 

 

 

Unrealized

 

Unrealized

(In Thousands)

    

Maturity (a)

    

Rate (a)

    

Balance

    

Cost

    

Fair Value

    

Gains

    

Losses

MBS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Freddie Mac Loans

 

06/2032

 

5.6

%  

$

34,932

 

$

28,676

 

$

28,752

 

$

1,605

 

$

(1,528)

Commercial Loans

 

06/2043

 

5.5

 

 

6,314

 

 

1,472

 

 

1,131

 

 

 

 

 

(342)

Tax Liens

 

03/2031

 

6.5

 

 

2,534

 

 

2,533

 

 

2,508

 

 

 —

 

 

(25)

Total

 

12/2033

 

5.7

%  

$

43,780

 

$

32,681

 

$

32,391

 

$

1,605

 

$

(1,895)


(a)

Weighted based on current principal balance

The following table presents certain information about the maturity of the Company’s MBS portfolio as of December 31, 2017.

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

 

    

Weighted

    

 

 

    

 

 

    

 

 

 

 

Average

 

 

 

 

 

 

 

 

 

 

 

Interest 

 

Principal

 

Amortized 

 

 

(In Thousands)

 

Rate (a)

 

Balance

 

Cost

 

 Fair Value

After five years through ten years

 

8.9

%  

$

8,919

 

$

8,205

 

$

8,904

After ten years

 

4.6

 

 

45,488

 

 

30,263

 

 

31,018

Total

 

5.3

%  

$

54,407

 

$

38,468

 

$

39,922

147


The following table presents certain information about the maturity of the Company’s MBS portfolio as of December 31, 2016.

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2016

 

    

Weighted

    

 

 

    

 

 

    

 

 

 

 

Average

 

 

 

 

 

 

 

 

 

 

 

Interest 

 

Principal

 

Amortized 

 

 

(In Thousands)

 

Rate (a)

 

Balance

 

Cost

 

Fair Value

After five years through ten years

 

8.9

%  

$

13,616

 

$

12,579

 

$

12,709

After ten years

 

4.2

 

 

30,164

 

 

20,102

 

 

19,682

Total

 

5.7

%  

$

43,780

 

$

32,681

 

$

32,391

Note 9 – Servicing rights

The Company performs servicing activities for mortgage loans held for investmentthird parties, which primarily include collecting principal, interest and other payments from borrowers, remitting the corresponding payments to investors and monitoring delinquencies. The Company’s servicing fees are not necessarily indicativespecified by pooling and servicing Agreements.

The following table presents information about the Company’s portfolios of cumulative gainsservicing rights:

 

 

 

 

 

 

 

 

 

Year Ended December 31, 

(In Thousands)

    

2017

    

2016

SBA servicing rights, at amortized cost

 Beginning net carrying amount

 

$

20,276

 

$

26,329

   Additions due to loans sold, servicing retained

 

 

1,996

 

 

951

   Amortization

 

 

(4,034)

 

 

(5,110)

   Impairment

 

 

(1,554)

 

 

(1,894)

Ending net carrying value of SBA servicing rights

 

$

16,684

 

$

20,276

Freddie Mac servicing rights, at amortized cost

 Beginning net carrying amount

 

$

2,202

 

$

921

   Additions due to loans sold, servicing retained

 

 

3,290

 

 

2,009

   Amortization

 

 

(610)

 

 

(550)

   Recovery (Impairment)

 

 

177

 

 

(178)

Ending net carrying value of Freddie Mac servicing rights

 

$

5,059

 

$

2,202

Ending net carrying value of SBA and Freddie Mac servicing rights, at amortized cost

 

$

21,743

 

$

22,478

Residential mortgage servicing rights, at fair value

 Beginning Balance

 

$

61,376

 

$

 —

Acquired in connection with reverse merger

 

 

 —

 

 

51,302

Additions due to loans sold, servicing retained

 

 

20,565

 

 

3,157

Loan pay-offs

 

 

(5,646)

 

 

 —

Unrealized gains (losses)

 

 

(4,000)

 

 

6,917

Ending fair value of residential mortgage servicing rights

 

$

72,295

 

$

61,376

Total servicing rights

 

$

94,038

 

$

83,854

Servicing rights – SBA and Freddie Mac

The Company’s SBA and Freddie Mac servicing rights are carried at the lower of cost or losses related to loans because it does not take into accountamortized cost. The Company estimates the fair value of the loansSBA and Freddie Mac servicing rights carried at the dateamortized cost using a combination of acquisition.

105

5. Mortgage Loans Held for Investment, at Fair Valueinternal models and data provided by third-party valuation experts. The assumptions used in our internal models include forward prepayment rates, forward default rates, discount rates, and servicing expenses.

 

DistressedThe Company’s models calculate the present value of expected future cash flows utilizing assumptions that we believe are used by market participants. We derive forward prepayment rates, forward default rates and re-performing loans atdiscount rates from historical experience adjusted for prevailing market conditions. Components of the timeestimated future cash flows include servicing fees, late fees, other ancillary fees and cost of purchaseservicing.

 

During the year ended December 31, 2015, the Company did not acquire any mortgage loans held for investment which showed evidence

148


During the years ended December 31, 2014 and December 31, 2013, the Company's acquisition of mortgage loans held for investment which showed evidence of credit deterioration at the time of purchase was as follows:

  Year Ended 
  

December 31

2014

  

December 31,

2013

 
Aggregate Unpaid Principal Balance $100,422,418  $412,865,280 
Loan Repurchase Facilities Used  60,557,196   231,981,549 

The following tables present certaintable presents additional information regardingabout the Company's mortgage loans held for investment at December 31, 2015Company’s SBA and December 31, 2014 which showed evidence of credit deterioration at the time of purchase:Freddie Mac servicing rights:

 

December 31, 2015

   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
 
Mortgage Loans Held for Investment                                    
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 Mortgage Loans Held for Investment $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%

December 31, 2014

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

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

Year Ended 
December 31,
2015
  December 31,
2014
  December 31,
2013
 
$(9,305,484) $22,810,802  $7,136,482 

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

106

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As of December 31, 2017

 

As of December 31, 2016

 

 

Unpaid Principal

 

 

 

Unpaid Principal

 

 

(In Thousands)

 

Amount

 

Carrying Value

 

Amount

 

Carrying Value

SBA

 

$

427,623

 

$

16,684

 

$

449,115

 

$

20,276

Freddie Mac

 

 

559,823

 

 

5,059

 

 

224,826

 

 

2,202

Total

 

$

987,446

 

$

21,743

 

$

673,941

 

$

22,478

 

 

 

 

 

 

 

 

 

 

 

 

 

    

The changesignificant assumptions used 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 years ended December 31, 2015, December 31, 20142017 and December 31, 2013 is as follows:2016 estimated valuation of the Company’s SBA and Freddie Mac commercial servicing rights carried at amortized cost include:

 

  Year Ended 
  

December 31,

2015

  

December 31,

2014

  

December 31,

2013

 
Accretable yield, beginning of year $267,509,905  $223,401,697  $ 
Acquisitions     55,532,098   222,899,189 
Accretion  (25,582,964)  (26,137,006)  (10,470,435)
Reclassifications from nonaccretable difference  5,825,003   14,713,116   10,972,942 
Accretable yield, end of year $247,751,944  $267,509,905  $223,401,696 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

 

December 31, 2016

 

 

    

Range of input
values

 

Weighted
Average

    

Range of input
values

 

Weighted
Average

SBA servicing rights (at amortized cost)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

• Forward prepayment rate

 

2.4

-

20.5

%

 

11.5

%

 

2.1

-

19.1

%

 

13.1

%

 

• Forward default rate

 

0.0

-

9.5

%

 

2.7

%

 

0.0

-

10.8

%

 

1.2

%

 

• Discount rate

 

12.0

-

12.0

%

 

12.0

%

 

12.0

-

12.0

%

 

12.0

%

 

• Servicing expense

 

0.4

-

0.4

%

 

0.4

%

 

0.4

-

0.4

%

 

0.4

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Freddie Mac commercial servicing rights (at amortized cost)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

• Forward prepayment rate

 

0.0

-

13.0

%

 

4.2

%

 

10.0

-

10.0

%

 

10.0

%

 

• Forward default rate

 

0.0

-

2.0

%

 

2.0

%

 

1.1

-

1.1

%

 

1.1

%

 

• Discount rate

 

12.0

-

12.0

%

 

12.0

%

 

12.0

-

12.0

%

 

12.0

%

 

• Servicing expense

 

0.2

-

0.2

%

 

0.2

%

 

0.2

-

0.2

%

 

0.2

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Newly originated loansThese assumptions can change between and at the time of purchase

During the years ended December 31, 2015each reporting period as market conditions and December 31, 2014, the Company's acquisition of mortgage loans held for investment which were newly originated at the time of purchase was as follows:

  Year Ended 
  December 31,
2015
  December 31,
2014
 
Aggregate Unpaid Principal Balance $21,336,404  $766,965 
Loan Repurchase Facilities Used  18,129,422   690,268 

During the year ended December 31, 2013, the Company did not acquire any mortgage loans held for investment which were newly originated at the time of purchase.projected interest rates change.

 

The following tables present certain information regardingtable reflects the Company's mortgage loans held for investment, at fair value, at December 31, 2015possible impact of 10% and December 31, 2014 which were newly originated at20% adverse changes to key assumptions on the timecarrying amount of purchase and sourced through the Company’s loan purchase program:SBA and Freddie Mac servicing rights.

 

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%

December 31, 2014

  Unpaid        

Gross Unrealized(1)

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

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

Year Ended 
December 31,
2015
  December 31,
2014
 
$(63,235) $3,538 

107

 

 

 

 

 

 

 

(In Thousands)

    

December 31, 2017

    

December 31, 2016

SBA servicing rights (at amortized cost)

 

 

 

 

 

 

• Forward prepayment rate

 

 

 

 

 

 

10% adverse change

 

$

(514)

 

$

(664)

20% adverse change

 

 

(998)

 

 

(1,290)

 

 

 

 

 

 

 

• Default rate

 

 

 

 

 

 

10% adverse change

 

$

(24)

 

$

(12)

20% adverse change

 

 

(48)

 

 

(24)

 

 

 

 

 

 

 

• Discount rate

 

 

 

 

 

 

10% adverse change

 

$

(520)

 

$

(576)

20% adverse change

 

 

(1,008)

 

 

(1,290)

 

 

 

 

 

 

 

Freddie Mac commercial servicing rights (at amortized cost)

 

 

 

• Forward prepayment rate

 

 

 

 

 

 

10% adverse change

 

$

(43)

 

$

(55)

20% adverse change

 

 

(84)

 

 

(107)

 

 

 

 

 

 

 

• Default rate

 

 

 

 

 

 

10% adverse change

 

$

(6)

 

$

(2)

20% adverse change

 

 

(12)

 

 

(4)

 

 

 

 

 

 

 

• Discount rate

 

 

 

 

 

 

10% adverse change

 

$

(270)

 

$

(54)

20% adverse change

 

 

(518)

 

 

(104)

 

Concentrations

149


The estimated future amortization expense for the servicing rights is expected to be as follows:

 

 

 

 

(In Thousands)

    

December 31, 2017

2018

 

$

4,353

2019

 

 

3,675

2020

 

 

3,087

2021

 

 

2,585

2022

 

 

2,145

Thereafter

 

 

5,898

Total

 

$

21,743

Residential mortgage servicing rights

 

The Company's residential 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 December 31, 2015 and December 31, 2014:

  December 31,
2015
  December 31,
2014
 
       
Percentage of fair value of mortgage loans with unpaid principal balance to current property value in excess of 100%  44.1%  55.7%
Percentage of fair value of mortgage loans secured by properties in the following states:        
         
Each representing 10% or more of fair value:        
California  26.2%  26.2%
Florida  16.1%  16.6%
Additional state representing more than 5% of fair value:        
Georgia  6.1%  5.7%
New York  4.8%  5.1%
Percentage of unpaid principal balance of mortgage loans carrying mortgage insurance  8.2%  10.3%

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

December 31,
2015
December 31,
 2014
Interest rates1.75% - 12.20%1.75% - 12.20%
Contractual maturities1 - 45 years1 - 46 years

REO

Additional information about the Company’s REO assets at December 31, 2015 and December 31, 2014, are as follows:

  December 31,
2015
  December 31,
 2014
 
Net realizable value (included in other assets in the Company's consolidated balance sheets) $1,784,670  $1,282,669 
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  5,597,611   4,762,509 

6. Mortgage Loans Held for Sale, at Fair Value

During the year ended December 31, 2015 and December 31, 2014, the Company's mortgage loans held for sale activity was as follows:

  Year Ended 
  

December 31,

2015

  

December 31,

2014

 
Balance at beginning of year $97,690,960  $ 
Acquisition of GMFS     92,512,390 
Originations and repurchases  1,851,206,995   253,934,598 
Proceeds from sales and principal payments  (1,893,833,985)  (245,140,671)
Transfers to mortgage loans held for investment, at cost, net  (443,932)   
Gain on sale  61,322,192   (3,615,357)
Balance at end of year $115,942,230  $97,690,960 

108

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

  December 31, 2015  December 31, 2014 
  Unpaid
Principal
Balance
  Fair Value  Unpaid
Principal
Balance
  Fair Value 
Conventional $54,962,904 ��$56,586,717  $55,073,645  $57,058,195 
Governmental  30,531,301   32,131,354   13,407,781   14,601,797 
United States Department of Agriculture loans  16,222,152   17,059,982   16,105,088   17,069,138 
United States Department of Veteran Affairs loan  8,922,978   9,314,255   6,730,696   7,196,278 
Reverse mortgage  754,089   849,922   1,600,449   1,765,552 
Total $111,393,424  $115,942,230  $92,917,659  $97,690,960 

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

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

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

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

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%

December 31, 2014

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

(1)See Note 2 – 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.

109

  December 31, 2015  December 31, 2014 
  Non-Agency RMBS  Other Investment
Securities
  Non-Agency RMBS  Other Investment
Securities
 
Notional balance of IO included in Alternative A $35,042,860     $48,569,424    
Contractual maturities (range)  18.1 to 31.3 years   

8.4 to

12.3 years

   20.3 to 32.3 years   9.7 years 
Weighted average maturity  24.4 years   10.1 years   24.9 years   9.7 years 

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

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

Realized losses from OTTI on non-Agency RMBS or Other Investment Securities for the years ended December 31, 2015, December 31, 2014 and December 31, 2013 are as follows:

Year Ended 

December 31,

2015

  

December 31,

2014

  

December 31,

2013

 
$  $  $1,108,024 

8. Mortgage Servicing Rights, at Fair Value

The Company's MSRsservicing rights 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 FHAFederal Housing Administration or partially guaranteed against loss by the VA.

The activityDepartment of MSRs for the years ended December 31, 2015 and December 31, 2014 is as follows:Veterans Affairs.

  Year Ended 
  

December 31,

2015

  

December 31,

2014

 
Balance at beginning of year $33,378,978  $ 
Acquisition of MSRs in connection with purchase of GMFS on October 31, 2014     32,300,337 
Additions due to loans sold, servicing retained  18,958,514   2,763,014 
Change in fair value of MSRs (1)        
Changes in values of market related inputs or assumptions used in a valuation model (2)  29,378   (1,420,925)
Other changes(3)  (4,157,854)  (263,448)
Total - change in fair value of MSRs  (4,128,476)  (1,684,373)
Balance at end of year $48,209,016  $33,378,978 

(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 year.

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

110

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

  December 31, 2015  December 31, 2014 
  Unpaid Principal
Balance
  Fair Value  Unpaid Principal
Balance
  Fair Value 
Fannie Mae $1,880,177,827  $20,751,648  $1,640,799,719  $17,078,181 
Ginnie Mae  1,488,159,758   18,231,527   1,146,234,768   13,102,076 
Freddie Mac  805,589,808   9,225,841   291,939,855   3,198,721 
Total $4,173,927,393  $48,209,016  $3,078,974,342  $33,378,978 

 

The following is a quantitative summarytable presents additional information about the Company’s residential mortgage servicing rights carried at fair value:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As of December 31, 2017

 

As of December 31, 2016

 

 

Unpaid Principal

 

 

 

Unpaid Principal

 

 

(In Thousands)

 

Amount

 

Fair Value

 

Amount

 

Fair Value

Fannie Mae

 

$

2,524,897

 

$

26,929

 

$

2,211,493

 

$

23,924

Ginnie Mae

 

 

2,134,772

 

 

24,135

 

 

1,817,009

 

 

21,205

Freddie Mac

 

 

1,898,786

 

 

21,231

 

 

1,452,902

 

 

16,247

Total

 

$

6,558,455

 

$

72,295

 

$

5,481,404

 

$

61,376

The significant assumptions used in the valuation of the Company’s residential mortgage servicing rights carried at fair include:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

 

December 31, 2016

 

 

    

Range of input
values

 

Weighted
Average

    

Range of input
values

 

Weighted
Average

Residential mortgage servicing rights (at fair value)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

• Forward prepayment rate

 

7.0

-

29.2

%

 

8.8

%

 

6.9

-

11.7

%

 

9.3

%

 

• Discount rate

 

10.5

-

13.0

%

 

10.9

%

 

10.5

-

11.5

%

 

10.8

%

 

• Servicing expense

 

0.7

-

0.8

%

 

0.7

%

 

0.4

-

1.7

%

 

0.5

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The following table reflects the possible impact of 10% and 20% adverse changes to key input assumptions and their related impact on the estimated fair value of the MSRs from adverseCompany’s residential mortgage servicing rights.

 

 

 

 

 

 

 

(In Thousands)

    

December 31, 2017

 

December 31, 2016

Prepayment rate

 

 

 

 

 

 

10% adverse change

 

$

(2,721)

 

$

(2,038)

20% adverse change

 

 

(4,928)

 

 

(3,983)

Discount rate

 

 

 

 

 

 

10% adverse change

 

$

(3,029)

 

$

(2,299)

20% adverse change

 

 

(5,823)

 

 

(4,438)

Cost of servicing

 

 

 

 

 

 

10% adverse change

 

$

(1,230)

 

$

(1,304)

20% adverse change

 

 

(2,460)

 

 

(2,607)

Note 10 – Gains on residential mortgage banking activities, net of variable loan expenses

Gains on residential mortgage banking activities, net of variable loan expenses, reflects revenue and expense within our residential mortgage banking business directly related to loan origination and sale activity. This primarily consists of the realized gains on sales of residential loans held for sale and loan origination fee income, offset by direct costs, such as correspondent fee expenses and other direct expenses relating to these loans, which vary based on loan origination

150


volumes. Gains on residential mortgage banking activities, net of direct, variable loan expenses, also consists of unrealized gains and losses associated with the changes in those assumptions (weighted averages are based upon unpaid principal balance) at December 31, 2015:fair value of the loans held for sale, the fair value of retained MSR additions, and the realized and unrealized gains and losses from derivative instruments.

 

Discount rate:    
Range  6.6%-12.2%
Weighted average  9.4%
     
Effect on fair value of adverse change of:    
5% $(958,786)
10% $(1,881,870)
20% $(3,628,281)
     
Prepayment speed(1) :    
Range  7.0%-12.0%
Weighted average  9.3%
     
Effect on fair value of adverse change of:    
5% $(938,584)
10% $(1,756,195)
20% $(3,428,890)
     
Per-loan annual cost of servicing:    
Range  $64-$119 
Weighted average $92 
     
Effect on fair value of adverse change of:    
5% $(547,228)
10% $(1,094,455)
20% $(2,188,910)

(1)Prepayment speed is measured using CPR.

  Year Ended 
  December 31,
2015
  December 31,
2014
 
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 still held at the reporting date $29,378  $(1,420,925)

The Company contracts with licensed sub-servicers to perform all servicing functions for these loans. The following table presents the loan servicing fee income,components of gains on residential mortgage banking activities, net of direct costs, forvariable loan expenses, recorded in the years ended December 31, 2015 and December 31, 2014:Company’s consolidated statements of operations.

 

  Year Ended 
  

December 31,

2015

  

December 31,

2014

 
Loan servicing fee income $10,641,288  $1,412,583 
Late fee income  64   60 
Sub-servicing costs  (3,548,921)  (482,925)
Loan servicing fee income, net of direct costs $7,092,431  $929,718 

 

 

 

 

 

 

 

 

 

For the Year Ended December 31,

(In Thousands)

    

2017

    

2016

Realized and unrealized gains and losses of residential mortgage loans held for sale, at fair value

 

$

63,024

 

$

2,943

Creation of new mortgage servicing rights, net of payoffs

 

 

14,919

 

 

3,157

Loan origination fee income on residential mortgage loans

 

 

8,193

 

 

1,404

Correspondent fees and other direct loan expenses, including provision for loan indemnification

 

 

(41,737)

 

 

(597)

Unrealized gains (loss) on IRLCs and other derivatives

 

 

(2,699)

 

 

126

Total gains on residential mortgage banking activities, net of variable loan expenses

 

$

41,700

 

$

7,033

 

 

 

 

 

 

Note 11 – Secured Borrowings and Promissory Note

The following tables present certain characteristics of our secured borrowings and promissory note:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Pledged Assets
Carrying Value at

 

Carrying Value
of Borrowing at

(In Thousands)

Maturity

  

Pricing

  

Facility
Size

  

December 31,
2017

  

December 31,
2016

  

December 31,
2017

  

December 31,
2016

Borrowings under credit facilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

JPMorgan - Commercial (1)

June 2018

 

L+ 3.25 to 3.50%

 

$

250,000

 

$

107,697

 

$

226,253

 

$

60,459

 

$

190,066

 Keybank - Commercial (2)

September 2018

 

L + 1.75%

 

 

100,000

 

 

67,589

 

 

17,311

 

 

66,642

 

 

17,162

 Comerica - Residential (3)

March 2018

 

L + 2.125%

 

 

150,000

 

 

71,035

 

 

35,102

 

 

67,336

 

 

33,575

 UBS - Residential loans (3)

November 2017

 

L + 2.30%

 

 

65,000

 

 

 —

 

 

43,121

 

 

 —

 

 

39,750

 Associated Bank - Residential loans (3) 

August 2018

 

L + 2.125%

 

 

40,000

 

 

29,242

 

 

28,575

 

 

27,699

 

 

27,869

 Origin Bank - Residential loans (3)

May 2018

 

L + 2.25%

 

 

40,000

 

 

27,891

 

 

18,910

 

 

26,538

 

 

18,188

Total borrowings under credit facilities (9)

 

 

 

 

$

645,000

 

$

303,454

 

$

369,272

 

$

248,674

 

$

326,610

Borrowings under repurchase agreements

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 Deutsche Bank- Commercial (4)

February 2018

 

L + 2.50 to 3.50%

 

$

275,000

 

$

252,499

 

$

118,962

 

$

173,811

 

$

82,716

 JPMorgan - Commercial (5)

December 2020

 

L + 2.50 to 4.50%

 

 

200,000

 

 

90,829

 

 

93,691

 

 

55,355

 

 

52,169

 Citibank - Commercial (6)

June 2018

 

L + 2.25 to 3.00%

 

 

200,000

 

 

150,707

 

 

119,376

 

 

88,095

 

 

102,576

 JPMorgan - MBS (7)

February 2018

 

2.56 to 5.00%

 

 

53,325

 

 

80,690

 

 

42,253

 

 

53,325

 

 

30,363

 Citibank - MBS (7)

February 2018

 

3.42%

 

 

5,957

 

 

11,496

 

 

11,496

 

 

5,957

 

 

5,226

 Bank of America - MBS (7)

January 2018

 

3.38 to 3.48%

 

 

8,112

 

 

8,778

 

 

11,815

 

 

6,069

 

 

8,112

 Mizuho - STI (8)

N/A

 

N/A

 

 

99,950

 

 

 —

 

 

100,000

 

 

 —

 

 

99,950

 Societe Generale - STI (8)

N/A

 

N/A

 

 

19,940

 

 

 —

 

 

19,994

 

 

 —

 

 

19,940

 RBC - STI (8)

N/A

 

N/A

 

 

199,800

 

 

 —

 

 

199,990

 

 

 —

 

 

199,800

Total borrowings under repurchase agreements (10)

 

 

 

 

$

1,062,084

 

$

594,999

 

$

717,577

 

$

382,612

 

$

600,852

Total secured borrowings

 

 

 

 

$

1,707,084

 

$

898,453

 

$

1,086,849

 

$

631,286

 

$

927,462

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Promissory note payable

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 FCB - Commercial

June 2021

 

2.75%

 

$

6,554

 

$

7,752

 

$

9,144

 

$

6,107

 

$

7,378

Total promissory note payable

 

 

 

 

$

6,554

 

$

7,752

 

$

9,144

 

$

6,107

 

$

7,378

 

111

(1)

Borrowings are used to finance SBC and SBA loan acquisitions, and SBA loan originations.

(2)

Borrowings are used to finance Freddie Mac SBC loan originations.

(3)

Borrowings are used to finance Residential Agency loan originations.

(4)

Borrowings are used to finance SBC loan originations.

(5)

Borrowings are used to finance SBC loan originations, Transitional loan originations, and SBC loan acquisitions.

(6)

Borrowings are used to finance SBC loan originations and SBC loan acquisitions.

(7)

Borrowings are used to finance Mortgage backed securities and Retained interests in consolidated VIE's.

(8)

Borrowings are used to finance Short-term investments.

(9)

The weighted average interest rate of borrowings under credit facilities was 3.9% and 4.2% as of December 31, 2017 and 2016, respectively.

(10)

The weighted average interest rate of borrowings under repurchase agreements was 3.1% and 1.8% as of December 31, 2017 and 2016, respectively.

 

151


The following table presents the carrying value of the Company’s collateral pledged with respect to secured borrowings and promissory note payable outstanding with our lenders:

 

 

 

 

 

 

 

 

Pledged Assets
Carrying Value at

(In Thousands)

 

December 31,
2017

December 31,
2016

Collateral pledged - borrowings under credit facilities

 

 

 

 

 

Loans, net

 

$

303,133

$

369,272

Real estate acquired in settlement of loans

 

 

321

 

 —

Total collateral pledged on borrowings under credit facilities

 

$

303,454

$

369,272

Collateral pledged - borrowings under repurchase agreements

 

 

 

 

 

Short-term investments

 

$

 —

$

319,984

Loans, net

 

 

494,035

 

332,029

Mortgage backed securities

 

 

37,397

 

11,815

Retained interest in assets of consolidated VIEs

 

 

63,567

 

53,749

Total collateral pledged on borrowings under repurchase agreements

 

$

594,999

$

717,577

Total collateral pledged on secured borrowings

 

$

898,453

$

1,086,849

Collateral pledged - promissory note payable

 

 

 

 

 

Loans, net

 

$

7,752

$

9,144

Total collateral pledged on promissory note payable

 

$

7,752

$

9,144

 

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

9. Warehouse Lines of Credit

At December 31, 2015Company’s secured borrowings and December 31, 2014,promissory note require 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 includemaintain certain financial requirements, including maintenance of minimum liquidity, minimum tangible net worth, maximumand 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.covenants. The Company was in compliance with all significant debt and financial covenants atas of December 31, 20152017 and 2016.

Note 12 – Offsetting Assets and Liabilities

In order to better define its contractual rights and to secure rights that will help the Company mitigate its counterparty risk, the Company may enter into an International Swaps and Derivatives Association (“ISDA”) Master Agreement with multiple derivative counterparties. An ISDA Master Agreement, published by ISDA, is a bilateral trading agreement between two parties that allow both parties to enter into over-the-counter (“OTC”), derivative contracts. The ISDA Master Agreement contains a Schedule to the Master Agreement and a Credit Support Annex, which governs the maintenance, reporting, collateral management and default process (netting provisions in the event of a default and/or a termination event). Under an ISDA Master Agreement, the Company may, under certain circumstances, offset with the counterparty certain derivative financial instruments’ payables and/or receivables with collateral held and/or posted and create one single net payment. The provisions of the ISDA Master Agreement typically permit a single net payment in the event of default, including the bankruptcy or insolvency of the counterparty. However, bankruptcy or insolvency laws of a particular jurisdiction may impose restrictions on or prohibitions against the right of offset in bankruptcy, insolvency or other events. In addition, certain ISDA Master Agreements allow counterparties to terminate derivative contracts prior to maturity in the event the Company’s stockholders’ equity declines by a stated percentage or the Company fails to meet the terms of its ISDA Master Agreements, which would cause the Company to accelerate payment of any net liability owed to the counterparty.  As of December 31, 20142017 and 2016 and for the yearsperiods then ended, the Company was in good standing on all of its ISDA Master Agreements or similar arrangements with its counterparties.

For derivatives traded under an ISDA Master Agreement, the collateral requirements are listed under the Credit Support Annex, which is the sum of the mark to market for each derivative contract, the independent amount due to the derivative counterparty and any thresholds, if any. Collateral may be in the form of cash or any eligible securities, as defined in the respective ISDA agreements. Cash collateral pledged to and by the Company with the counterparty, if any, is reported separately on the consolidated balance sheets as restricted cash. All margin call amounts must be made before the notification time and must exceed a minimum transfer amount threshold before a transfer is required. All margin calls must be responded to and completed by the close of business on the same day of the margin call, unless otherwise specified. Any margin calls after the notification time must be completed by the next business day. Typically, the Company and its counterparties are not permitted to sell, rehypothecate or use the collateral posted. To the extent amounts due to the Company from its counterparties are not fully collateralized, the Company bears exposure and the risk of loss from a defaulting counterparty. The Company attempts to mitigate counterparty risk by establishing ISDA agreements with only high grade counterparties that have the financial health to honor their obligations and diversification, entering into agreements with multiple counterparties.

In accordance with ASU 2013-01, Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities, the Company is required to disclose the impact of offsetting of assets and liabilities represented in

152


the consolidated balance sheets to enable users of the consolidated financial statements to evaluate the effect or potential effect of netting arrangements on its financial position for recognized assets and liabilities.  These recognized assets and liabilities are financial instruments and derivative instruments that are either subject to enforceable master netting arrangements or ISDA Master Agreements or meet the following right of setoff criteria: (a) the amounts owed by the Company to another party are determinable, (b) the Company has the right to set off the amounts owed with the amounts owed by the counterparty, (c) the Company intends to set off, and (d) the Company’s right of setoff is enforceable at law.  As of December 31, 20152017 and 2016, the Company has elected to offset assets and liabilities associated with its OTC derivative contracts in the consolidated balances sheets.

The following table provides disclosure regarding the effect of offsetting of the Company’s recognized assets and liabilities presented in the consolidated balance sheet as of December 31, 2014.The2017:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross

 

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amounts

 

Presented in

 

 Gross Amounts Not Offset in the Consolidated 

 

 

Gross 

 

Offset in the

 

the

 

Balance Sheets (1)

 

 

Amounts of

 

Consolidated

 

 Consolidated

 

 

 

 

Cash 

 

 

 

 

 

Recognized

 

 Balance

 

Balance 

 

Financial 

 

Collateral 

 

 

 

(In Thousands)

    

Assets

    

 Sheets

    

Sheets

    

Instruments

    

Received

    

Net Amount

Interest rate swaps

 

$

2,898

 

$

 —

 

$

2,898

 

$

 —

 

$

2,898

 

$

 —

Total

 

$

2,898

 

$

 —

 

$

2,898

 

$

 —

 

$

2,898

 

$

 —

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross

 

Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amounts

 

Presented in

 

 Gross Amounts Not Offset in the Consolidated

 

 

Gross 

 

Offset in the

 

the

 

 Balance Sheets (1)

 

 

Amounts of 

 

Consolidated

 

Consolidated

 

 

 

 

Cash 

 

 

 

 

 

Recognized

 

Balance

 

Balance 

 

Financial 

 

Collateral 

 

 

 

(In Thousands)

    

Liabilities

    

 Sheets

    

Sheets

    

Instruments

    

Paid

    

Net Amount

Interest rate swaps

 

$

216

 

$

 —

 

$

216

 

$

 —

 

$

216

 

$

 —

Credit default swaps

 

 

66

 

 

 —

 

 

66

 

 

 —

 

 

66

 

 

 —

Secured borrowings

 

 

631,286

 

 

 —

 

 

631,286

 

 

631,286

 

 

 —

 

 

 —

Promissory note, net

 

 

6,107

 

 

 —

 

 

6,107

 

 

6,107

 

 

 —

 

 

 —

Total

 

$

637,675

 

$

 —

 

$

637,675

 

$

637,393

 

$

282

 

$

 —

The following table provides disclosure regarding the effect of offsetting of the Company’s recognized assets and liabilities presented in the consolidated balance sheet as of December 31, 2016:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross 

 

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amounts 

 

Presented in

 

 Gross Amounts Not Offset in the Consolidated 

 

 

Gross 

 

Offset in the

 

the

 

 Balance Sheets (1)

 

 

Amounts of

 

Consolidated

 

Consolidated

 

 

 

 

Cash

 

 

 

 

 

Recognized 

 

Balance 

 

Balance 

 

Financial

 

Collateral 

 

 

 

(In Thousands)

    

Assets

    

Sheets

    

Sheets

    

Instruments

    

Received

    

 Net Amount

Credit default swaps

 

$

173

 

$

 —

 

$

173

 

$

 —

 

$

 —

 

$

173

Interest rate swaps

 

 

2,924

 

 

 2

 

 

2,922

 

 

 —

 

 

 —

 

 

2,922

Total

 

$

3,097

 

$

 2

 

$

3,095

 

$

 —

 

$

 —

 

$

3,095

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross

 

Presented in

 

 Gross Amounts Not Offset in the Consolidated 

 

 

Gross

 

Amounts

 

the 

 

Balance Sheets  (1)

 

 

Amounts of

 

Offset in the

 

Consolidated

 

 

 

 

Cash

 

 

 

 

 

Recognized

 

Consolidated

 

Balance 

 

Financial

 

Collateral

 

 

 

(In Thousands)

    

Liabilities

    

Balance Sheets

    

Sheets

    

Instruments

    

Paid

    

 Net Amount

Interest rate swaps

 

$

643

 

$

 —

 

$

643

 

$

 —

 

$

643

 

$

 —

Secured borrowings

 

 

927,462

 

 

 

 

927,462

 

 

925,602

 

 

1,860

 

 

Promissory note, net

 

 

7,378

 

 

 —

 

 

7,378

 

 

7,378

 

 

 —

 

 

Total

 

$

935,483

 

$

 —

 

$

935,483

 

$

932,980

 

$

2,503

 

$

 —

Note 13 – Derivative Instruments

The Company didis exposed to changing interest rates and market conditions, which affect cash flows associated with borrowings. The Company uses derivative instruments to manage interest rate risk and conditions in the commercial mortgage market and, as such, views them as economic hedges. Interest rate swaps are used to mitigate the exposure to changes in interest rates and involve the receipt of variable-rate interest amounts from a counterparty in exchange for

153


making payments based on a fixed interest rate over the life of the swap contract. CDS are executed in order to mitigate the risk of deterioration in the current credit health of the commercial mortgage market. IRLCs are entered into with customers who have applied for residential mortgage loans and meet certain underwriting criteria. These commitments expose GMFS to market risk if interest rates change, and if the loan is not have any warehouse lineseconomically hedged or committed to an investor.

The Company has not elected hedge accounting for these derivative instruments and, as a result, the fair value adjustments on such instruments are recorded in earnings. The fair value adjustments for interest rate swaps and CDS, along with the related interest income, interest expense and gains/(losses) on termination of credit prior tosuch instruments, are reported as a net realized gain on financial instruments on the acquisitionconsolidated statements of GMFSincome. The fair value adjustments for IRLCs, along with the related interest income, interest expense and gains/(losses) on October 31, 2014.termination of such instruments, are reported in gains on residential mortgage banking activities, net of variable loan expenses on the consolidated statements of income.

 

The following tables present certain information regardingsummarize the Company's warehouse linesCompany’s use of creditderivatives and repurchase agreementstheir effect on the consolidated financial statements. Notional amounts included in its residential mortgage banking segment atthe table are the average notional amounts on the consolidated balance sheet dates. We believe these are the most relevant measure of volume or derivative activity as they best represent the Company’s exposure to underlying instruments.

As of December 31, 2015 and December 31, 2014:

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

  December 31, 2015  December 31, 2014 
Maturity Dates Balance  Weighted
Average Rate
  Balance  Weighted
Average Rate
 
30 days or less $   % $21,210,431   2.47%
181 days to 1 year  100,768,428   2.72   57,118,533   2.46 
Greater than 1 year        11,088,600   2.92 
Total balance and weighted average rate $100,768,428   2.72% $89,417,564   2.52%

Collateral

  December 31, 2015  December 31, 2014 
Mortgage loans held for sale pledged as collateral to secure the warehouse lines of credit and repurchase agreements related to the GMFS mortgage banking platform $115,942,230  $97,690,960 

These obligations are also fully guaranteed by the Company.

10. Loan Repurchase Facilities

At December 31, 2015 and December 31, 2014,2017 the Company had one open credit default swap contract and 52 open interest rate swap contracts with counterparties. As of December 31, 2016 the following outstanding master repurchase agreementsCompany had one open credit default swap contract and 49 open interest rate swap contracts 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:counterparties.

 

  December 31, 2015  December 31, 2014 
  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  $100,000,000 
Maturity date  May 20, 2016   June 27, 2016   May 22, 2015   August 13, 2015 
Outstanding balance $279,467,573  $17,321,757  $299,402,024  $690,269 

112

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As of December 31, 2017

 

As of December 31, 2016

 

    

 

    

 

 

    

Asset

    

Liability

 

 

 

    

Asset 

    

Liability 

 

 

 

 

Notional 

 

Derivatives

 

Derivatives

 

Notional 

 

Derivatives

 

Derivatives

(In Thousands)

 

Primary Underlying Risk

 

Amount

 

Fair Value

 

Fair Value

 

Amount

 

Fair Value

 

Fair Value

Credit Default Swaps

 

Credit Risk

 

$

15,000

 

$

 —

 

$

(66)

 

$

15,000

 

$

173

 

$

 –

Interest Rate Swaps

 

Interest rate risk

 

 

391,381

 

 

2,898

 

 

(216)

 

 

378,050

 

 

2,922

 

 

(643)

Interest rate lock commitments

 

Interest rate risk

 

 

167,533

 

 

1,827

 

 

 —

 

 

212,530

 

 

2,690

 

 

 —

Total

 

 

 

$

573,914

 

$

4,725

 

$

(282)

 

$

605,580

 

$

5,785

 

$

(643)

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

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

The Company pledges cash and certain of its Trust Certificates as collateral under the Loan Repurchase Facilities. The amounts available to be borrowed are dependent upon the fair value of the Trust Certificates pledged as collateral, which fluctuates with changes in interest rates, type of underlying mortgage loans and liquidity conditions within the banking, mortgage finance and real estate industries. In response to declines in the fair value of pledged Trust Certificates, the lenders may require the Company to post additional collateral or pay down borrowings to re-establish agreed upon collateral requirements, referred to as margin calls. During the years ended December 31, 2015, December 31, 2014 and December 31, 2013 and at December 31, 2015 and December 31, 2014, the Company has met all margin call requirements related to any outstanding balances under its Loan Repurchase Facilities.

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

 

The following tables present certain information regardingsummarize the Company's Loan Repurchase Facilities at December 31, 2015gains and December 31, 2014:losses on the Company’s derivatives:

 

  December 31, 2015  December 31, 2014 
  Balance  Weighted 
Average Rate
  Balance  Weighted 
Average Rate
 
Loan Repurchase Facilities borrowings maturing within              
91-180 days $296,789,330   3.14% $299,402,024   2.92%
181 days to 1 year        690,269   2.46%
Total balance and weighted average rate $296,789,330   3.14% $300,092,293   2.92%

  December 31,
2015
  December 31,
2014
 
Fair value of Trust Certificates pledged as collateral $394,942,512  $415,814,067 
Fair value of mortgage loans not pledged as collateral  2,735,628   145,771 
Cash pledged as collateral  375,579    
Unused Amount (1)  128,210,670   124,907,707 

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

  Year Ended 
  December 31,
2015
  December 31,
2014
 
Weighted average interest rate (1)  3.16%  3.11%
Average unpaid principal balance of loans sold under agreements to repurchase $688,271  $193,332 
Maximum daily amount outstanding $302,037,635  $310,575,669 

(1)Includes commitment fees.

113

 

 

 

 

 

 

 

 

 

Year Ended December 31, 2017

 

 

 

 

    

Net Change in 

 

 

              Net Realized 

 

Unrealized 

(In Thousands)

 

                  (Loss)

 

Gain (Loss)

Credit default swaps (1)

 

$

 —

 

$

(238)

Interest rate swaps (1)

 

 

(1,256)

 

 

2,238

Residential mortgage banking activities interest rate swaps (2)

 

 

 —

 

 

(1,836)

Interest rate lock commitments (2)

 

 

 —

 

 

(863)

Total

 

$

(1,256)

 

$

(699)

(1) Gains (losses) are recorded in net unrealized gain (loss) on financial instruments or net realized gain (loss) on financial instruments in the consolidated statements of income.
(2) Gains (losses) are recorded in gains on residential mortgage banking activities, net of variable loan expenses, in the consolidated statements of income.

 

11. Securities Repurchase AgreementsNote 14 – Senior secured notes, net and Convertible notes, net

 

Securities repurchase agreements related to real estate securitiesSenior secured notes, net

On February 13, 2017, ReadyCap Holdings LLC, a subsidiary of the Company, issued $75.0 million in 7.50% Senior Secured Notes due 2022. On June 13, 2017, ReadyCap Holdings LLC, issued an additional $65.0 million in aggregate principal amount of 7.50% Senior Secured Notes due 2022, which have identical terms (other than issue date 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 equalissue price) to the fair valuenotes issued on February 13, 2017 (collectively “the Senior Secured Notes”). The additional $65.0 million in Senior Secured Notes were priced with a yield-to-maturity of 6.75%.Payments of the assets pledged less an agreed-upon discount, referred to as a "haircut." Repurchase agreements related to real estate securitiesamounts due on the Senior Secured

154


Notes are fully and Other Investment Securities entered intounconditionally guaranteed 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 30its subsidiaries: Sutherland Partners LP, Sutherland Asset I, LLC, and RCC. The funds were used to 90 days. The Company maintains the beneficial interest in the specific securities pledged during the term of the repurchase arrangementfund new SBC 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.SBA loan originations.

 

The Company has master repurchase agreements with four financial institutions atAs of December 31, 2015 and December 31, 2014.

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

  December 31, 2015 
  Non-Agency RMBS  Other Investment Securities 
  Balance  Weighted
Average Rate
  Balance  Weighted
Average Rate
 
Securities repurchase agreements maturing within                
30 days or less $71,910,849   1.80% $1,389,310   2.17%
Total balance/weighted average rate $71,910,849   1.80% $1,389,310   2.17%

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

Although securities repurchase agreements are committed borrowings until maturity, the lender retains the right to mark the underlying collateral to fair value. A reduction2017, we were 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 fluctuatescompliance with changes in interest rates, type of securities and liquidity conditions within the banking, mortgage finance and real estate industries. In response to declines in the fair value of pledged RMBS and Other Investment Securities, the lenders may require the Company to post additional collateral or pay down borrowings to re-establish agreed upon collateral requirements, referred to as margin calls. During the years ended December 31, 2015, December 31, 2014 and December 31, 2013 and at December 31, 2015 and December 31, 2014, the Company has met all margin call requirements under its securities repurchase agreements.

114

The following table presents informationcovenants with respect to the Company's posting of collateral under its securities repurchase agreements at December 31, 2015 and December 31, 2014:Senior Secured Notes.

 

  December 31,
2015
  December 31,
2014
 
Fair value of non-Agency RMBS pledged as collateral $95,627,850  $135,779,193 
Fair value of Other Investment Securities pledged as collateral  1,989,174   2,040,532 
Fair value of non-Agency RMBS not pledged as collateral  13,711,431   12,806,540 
Fair value of Other Investment Securities not pledged as collateral  10,815,022    
Cash pledged as collateral  2,029,581   684,256 

12. 8.0% Exchangeable Senior Notes due 2016Convertible notes, net

 

On November 25, 2013,August 9, 2017, the Operating Partnership issued the Exchangeable Senior Notes with a stated rateCompany closed an underwritten public sale of 8.0% and an$115.0 million aggregate principal amount of $57.5 million (the "Exchangeable Senior Notes"its 7.00% convertible senior notes due 2023 (“Convertible Notes”). The Exchangeable SeniorConvertible Notes were issued pursuantwill mature on August 15, 2023, unless earlier repurchased, redeemed or converted. During certain periods and subject to an Indenture, dated November 25, 2013, betweencertain conditions, 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 anynotes will be convertible by holders into shares of the Company's secured indebtedness (including existing unsecured indebtedness that the Company later secures) to the extentcommon stock at an initial conversion rate of 1.4997 shares of common stock per $25 principal amount of the valuenotes, which is equivalent to an initial conversion price of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness (including trade payables) incurred byapproximately $16.67 per share of common stock. Upon conversion, holders will receive, at the Company's subsidiaries, financing vehicles or similar facilities.

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

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

 

The exchange rate was initially 52.5417 sharesCompany may redeem all or any portion of common stock per $1,000the Convertible Notes, at its option, on or after August 15, 2021, at a redemption price payable in cash equal to 100% of the principal amount of Exchangeable Seniorthe Convertible 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 anyredeemed, plus accrued and unpaid interest. In addition, ifAdditionally, upon the occurrence of 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.

115

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," thetransactions, holders of the Exchangeable Senior Notes may require the Company to repurchasepurchase the Convertible Notes for cash all or part of their Exchangeable Senior Notes at a repurchasepurchase price equal to 100% of the principal amount of the Exchangeable SeniorConvertible Notes to be repurchased,purchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date. The Company is currently evaluating alternatives to settle the obligation at maturity in light of the pending strategic review.interest.

 

The Exchangeable SeniorConvertible Notes bear interest at a ratewill be convertible only upon satisfaction 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 rateone or more of the Exchangeable Senior Notes, whichfollowing conditions: (1) the closing market price of the Company’s common stock is greater than or equal to the stated rate of 8.0% plus the amortization120% of the original issue discountconversion price of the respective Convertible Notes for at least 20 out of 30 days prior to the end of the preceding fiscal quarter, (2) the trading price of the Convertible Notes is less than 98% of the product of (i) the conversion rate and associated costs, is 10.2%.(ii) the closing price of the Company’s common stock during any five consecutive trading day period, (3) the Company issues certain equity instruments at less than the 10-day average closing market price of its common stock or the per-share value of certain distributions exceeds the market price of the Company’s common stock by more than 10%, or (4) certain other specified corporate events (significant consolidation, sale, merger share exchange, etc.) occur.

 

The following table presents informationAt issuance, we allocated $112.7 million and $2.3 million of the carrying value of the Convertible Notes to its debt and equity components, respectively, before the allocation of deferred financing costs.

As of December 31, 2017, we were in compliance with all covenants with respect to the Exchangeable Senior Notes at December 31, 2015 and December 31, 2014:

  December 31,
2015
  December 31,
2014
 
Fair value of conversion option derivative liability $612,878  $1,022,248 
Unamortized discount  990,954   2,025,259 

13. Derivative Instruments

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

Residential Mortgage Investments Segment

Interest Rate Swap and Swaption Agreements

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

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

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.

TBA Securities

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

 The Company had no exposure to TBA contracts for this segment at any time during the years ended December 31, 2015 and December 31, 2014. During the year ended December 31, 2013, the Company paired off purchases of TBA securities with a combined notional amount of $643.0 million by entering into simultaneous sales of TBA securities and realized losses of $4.2 million and recognized a change in unrealized gains or losses of $0.5 million as a result. At December 31, 2015 and December 31, 2014 the Company did not have any TBA contracts outstanding relating to this segment.

116

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.

The Company did not have any IRLCs, MBS Forward Sales Contracts or TBA Securities related to the residential mortgage banking segment prior to the acquisition of GMFS on October 31, 2014.

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 December 31, 2015 and December 31, 2014:

Non-hedge derivatives December 31, 2015  December 31, 2014 
Notional amount of interest rate swaption $  $225,000,000 
Notional amount of interest rate swaps  17,200,000   17,200,000 
LPCs (Principal balance of underlying loans)  18,494,332   1,905,700 
IRLCs (Principal balance of underlying loans)  190,933,017   118,486,590 
Notional amount of MBS forward sales contracts  179,417,280   154,000,000 

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

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

Derivative instruments

 Designation Balance Sheet Location December 31,
2015
  December 31,
2014
 
Interest rate swaps Non-hedge Derivative liabilities, at fair value $(1,009,014) $(860,553)
             
Interest rate swaption Non-hedge Derivative assets, at fair value      
             
LPCs Non-hedge Derivative (liabilities) assets, at fair value  (9,871)  4,037 
             
IRLCs Non-hedge Derivative assets, at fair value  2,376,187   2,481,063 
             
MBS forward sales contracts Non-hedge Derivative liabilities, at fair value  (200,204)  (702,383)
             
Conversion Option - Exchangeable Senior Notes Non-hedge Derivative liabilities, at fair value  (612,878)  (1,022,248)

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

117

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

    Year Ended 
Non-hedge derivatives Income Statement 
Location
 

December 31,

2015

  

December 31,

2014

 

December 31,

2013

 
Interest rate swaps Gain/(loss) on derivative instruments related to investment portfolio $(567,321) $(1,571,371) $10,548,012 
               
Interest rate swaption Gain/(loss) on derivative instruments related to investment portfolio     (4,803,750)   
               
LPCs Gain/(loss) on derivative instruments related to investment portfolio  (13,908)  4,037    
               
IRLCs Mortgage banking activities, net  (104,876)  (221,891)   
               
MBS forward sales contracts Mortgage banking activities, net  502,179   410,411    
               
Conversion Option - Exchangeable Senior Notes Gain/(loss) on derivative instruments related to investment portfolio  409,370   449,359   (147,201)
               
TBAs Gain/(loss) on derivative instruments related to investment portfolio        (4,785,996)

Interest Rate Swaption

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

Swaption Expiration Notional Amount  Strike Rate  Swap Maturity  Cash Pledged as
Collateral(1)
 
January 15, 2015 $225,000,000   3.64%  2025  $4,886,011 

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

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

Interest Rate Swaps

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

  December 31,
2015
  December 31,
2014
 
Maturity  2023   2023 
Notional Amount $17,200,000  $17,200,000 
Weighted Average Pay Rate  2.72%  2.72%
Weighted Average Receive Rate  0.33%  0.23%
Weighted Average Years to Maturity  7.6   8.6 
Cash Pledged as Collateral(1) $1,966,565  $1,572,811 

118

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

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

14. Mortgage Banking ActivitiesConvertible Notes.

 

The following table presents the components of mortgage banking activities, net, recorded in the Company's consolidated statements of operationsSenior Secured Notes and Convertible Notes, including the carrying value for the years ended December 31, 2015 and December 31, 2014:aggregate contractual maturities, on the consolidated balance sheet:

  


December 31, 

2015

  


December 31, 

2014

 
Gain on sale of mortgage loans held for sale, net of direct costs(1) $44,847,548  $5,344,361 
Loan expenses, including provision for loan indemnification  (762,239)  (118,895)
Loan origination fee income  1,772,153   213,540 
Total $45,857,462  $5,439,006 

 

 

 

 

 

 

 

 

 

(in thousands, except rates)

  

Coupon Rate

 

Maturity Date

  

December 31, 2017

2017 Senior secured notes principal amount(1)

 

7.50

%

 

2/15/2022

 

$

140,000

Unamortized premium - Senior secured notes

 

 

 

 

 

 

 

1,735

Unamortized deferred financing costs - Senior secured notes

 

 

 

 

 

 

 

(3,657)

Total Senior secured notes, net

 

 

 

 

 

 

$

138,078

2017 Convertible notes- principal amount (2)

 

7.00

%

 

8/15/2023

 

 

115,000

Unamortized discount - Convertible notes (3)

 

 

 

 

 

 

 

(2,139)

Unamortized deferred financing costs - Convertible notes

 

 

 

 

 

 

 

(3,870)

Total Convertible notes, net

 

 

 

 

 

 

$

108,991

Total carrying amount of debt components

 

 

 

 

 

 

$

247,069

Total carrying amount of conversion option of equity components recorded in equity

 

 

 

 

 

 

$

2,139

(1)

Interest on the Senior Secured Notes is payable semiannually on each February 15 and August 15, beginning on August 15, 2017.

(2)

Interest on the Convertible Notes is payable quarterly on February 15, May 15, August 15, and November 15 of each year, beginning on November 15, 2017.

(3)

Represents the discount created by separating the conversion option from the debt host instrument. 

 

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

15. Loan Indemnification ReserveNote 15 – Guaranteed loan financing

 

A liability has been established for potential losses related to representations and warranties made by GMFS for loans sold withParticipations or other partial loan sales which do not meet the definition of a corresponding provision recorded for loan indemnification losses. The liability is included in accounts payable and other liabilities inparticipating interest remain as an investment on the Company's consolidated balance sheets and the provision forportion sold is recorded as guaranteed loan indemnification losses is included in mortgage banking activities, netfinancing in the Company'sliabilities section of the consolidated balance sheets. For these partial loan sales, the interest earned on the entire loan balance is

155


recorded as interest income and the interest earned by the buyer in the partial loan sale is recorded within interest expense in the accompanying 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.income.

 

The activity forfollowing table presents guaranteed loan financing and the loan indemnification reserve for the years ended December 31, 2015related interest rates and December 31, 2014 is as follows:maturity dates:

 

  Year Ended 
  

December 31,

2015

  

December 31,

2014

 
Balance at the beginning of year $2,662,162  $ 
Balance at the date of acquisition     2,560,907 
Loan indemnification losses incurred  (198,834)   
Provision for loan indemnification losses  737,672   101,255 
Total $3,201,000  $2,662,162 

 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 December 31, 2015 and December 31, 2014, the reasonably possible loss above the recorded loan indemnification reserve was not considered material.

16. Income Taxes

For the years ended December 31, 2015, December 31, 2014, and December 31, 2013 and at December 31, 2015 and December 31, 2014, the Company qualified to be taxed as a REIT under the Code for U.S. federal income tax purposes. As long as the Company qualifies as a REIT, the Company generally will not be subject to U.S. federal income taxes on its taxable income to the extent it annually distributes its net taxable income to stockholders and does not engage in prohibited transactions. The majority of states also recognize the Company's REIT status.

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

119

 

 

 

 

 

 

 

 

 

 

 

    

Weighted 

    

Range of 

    

 

    

 

 

 

 

Average 

 

Interest 

 

Range of 

 

 

 

(In Thousands)

 

Interest Rate

 

Rates

 

Maturities (Years)

 

 Ending Balance

December 31, 2017

 

3.51

%  

1.62 – 7.00 %

 

2018 - 2038

 

$

293,045

December 31, 2016

 

2.79

%  

3.50 – 8.75 %

 

2017 - 2038

 

$

390,555

 

The following table summarizes the tax provision (benefit) recorded at the TRS entity level for the years ended December 31, 2015, December 31, 2014 and December 31, 2013:

Provision for Income Taxes

  Year Ended 
  

December 31,

2015

  

December 31,

2014

  

December 31,

2013

 
Current tax expense (benefit)            
Federal $  $  $ 
State         
Total current tax (benefit) expense         
             
Deferred tax expense (benefit)            
Federal  3,547,809   (677,780)   
State  867,665   (173,216)   
Total deferred tax expense (benefit) $4,415,474  $(850,996)   
Total expense (benefit) for income taxes $4,415,474  $(850,996) $ 

The following is a reconciliationcontractual maturities of the statutory federal and state rate to the effective rate for the years ended December 31, 2015, December 31, 2014 and December 31, 2013:

Reconciliation of Statutory Tax Rate to Effective Tax Rate

  Year Ended 
  

December 31,

2015

  

December 31,

2014

  

December 31,

2013

 
Tax expense/(benefit) at statutory rate  34.00%  35.00%  35.00%
State and local taxes, net of Federal Benefit  13.61%  (0.82)%  0.00%
Impact of REIT election(1)  58.88%  (39.46)%  (35.00)%
Change in valuation allowance(2)  37.11%  2.31%  0.00%
Other non-deductible/non-taxable items(3)  2.42%  0.03%  0.00%
Adjustment of tax rate used to value deferred taxes(4)  1.35%  0.00%  0.00%
Effective Tax Rate  147.37%  (2.94)%  0.00%

(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 years ended December 31, 2015 and December 31, 2014, 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, LLC and ZFC Funding, Inc.

(3)For the years ended December 31, 2015 and December 31, 2014, the amount primarily relates to non-deductible meals and entertainment expenses.

(4)For the year ended December 31, 2015, the amount primarily relates to the change in U.S. Federal statutory income tax rate used to value deferred tax assets and liabilities from 35% to 34%.

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

 

120

 

 

 

 

(In Thousands)

    

December 31, 2017

2018

 

$

1,990

2019

 

 

2,713

2020

 

 

3,251

2021

 

 

4,767

2022

 

 

4,810

Thereafter

 

 

275,514

Total

 

$

293,045

 

For the year ended December 31, 2015, the Company had activity in the ZFC Honeybee TRS, LLC which resulted in gross deferred tax assetsOur guaranteed loan financings are secured by loans, net of $3.9$296.9 million and gross deferred tax liabilities of $7.5$396.9 million and net deferred tax liability of $3.6 million. Based on ZFC Honeybee TRS, LLC’s earnings forecast and the availability of deferred tax liabilities, the Company feels that it is more likely than not that the Company will be able to utilize these deferred tax assets . The Company also had activity in ZFC Trust TRS I, LLC and ZFC Funding, Inc., which resulted in deferred tax assets of $1.8 million. Asas of December 31, 2015, the Company has established a full valuation allowance for deferred tax assets related to net operating loss2017 and other future deductible amounts of ZFC Trust TRS I, LLC and ZFC Funding, Inc., as these entities do not have a history of earnings and are currently in a cumulative taxable loss position since inception. At December 31, 2014, the Company had activity in the TRS entities, which resulted in a deferred tax asset of $0.8 million after establishing a partial valuation allowance related to net operating losses and other future deductible amounts for tax purposes. The Company is allowed to carryforward its net operating losses for 20 years under U.S. Federal Income tax law and between 12 and 20 years in the majority of states which it operates in. The Company's net operating losses will expire between the years 2026-2035.2016, respectively.

 

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

  December 31, 2015  December 31, 2014 
Deferred tax assets:        
Tax effect of unrealized losses and other temporary differences $519,503  $1,207,520 
Accrued compensation  333,946    
Loan loss reserves  249,745    
Goodwill and intangible assets  634,491    
Capital loss carryforward  364,803    
Net operating loss carryforward  3,586,676   673,052 
Total deferred tax assets  5,689,164   1,880,572 
Valuation allowance  (1,762,628)  (671,913)
Total deferred tax assets less valuation allowance  3,926,536   1,208,659 
         
Deferred tax liabilities:        
MSRs  (7,187,289)    
Tax effect of unrealized gains and other temporary differences  (303,725)  (357,663)
Total deferred tax liabilities  (7,491,014)  (357,663)
Total Deferred Tax (Liability) Asset, net of Valuation Allowance $(3,564,478) $850,996 

The Company evaluates uncertain income tax positions each period. Based upon its analysis of income tax positions, the Company concluded that there are no significant uncertain tax positions that meet the recognition or measurement criteria at either December 31, 2015 or December 31, 2014. Additionally, there were no amounts accrued for penalties or interest as of or during the periods presented in the Company's consolidated financial statements.Note 16 – Related Party Transactions

 

17. Other Assets and Liabilities

Servicing Advances

Servicing advances represent escrows and other advances on behalf of borrowers and investors to cover delinquent balances for property taxes, insurance premiums and other out-of-pocket costs. Advances are made in accordance with the Company's servicing agreements and are recoverable upon liquidation. At December 31, 2015 and December 31, 2014, the Company had servicing advances of $3,546,186 and $1,987,073, respectively. Such amounts are included in other assets in the Company's consolidated balance sheets.

Loans Eligible for Repurchase from Ginnie MaeManagement Agreement

 

The Company has recorded an asset and liability in its consolidated balance sheets representingentered into a management agreement with the unilateral right it hasManager (the “Management Agreement”), which describes the services to repurchase Ginnie Mae pool loans it has previously sold (generally loans that are more than 90 days past due).

There were no actual repurchases of Ginnie Mae delinquent or defaulted mortgage loans during the year ended December 31, 2015 and for the period from November 1, 2014be provided to December 31, 2014. The Company did not have any loans eligible for repurchase from Ginnie Mae prior to the acquisition of GMFS on October 31, 2014.

121

Escrow and Fiduciary Funds

Escrow and fiduciary funds are $24,985,730 and $25,619,979 at December 31, 2015 and December 31, 2014, respectively, and are excluded from the Company's consolidated balance sheets.

Real Estate Owned

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

Accounts Payable and Other Liabilities

At December 31, 2015 and December 31, 2014, the Company’s accounts payable and accrued expenses consisted of the following:

  

December 31,

2015

  

December 31,

2014

 
Accrued compensation and benefits $5,692,244  $1,466,899 
Accounts payable and accrued expenses  4,714,192   5,220,346 
Loan indemnification reserve  3,201,000   2,662,162 
Deferred tax liability  3,564,478    
Accrued interest expense  985,310   856,834 
Other liabilities  415,389   1,524,848 
Total $18,572,613  $11,731,089 

18. Earnings Per Share

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

  Year Ended 
  

December 31,

2015

  

December 31,

2014

  

December 31,

2013

 
Numerator:            
Net (loss) income attributable to ZAIS Financial Corp. common stockholders (Basic) $(1,260,709) $26,741,970  $6,657,728 
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  (158,568)  3,109,760   880,358 
Exchangeable Senior Notes:            
Interest expense     3,240,561    
Gain on conversion option derivative liability     (256,068)   
Total – Exchangeable Senior Notes     2,984,493    
Net (loss) income available to stockholders, after effect of dilutive securities $(1,419,277) $32,836,223  $7,538,086 
Denominator:            
Weighted average number of shares of common stock  7,970,886   7,970,886   7,273,366 
Effect of dilutive securities:            
Weighted average number of OP Units  926,914   926,914   926,914 
Weighted average number of shares convertible under Exchangeable Senior Notes     1,779,560    
Diluted weighted average shares outstanding  8,897,800   10,677,360   8,200,280 
Net (loss) income per share applicable to ZAIS Financial Corp. common stockholders – Basic $(.16) $3.35  $0.92 
Net (loss) income per share applicable to ZAIS Financial Corp. common stockholders – Diluted $(.16) $3.08  $0.92 

122

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

19. Related Party Transactions

ZAIS REIT Management, LLC

The Company is externally managed and advisedus by the Advisor, a subsidiary of ZAIS. Subject to certain restrictionsManager and limitations, the Advisorcompensation for such services. The Manager is responsible for managing the Company's affairs on aCompany’s day-to-day basis including, among other responsibilities, (i)operations, subject to the origination, selection, purchasedirection and saleoversight of the Company's portfolioCompany’s board of assets, (ii) arranging the Company's financing activities and (iii) providing the Company with advisory services.directors.

 

The Company paysManagement Fee

Pursuant to its Advisor an advisorythe terms of the Management Agreement, our Manager is paid a management fee calculated and payable quarterly in arrears equal to 1.5% per annum of the Company's stockholders'Company’s stockholders’ equity as(as defined in the amendedManagement Agreement) up to $500 million and restated investment advisory agreement between1.00% per annum of stockholders’ equity in excess of $500 million.

The following table presents certain information on the Company and the Advisor, as amended from timemanagement fee payable to time (the "Investment Advisory Agreement"). Priorour Manager:

 

 

 

 

 

 

 

 

 

For the Year Ended December 31, 

 

 

2017

 

2016

Management fee - total

 

$

8.1 million

 

$

7.4 million

Management fee - amount unpaid

 

$

2.0 million

 

$

3.7 million

Incentive Distribution

The Manager is entitled to an incentive distribution in an amount equal to the Company's IPO,product of (i) 15% and (ii) the advisory fee paidexcess of (a) core earnings (as defined in the partnership agreement or our operating partnership) on a rolling four-quarter basis over (b) an amount equal to 8.00% per annum multiplied by the weighted average of the issue price per share of the common stock or OP units multiplied by the weighted average number of shares of common stock outstanding, provided that core earnings over the prior twelve calendar quarters (or the period since the closing of the ZAIS Financial merger, whichever is shorter) is greater than zero. For purposes of determining the incentive distribution payable to our Manager, core earnings is defined under the partnership agreement of our operating partnership in a manner that is similar to the Advisor was calculated baseddefinition of Core Earnings described above under Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Non-GAAP Financial Measures” included in this annual report on Form 10-K but with the following additional adjustments which (i) further exclude: (a) the incentive distribution, (b) non-cash equity compensation

156


expense, if any, (c) unrealized gains or losses on SBC loans (not just MBS and MSRs), (d) depreciation and amortization (to the extent we foreclose on any property), and (e) one-time events pursuant to changes in U.S. GAAP and certain other non-cash charges after discussions between our Manager and our independent directors and after approval by a majority of the independent directors and (ii) add back any realized gains or losses on the Company's net asset value, as set forth insales of MBS and on discontinued operations which were excluded from the Investment Advisory Agreement. definition of Core Earnings described under "Non-GAAP Financial Measures". There was no incentive fee distribution for the years ended December 31, 2017 or 2016.

The Advisorinitial term of the Management Agreement extends for three years from the closing of the ZAIS Financial merger and is automatically renewed for one-year terms on each anniversary thereafter. Following the initial term, the Management Agreement 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'sour independent directors or by a vote of the holders of at least two-thirdsa majority of the outstanding common stock (excluding shares held by employees and affiliates of the Company's common stockManager), based upon (i)(1) unsatisfactory performance by the Advisorour Manager that is materially detrimental to the Company or (ii)(2) a determination that the advisory feesmanagement fee payable to the Advisor areManager is not fair, subject to the Advisor'sManager’s right to prevent such a termination due tobased on unfair fees by accepting a mutually acceptable reduction of advisorymanagement fees agreed to by at least two-thirds of the Company'sour independent directors. Additionally, uponThe Manager must be provided with written notice of any such a termination without cause,at least 180 days prior to the Investment Advisory Agreement provides thatexpiration of the Companythen existing term and will pay the Advisorbe paid a termination fee equal to three times the sum of the average annual advisorymanagement fee earned by the Advisor during the prior 24-month period immediately preceding suchthe date of termination, calculated as of the end of the most recently completed fiscal year beforequarter prior to the date of termination.

 

On August 11, 2014,Expense Reimbursement

In addition to the management fees and incentive distribution described above, the Company amended its Investment Advisory Agreement to provide thatis also responsible for reimbursing the Manager for certain expenses paid by our Manager on behalf of the Company shall pay its Advisor a loan sourcing fee quarterly in arrears in lieu of any payments or reimbursements that would otherwise be dueand for certain services provided by the Manager to the AdvisorCompany.Expenses incurred by the Manager and reimbursed by us are typically included in salaries and benefits or its affiliates pursuantgeneral and administrative expense on the consolidated statements of income.

The following table presents certain information on reimbursable expenses payable to Investment Advisory Agreementour Manager:

 

 

 

 

 

 

 

 

 

For the Year Ended December 31, 

 

 

2017

 

2016

Reimbursable expenses payable to our Manager - total

 

$

4.9 million

 

$

4.1 million

Reimbursable expenses payable to our Manager - amount unpaid

 

$

2.4 million

 

$

3.4 million

Other

In June of 2017, the Company acquired four loans, net, from RCSF III, LLC, an entity also managed by our Manager for loan sourcing services provided.$57.3 million. The loan sourcing fee is equal to 0.50% of thetotal unpaid principal balance of newly originated residential mortgagethe loans sourced by the Advisor or its affiliates through its loan conduit program and acquired by the Company's subsidiaries.was $57.0 million.

 

On March 17, 2015,In November of 2017, the Company acquired an interest in an SBC loan pool through a business combination was completed between HF2 Financial Management Inc. ("HF2 Financial")joint venture, WFLLA, LLC, with Waterfall Victoria Master Fund, Ltd., a special purpose acquisition company, and ZAIS Group Parent, LLC ("ZGP"), which wholly owns ZAIS, pursuant to a definitive agreement dated September 16, 2014.fund also managed by our Manager. The current owners of ZGP did not receive any proceeds atCompany’s investment in 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.joint venture was $54.2 million.

 

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

  Year Ended 
  December 31,
2015
  December 31,
2014
  December 31,
2013
 
Advisory fees $2,850,062  $2,850,062  $2,629,815 
Loan sourcing fees  103,053   3,834    
Total – Advisory fees – related party $2,953,115  $2,853,896  $2,629,815 

Such amounts are included in "Advisory feeNote 17related party" in the Company's consolidated statements of operations.

123

The Company incurred the following Expense Reimbursements for amounts incurred by the Advisor for researchFinancial Instruments with Off-balance Sheet Risk, Credit Risk, and market data (including the amortization expense related to amounts prepaid to the Advisor):

  Year Ended 
  December 31,
2015
  December 31,
2014
  December 31,
2013
 
Expense Reimbursements $880,551  $463,086  $199,694 

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

 

Amounts payable toIn the Advisor for advisory fees, loan sourcing fees and Expense Reimbursements at December 31, 2015 and December 31, 2014 are as follows:

December 31,
2015
  December 31,
2014
 
$867,415  $984,603 

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 portionnormal course of its office space (see Note 22) from a related party:

Year Ended 
December 31,
2015
  December 31,
2014
  December 31,
2013
 
$38,960  $7,200  $ 

Such amounts are included in other income in the Company's consolidated statements of operations. The Company did not have any sub-lease income prior to the acquisition of GMFS on October 31, 2014.

20. Equity

Common Stock

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

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

Initial Public Offering

On February 13, 2013, the Company completed its IPO, pursuant toassociated with financial instruments and markets in which the Company sold 5,650,000 sharesinvests. These financial instruments expose us to varying degrees of its common stockmarket risk, credit risk, interest rate risk, liquidity risk, off balance sheet risk and prepayment risk.

Market Risk — Market risk is the potential adverse changes in the values of the financial instrument due to unfavorable changes in the public at a pricelevel or volatility of $21.25 per share for gross proceedsinterest rates, foreign currency exchange rates, or market values of $120.1 million. Net proceeds after the paymentunderlying financial instruments. We attempt to mitigate our exposure to market risk by entering into offsetting transactions, which may include purchase or sale of offering costs of approximately $1.2 million were $118.9 million. In connection with the IPO, the Advisor paid $6.3 million in underwriting fees.interest-bearing securities and equity securities.

Credit Risk — The Company did not pay any underwriting fees, discounts or commissionsis subject to credit risk in connection with our investments in SBC loans and SBC MBS and other target assets we may acquire in the IPO above those paidfuture. The credit risk related to these investments pertains to the ability and willingness of the borrowers to pay, which is assessed before credit is granted or renewed and periodically reviewed

157


throughout the loan or security term. We believe that loan credit quality is primarily determined by the Advisor.

124

Common Stock Repurchase

In January 2013, the Company’s agreementborrowers' credit profiles and loan characteristics. We seek to mitigate this risk by seeking to acquire assets at appropriate prices given anticipated and unanticipated losses and by deploying a value−driven approach to underwriting and diligence, consistent with oneour historical investment strategy, with a focus on projected cash flows and potential risks to cash flow. We further mitigate our risk of its stockholders to repurchase 515,035 shares of common stock was amended to require the Company to repurchase only 265,245 shares of the Company’s common stock. The amended repurchase amount was approximately $5.8 million which was predominantly paid to such stockholder during the three months ended March 31, 2013potential losses while managing and servicing our loans by performing various workout and loss mitigation strategies with the remaining amount paid during the three months ended June 30, 2013.

Dividends and Distributions

During the years ended December 31, 2015, December 31, 2014 and December 31, 2013 the Company declared the following dividends:

Declaration Date Record Date Payment Date 

Amount per Share

and OP Unit

 
Year ended December 31, 2015:        
March 19, 2015 March 31, 2015 April 15, 2015 $0.40 
June 18, 2015 June 30, 2015 July 15, 2015 $0.40 
September 17, 2015 September 30, 2015 October 15, 2015 $0.40 
December 17, 2015 December 31, 2015 January 15, 2016 $0.40 
         
Year ended December 31, 2014:        
March 19, 2014 March 31, 2014 April 14, 2014 $0.40 
June 17, 2014 June 30, 2014 July 15, 2014 $0.40 
September 17, 2014 September 30, 2014 October 15, 2014 $0.40 
December 18, 2014 December 31, 2014 January 15, 2015 $0.40 
         
Year ended December 31, 2013:        
May 14, 2013 May 24, 2013 May 31, 2013 $0.22 
June 25, 2013 July 9, 2013 July 23, 2013 $0.45 
September 18, 2013 September 30, 2013 October 11, 2013 $0.50 
December 19, 2013(1) December 31, 2013 January 15, 2014 $0.95 

(1)Comprised of a regular cash dividend of $0.40 per share of common stock and OP Unit for the quarter ending December 31, 2013, and an additional special cash dividend of $0.55 per share of its common stock and OP Unit. The Company declared the special cash dividend to distribute taxable income from 2013 attributable to the termination of interest rate swap contracts.

Other

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

21. Non-controlling Interests

Non-controlling interests included in the Company's consolidated financial statements consist of the OP Units in the Operating Partnership held by parties other than the Company and an interest in a joint venture of GMFS held by parties other than the Company.

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

GMFS has a 50% controlling interest in a joint venture which performs mortgage brokerage activities and has been consolidated by the Company at December 31, 2015 and December 31, 2014. 

125

22. Commitments and Contingencies

Advisor Servicesadversely impact operating results.

 

The Company is dependent on the Advisor for certain services that are essentialalso subject 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 GMFScredit risk with respect to residential mortgage loans that were sold servicing released by GMFSthe counterparties to this counterparty’s predecessor priorderivative contracts. If a counterparty becomes bankrupt or otherwise fails to perform 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).

Although the Company has establishedobligation under a loan indemnification reserve for potential losses related to loan sale representations and warranties with a corresponding provision recorded for loan losses (see Note 15),derivative contract due to the early stage of this matter and the limited information available the Company is not able to determine the likelihood of the outcome.

The Company believes thatfinancial difficulties, we may experience significant delays in obtaining any losses in excess of the loan indemnification reserve will be recovered by the Company as either a reduction of total contingent consideration owedrecovery under the GMFS Merger Agreement givenderivative contract in a dissolution, assignment for the indemnification provisions in the GMFS Merger Agreementbenefit of creditors, liquidation, winding-up, bankruptcy, or by withdrawing funds from an escrow account established by the sellers at the time of the acquisition (as of December 31, 2015, the balance in the escrow account was $4,004,424). The Company has delayed the first year installment payment of the contingent consideration.

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.other analogous proceeding. In the event of litigation or settlement with the insolvency of a counterparty to a derivative transaction, the Company intends to pursue claims against the sellers of GMFS seeking indemnification for any losses or any amounts paid in settlement, although there canderivative transaction would typically 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 disclosureterminated at its fair market value.  If we are owed this fair market value in the consolidated financial statements at December 31, 2015termination of the derivative transaction and its claim is unsecured, we will be treated as a general creditor of such counterparty, and will not have any claim with respect to the underlying security. We may obtain only a limited recovery or December 31, 2014.

Commitments to Originate Loans

GMFS enters into IRLCsmay obtain no recovery in such circumstances. In addition, the business failure of a counterparty 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,whom we enter a hedging transaction will most likely result in its default, which may result in the loss of potential future value and the loan is not economically hedged or committedloss of our hedge and force us to an investor. GMFS is also exposed to credit losscover our commitments, if any, at 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 December 31, 2015 and December 31, 2014:

December 31,
2015
  December 31,
2014
 
$216,072,457  $117,678,075 

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:

126

Year Ended 
December 31,
2015
  December 31,
2014
 
$797,981  $122,986 

Such amounts are included in operating expenses in the Company's consolidated statements of operations. The Company did not incur any rent expense prior to the acquisition of GMFS on October 31, 2014.

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

At December 31, 2015, the future minimum rental payments for the five years subsequent to December 31, 2015 and thereafter are as follows:

2016 $981,775 
2017 $807,361 
2018 $682,321 
2019 $130,080 
2020 $ 
Thereafter $ 

23. Counterparty Risk and Concentrationthen current market price.

 

Counterparty credit 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 Securitiesinvestments with repurchase agreements. Additionally, the Company finances a significant portion of its mortgages held for sale with its warehouse lines ofagreements and borrowings under credit and repurchase agreements.facilities. 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.(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 December 31, 2015 and December 31, 2014, a portion of the Company's operating cash was held with two custodians and three other financial institutions. The Company also maintains separate cash accounts with each of its warehouse lenders at December 31, 2015 and December 31, 2014. There is no guarantee that these custodians or other financial institutions will not become insolvent. While there are certain regulations that seek to protect customer property in the event of a failure, insolvency or liquidation of a custodian, there is no certainty that the Company would not incur losses due to its assets being unavailable for a period of time in the event of a failure of a custodian that has custody of the Company's assets. Although management monitors the credit worthiness of its custodians, such losses could be significant and could materially impair the ability of the Company to achieve its investment objective.

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

 

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 operatingLiquidity Risk — Liquidity risk arises in our investments and the general financing of our investing activities.  It includes the risk of not being able to fund acquisition and origination activities at settlement dates and/or liquidate positions in a timely manner at reasonable prices, in addition to potential increases in collateral requirements during times of heightened market volatility. If we were forced to dispose of an illiquid investment at an inopportune time, we might be forced to do so at a substantial discount to the market value, resulting in a realized loss. We attempt to mitigate our liquidity risk by regularly monitoring the liquidity of our investments in SBC loans, MBS and other financial instruments.  Factors such as our expected exit strategy for, the bid to offer spread of, and the number of broker dealers making an active market in a particular strategy and the availability of long-term funding, are considered in analyzing liquidity risk.  To reduce any perceived disparity between the liquidity and the terms of the debt instruments in which we invest, we attempt to minimize our reliance on short-term financing arrangements. While we may finance certain investment in security positions using traditional margin arrangements and borrowings under repurchase agreements, other financial instruments such as collateralized debt obligations, and other longer term financing vehicles may be utilized to attempt to provide us with sources of long-term financing.

Off‑Balance Sheet Risk —The Company has undrawn commitments on outstanding loans which are disclosed in Note 18.

158


Interest Rate — Interest rate risk is highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control.

Our operating results will depend, in part, on differences between the income from our investments and our financing costs. Generally, our debt financing is based on a floating rate of interest calculated on a fixed spread over the relevant index, subject to a floor, as determined by the particular financing arrangement. In the event of a significant rising interest rate environment and/or economic downturn, defaults could increase and result in credit losses to us, which could materially and adversely affect our business, financial condition, liquidity, results of operations and prospects.  Furthermore, such defaults could have an adverse effect on the spread between our interest-earning assets and interest-bearing liabilities.

Additionally, non-performing SBC loans are not as interest rate sensitive as performing loans, as earnings on non-performing loans are often generated from restructuring the assets through loss mitigation strategies and opportunistically disposing of them. Because non-performing SBC loans are short-term assets, the discount rates used for valuation are based on short-term market interest rates, which may not move in tandem with long-term market interest rates.  A rising rate environment often means an improving economy, which might have a positive impact on commercial property values, resulting in increased gains on the disposition of these assets.

While rising rates could make it more costly to refinance these assets, we expect that the impact of this would be mitigated by higher property values. Moreover, small business owners are generally less interest rate sensitive than large commercial property owners, and interest cost is a relatively small component of their operating expenses. An improving economy will likely spur increased property values and sales, thereby increasing the need for SBC financing.

Prepayment Risk — As we receive prepayments of principal on our investments, premiums paid on such investments will be amortized against interest income. In general, an increase in prepayment rates will accelerate the amortization of purchase premiums, thereby reducing the interest income earned on the investments and this is also affected by interest rate movements. Conversely, discounts on such investments are accreted into interest income. In general, an increase in prepayment rates will accelerate the accretion of purchase discounts, thereby increasing the interest income earned on the investments. An increase in prepayment rates will also adversely affect the fair value of our MSRs.

Note 18 – Commitments, Contingencies and Indemnifications

Litigation

The Company may be subject to litigation and administrative proceedings arising in the ordinary course of its business.

The Company has entered into agreements, which provide for indemnifications against losses, costs, claims, and liabilities arising from the performance of individual obligations under such agreements. The Company has had no prior claims or payments pursuant to these agreements. The Company’s individual maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Company that have not yet occurred. However, based on history and experience, the Company expects the risk of loss to be remote.

Management is not aware of any other contingencies that would require accrual or disclosure in the consolidated financial statements.

Unfunded Loan Commitments

As of December 31, 2017 and 2016, the Company had $9.6 million and $14.9 million of unfunded loan commitments related to loans, held at fair value, respectively. As of December 31, 2017 and 2016, the Company had $84.7 million and $29.3 million of unfunded loan commitments related to loans, held-for-investment, respectively.

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

159


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 borrower does not perform.

Commitments to originate loans do not necessarily reflect future cash requirements as some commitments are expected to expire without being drawn upon. As of December 31, 2017 and 2016, total commitments to originate loans were $147.6 million and $200.0 million, respectively.

Note 19 – Income Taxes

The Company is a REIT pursuant to IRC Section 856. Our qualification as a REIT depends on our ability to meet various requirements imposed by the Internal Revenue Code, which relate to our organizational structure, diversity of stock ownership and certain requirements with regard to the nature of our assets and the sources of our income. As a result, the Company is dependent on its warehouse linesREIT, we generally must distribute annually at least 90% of creditour net taxable income, subject to certain adjustments and repurchase facilitiesexcluding any net capital gain, in order to finance its continued operations and investments. If the Company's principal lenders decided to terminate orfor U.S. federal income tax not to renewapply to our earnings that we distribute. To the extent that we satisfy this distribution requirement, but distribute less than 100% of our net taxable income, we will be subject to U.S. federal income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our stockholders in a calendar year is less than a minimum amount specified under U.S. federal tax laws. Even if we qualify as a REIT, we may be subject to certain U.S. federal income and excise taxes and state and local taxes on our income and assets. If we fail to maintain our qualification as a REIT for any taxable year, we may be subject to material penalties as well as federal, state and local income tax on our taxable income at regular corporate rates and we would not be able to qualify as a REIT for the subsequent four taxable years. As of December 31, 2017 and 2016, we are in compliance with all REIT requirements.

Certain of our subsidiaries have elected to be treated as taxable REIT subsidiaries (“TRSs”). TRSs permit us to participate in certain activities from which REITs are generally precluded, as long as these credit facilitiesactivities meet specific criteria, are conducted within the parameters of certain limitations established by the Code, and are conducted in entities which elect to be treated as taxable subsidiaries under the Code. To the extent these criteria are met, we will continue to maintain our qualification as a REIT.

Our TRSs engage in various real estate related operations, including originating and securitizing commercial and residential mortgage loans, and investments in real property. The majority of our TRSs are held within the SBC Originations, SBA Originations, Acquisitions and Servicing, and Residential Mortgage Banking segments. Our TRSs are not consolidated for federal income tax purposes, but are instead taxed as corporations. For financial reporting purposes, a provision for current and deferred income taxes is established for the portion of earnings recognized by us with respect to our interest in TRSs.

The Tax Cuts and Jobs Act (the “TCJA”) was signed into law on December 22, 2017. The TCJA changed many aspects of U.S. corporate income taxation, including a reduction of the Company,corporate income tax rate from 35% to 21%, implementation of a territorial tax system, and imposition of a tax on deemed repatriated earnings of foreign subsidiaries. We recognized the losstax effects of borrowing capacity could havethe TCJA in our year ended December 31, 2017 results and recorded a material adverse impact on$1.0 million income tax benefit which relates entirely to the Company's consolidated financial statements unlessre-measurement of deferred tax balances to the Company found21% tax rate.

Our income tax provision consists of the following:

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

 

(In Thousands)

    

2017

    

2016

    

2015

 

Current

 

 

 

 

 

 

 

 

 

 

Federal income tax (benefit)

 

$

(1,235)

 

$

6,441

 

$

5,234

 

State and local income tax (benefit)

 

 

(171)

 

 

947

 

 

710

 

Net current tax provision (benefit)

 

 

(1,406)

 

 

7,388

 

 

5,944

 

Deferred

 

 

 

 

 

 

 

 

 

 

Federal income tax

 

 

3,779

 

 

1,401

 

 

750

 

State and local income tax

 

 

613

 

 

583

 

 

248

 

Valuation allowance

 

 

(1,147)

 

 

279

 

 

868

 

Net deferred tax provision

 

 

3,245

 

 

2,263

 

 

1,866

 

Total income tax provision

 

$

1,839

 

$

9,651

 

$

7,810

 

160


The following table is a suitable alternative source.reconciliation of our federal income tax determined using our statutory federal tax rate to our reported income tax provision for the years ended December 31, 2017, 2016 and 2015:

 

127

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31,

(In Thousands)

    

2017

    

2016

    

2015

U.S. statutory tax

 

$

16,679

 

$

22,825

 

$

18,099

State and local income tax

 

 

569

 

 

2,322

 

 

721

Income attributable to REIT

 

 

(10,795)

 

 

(14,522)

 

 

(10,138)

Income attributable to Non-controlling interests

 

 

(568)

 

 

(1,251)

 

 

(1,491)

Nondeductible

 

 

748

 

 

21

 

 

18

Change in tax rate (a)

 

 

(727)

 

 

 —

 

 

 —

Change in valuation allowance

 

 

(1,147)

 

 

279

 

 

868

Return to Provision

 

 

(2,547)

 

 

 —

 

 

 —

Other

 

 

(373)

 

 

(23)

 

 

(267)

Effective income tax

 

$

1,839

 

$

9,651

 

$

7,810

(a) For 2017 the amount relates to the effects of revaluing our net deferred tax balances for the TCJA that was enacted on December 22, 2017

 

 

 

 

 

 

 

 

 

 

 

MSRsDeferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of the assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Deferred tax assets and liabilities are presented net by tax jurisdiction and are reported in other assets and other liabilities, respectively. The following table presents the tax effects of temporary differences on their respective net deferred tax assets and liabilities (in thousands):

 

 

 

 

 

 

 

(In Thousands)

    

December 31, 2017

    

December 31, 2016

Deferred tax assets:

 

 

 

 

 

 

Net operating loss carryforwards

 

$

4,989

 

$

4,159

Unrealized losses

 

 

 —

 

 

488

Impairment and reserves

 

 

 —

 

 

7,826

Depreciation and amortization

 

 

997

 

 

668

Goodwill

 

 

3,110

 

 

7,134

Compensation

 

 

1,226

 

 

1,669

Intangibles

 

 

 —

 

 

896

Other

 

 

1,240

 

 

859

Total deferred tax assets

 

$

11,562

 

$

23,699

Deferred tax liabilities:

 

 

 

 

 

 

Accruals

 

$

216

 

$

(402)

Loan / servicing rights balance

 

 

12,014

 

 

20,995

Derivative instruments

 

 

373

 

 

1,152

Other taxable temporary difference

 

 

310

 

 

69

Total deferred tax liabilities

 

$

12,913

 

$

21,814

Valuation allowance

 

 

 —

 

 

(1,147)

Net deferred tax assets (liabilities)

 

$

(1,351)

 

$

738

The Company has $34.7 million of net operating loss carryforwards that will begin to expire in 2033.

In 2016 as result of the ZAIS Financial merger, our deferred tax assets increased by approximately $2.9 million. Based on our analysis of limitations imposed by Section 382 of the Internal Revenue Code, we estimate we are able to fully utilize this net operating loss, limited to $1.1 million per year.

We recognize deferred tax assets and liabilities for future tax consequences arising from differences between the carrying amounts of existing assets and liabilities under GAAP and their respective tax bases. We evaluate our deferred tax assets for recoverability using a consistent approach which considers the relative impact of negative and positive evidence, including our historical profitability and projections of future taxable income.

As of December 31, 2017, we continued to conclude that the positive evidence in favor of the recoverability of our deferred tax asset outweighed the negative evidence and that it is more likely than not that our deferred tax assets will be realized. Our framework for assessing the recoverability of deferred tax assets requires us to weigh all available evidence, including the sustainability of recent profitability required to realize the deferred tax assets, the cumulative net income in

161


our consolidated statements of income in recent years, and the carryforward periods for any carryforwards of net operating losses.

The tables above do not include tax information on discontinued operations. The tax rate on discontinued operations is approximately 39%. The difference between the statutory rate of 35% and the effective income tax rate is primarily due to state and local taxes.

As of December 31, 2017 and 2016, the Company had no uncertain tax positions recorded or disclosed in financial statements. Additionally, it is the belief of management that the total amount of uncertain tax positions, if any, will not materially change over the next 12 months.

Our major tax jurisdictions where we file income tax returns include Federal, New York State and New York City. Our 2014 and forward tax years are subject to substantial interest rate riskexamination. The TRS major tax jurisdictions are Federal, New York State, New York City, New Jersey and California. For Federal and state purposes, with the exception of New Jersey, the TRS entities are subject to examination for the 2014 and forward tax years. For New Jersey, the TRS entities are subject to examination for the 2013 and forward tax years.

Note 20 – Other Assets and Other Liabilities

The following table details the Company’s other assets and other liabilities as of the consolidated balance sheet dates.

 

 

 

 

 

 

 

(In Thousands)

    

December 31, 2017

    

December 31, 2016

Other assets:

 

 

 

 

 

 

Due from servicers

 

$

9,964

 

$

27,029

Intangible assets

 

 

3,264

 

 

3,636

Accrued interest

 

 

6,494

 

 

5,606

Real estate acquired in settlement of loans

 

 

1,644

 

 

3,933

Deferred financing costs

 

 

446

 

 

3,376

Deferred tax asset

 

 

17,155

 

 

1,371

Prepaid taxes

 

 

6,014

 

 

1,456

Other

 

 

11,859

 

 

7,870

Total other assets

 

$

56,840

 

$

54,277

Accounts payable and other accrued liabilities:

 

 

 

 

 

 

Accrued salaries, wages and commissions

 

$

16,508

 

$

17,450

Servicing principal and interest payable

 

 

5,659

 

 

10,664

Repair and denial reserve

 

 

5,687

 

 

6,813

Liability under subservicing agreements

 

 

1,496

 

 

6,757

Unapplied cash

 

 

2,445

 

 

6,278

Accrued interest payable

 

 

10,317

 

 

4,680

Payable to related parties

 

 

2,042

 

 

3,762

Deferred tax liability

 

 

18,506

 

 

632

Other accounts payable and accrued liabilities

 

 

11,976

 

 

13,171

Total accounts payable and other accrued liabilities

 

$

74,636

 

$

70,207

Real Estate Acquired in Settlement of Loans

The Company acquires real estate through the foreclosure of its loans and the valueoccasional purchase of MSRs generally tend to diminishreal estate. The Company’s real estate properties are held in periodsthe Company’s consolidated TRSs. The following tables summarize the carrying amount of declining interest ratesthe Company’s real estate holdings as borrowers can prepayof 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.consolidated balance sheet dates:

 

 

 

 

 

 

 

 

(In Thousands)

 

         December 31, 2017

 

       December 31, 2016

North Carolina

 

 

 —

 

 

1,850

Florida

 

 

303

 

 

1,320

Illinois

 

 

863

 

 

19

Other

 

 

478

 

 

744

Total

 

          $

1,644

 

           $

3,933

24. Offsetting Assets and Liabilities

162


Intangible assets

 

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

 

 

 

 

 

 

 

(In Thousands)

December 31, 2017

 

December 31, 2016

Estimated Useful Life

Trade name

$

1,017

 

$

1,190

15 years

Favorable lease

 

1,247

 

 

1,446

12 years

SBA license

 

1,000

 

 

1,000

Indefinite life

Total Intangible Assets

$

3,264

 

$

3,636

 

Amortization expense related to the intangible assets acquired for the years ended December 31, 2017 and 2016 was $0.4 and $0.1 million, respectively. Such amounts are recorded as other operating expenses in the consolidated statements of income.

At December 31, 2017, accumulated amortization for finite-lived intangible assets is as follows:

 

 

 

(In Thousands)

December 31, 2017

Trade name

$

206

Favorable lease

 

233

Total Accumulated Amortization

$

439

Amortization expense related to the finite-lived intangible assets for the five years subsequent to December 31, 2017 is as follows:

 

 

 

(In Thousands)

December 31, 2017

2018

$

349

2019

 

311

2020

 

277

2021

 

248

2022

 

222

Thereafter

 

857

Total

$

2,264

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 accrued liabilities that are subject to master netting arrangements (or similar agreements) and can potentially be offset in the Company's consolidated balance sheets at December 31, 2015 and December 31, 2014:

        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 
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) $ 
                         
December 31, 2014                        
Warehouse lines of credit $89,417,564  $  $89,417,564  $(89,417,564) $  $ 
Loan Repurchase Facilities  300,092,293      300,092,293   (300,092,293)      
Securities repurchase agreements  103,014,105      103,014,105   (102,329,849)  (684,256)   
Interest rate swap agreements  860,553      860,553      (860,553)   
Total $493,384,515  $  $493,384,515  $(491,839,706) $(1,544,809) $ 

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 December 31, 2015 or December 31, 2014.

25. Employee Benefit Plan

GMFS has a 401(k) profit sharing plan covering substantially all GMFS employees. The employees may contribute amounts as allowable by IRS and plan limitations. GMFS may make discretionary matching and non-elective contributions. GMFS contributions to the plan were as follows:

Year Ended 
December 31,
2015
  December 31,
2014
  December 31,
2013
 
$399,970  $69,719  $ 

Such amounts areprovision for loan indemnification losses is included in salaries, commissions and benefitsgains on residential mortgage banking activities, net of variable loan expenses, in the Company's consolidated statements of operations.income. 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. At December 31, 2017 and 2016, the loan indemnification reserve was $3.0 million and $2.8 million, respectively.

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 Company didestimate of the range of possible losses for representations and warranties does not haverepresent a 401(k) profit sharing plan priorprobable loss, and is based on current available information, significant judgment, and a number of assumptions that are subject to change. At December 31, 2017 and 2016, the acquisition of GMFS on October 31, 2014.reasonably possible loss above the recorded loan indemnification reserve was not considered material.

 

128

163


 

26. Segment Information

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

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

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

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

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

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

Year Ended December 31, 2015: Residential
 Mortgage
Investments
  Residential 
Mortgage
Banking
  Corporate/Other  Total 
Interest income $34,658,211  $3,144,345  $  $37,802,556 
Interest expense  10,912,951   2,151,690   5,785,264   18,849,905 
Net interest income (expense)  23,745,260   992,655   (5,785,264)  18,952,651 
Non-interest income     48,876,274      48,876,274 
Change in unrealized gain or loss  (14,989,408)        (14,989,408)
Realized gain  1,183,083         1,183,083 
Gain or (loss) on derivative instruments  (171,859)        (171,859)
Advisory fee – related party  1,536,078   542,842   874,195   2,953,115 
Salaries, commissions and benefits     30,934,727      30,940,727 
Operating expenses  342,243   6,337,911   5,614,180   12,294,334 
Other Expenses                
Expenses  2,693,489   64,652   980,418   3,738,559 
Depreciation and amortization     933,811      933,811 
Total other expenses  2,693,489   998,463   980,416   4,672,368 
Net income (loss) before income taxes  5,195,266   11,054,986   (13,254,057)  2,996,197 
Income tax expense     4,415,474      4,415,474 
Segment net income (loss) $5,195,266  $6,639,512  $(13,254,057) $(1,419,277)

Year Ended December 31, 2014 Residential
 Mortgage
Investments
  Residential 
Mortgage
Banking
  Corporate/Other  Total 
Interest income $40,998,530  $594,217  $  $41,592,747 
Interest expense  11,451,687   121,194   5,686,664   17,259,545 
Net interest income (expense)  29,546,843   473,023   (5,686,664)  24,333,202 
Non-interest income     4,730,212      4,730,212 
Change in unrealized gain or loss  19,090,520         19,090,520 
Realized gain  5,762,254         5,762,254 
Gain or (loss) on derivative instruments  (5,921,725)        (5,921,725)
Advisory fee – related party  3,835   143,674   2,706,387   2,853,896 
Salaries, commissions and benefits     3,765,784      3,765,784 
Operating expenses  251,305   1,089,640   6,521,363   7,862,308 
Other Expenses:                
Expenses  2,180,113         2,180,113 
Transaction costs relating to the acquisition of GMFS     2,177,617      2,177,617 
Depreciation and amortization     154,011      154,011 
Total other expenses  2,180,113   2,331,628      4,511,741 
Net income/(loss) before income taxes  46,042,639   (2,127,491)  (14,914,414)  29,000,734 
Income tax (benefit)     (850,996)     (850,996)
Segment net income (loss) $46,042,639  $(1,276,495) $(14,914,414) $29,851,730 

129

Note 21 – Other Income and Operating Expenses

 

The following table details the Company’s other income and operating expenses for the consolidated statements of income.

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Year Ended December 31,

 

(In Thousands)

 

2017

    

2016

    

2015

 

Other income

 

 

 

 

 

 

 

 

 

 

Origination income

 

$

4,302

 

$

4,144

 

$

2,935

 

Release/(Increase) of repair and denial reserve

 

 

1,013

 

 

1,258

 

 

10,120

 

Other

 

 

3,143

 

 

3,759

 

 

1,376

 

Total other income

 

$

8,458

 

$

9,161

 

$

14,431

 

Other operating expenses

 

 

 

 

 

 

 

 

 

 

Origination costs

 

$

6,862

 

$

4,098

 

$

2,779

 

Technology expense

 

 

3,692

 

 

2,945

 

 

2,414

 

Charge off of real estate acquired in settlement of loans

 

 

756

 

 

1,833

 

 

849

 

Rent expense

 

 

2,314

 

 

1,449

 

 

996

 

Recruiting, training and travel expenses

 

 

2,389

 

 

1,320

 

 

1,223

 

Other

 

 

10,926

 

 

5,535

 

 

3,693

 

Total other operating expenses

 

$

26,939

 

$

17,180

 

$

11,954

 

Note 22 – Variable Interest Entities and Securitization Activities

In the normal course of business, we enter into certain types of transactions with entities that are considered to be VIEs. Our primary involvement with VIEs has been related to our securitization transactions in which we transfer assets to securitization trusts. We primarily securitize acquired SBC loans, originated transitional loans, and acquired SBA loans, which provides a source of funding for us and has enabled us to transfer a certain portion of the economic risk of the loans or related debt securities to third parties.

We also transfer originated loans to securitization trusts sponsored by third parties, most notably Freddie Mac. Third-party securitizations are securitization entities in which we maintain an economic interest but do not sponsor.

The entity that has a controlling financial interest in a VIE is referred to as the primary beneficiary and is required to consolidate the VIE. The majority of the VIEs in which we have been involved in are consolidated in our financial statements. See Note 3 for a discussion of our accounting policies applied to the consolidation of the VIE and transfer of the loans in connection with the securitization.

Securitization-Related VIEs

Company sponsored securitizations

In a securitization transaction, assets are transferred to a trust, which generally meets the definition of a VIE. Our primary securitization activity is in the form of SBC and SBA loan securitizations, conducted through securitization trusts which we consolidate, as we determined that we are the primary beneficiary.

For financial statement reporting purposes, since the underlying trust is consolidated, the securitization is effectively viewed as a financing of the loans that were securitized to enable the senior security to be created and sold to a third-party investor. As such, the senior security is presented on the consolidated balance sheets as securitized debt obligations of consolidated VIEs. The third-party beneficial interest holders in the VIE have no recourse against the Company, except that the Company has an obligation to repurchase assets from the VIE in the event that certain representations and warranties in relation to the loans sold to the VIE are breached. In the absence of such a breach, the Company has no obligation to provide any other explicit or implicit support to any VIE.

The securitization trust receives principal and interest on the underlying loans and distributes those payments to the certificate holders. The assets and other instruments held by the securitization trust are restricted in that they can only be used to fulfill the obligations of the securitization trust. The risks associated with the Company’s involvement with the VIE is limited to the risks and rights as a certificate holder of the securities retained by the Company.

164


The consolidation of the securitization transactions includes the senior securities issued to third parties which are shown as securitized debt obligations of consolidated VIEs on the consolidated balance sheets. The following table presents additional information on the Company’s securitized debt obligations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

 

 

December 31, 2016

 

 

    

Current 

    

 

 

    

Weighted 

 

    

Current 

    

 

 

    

Weighted

 

 

 

Principal 

 

Carrying 

 

Average 

 

 

Principal

 

Carrying

 

Average

 

(In Thousands)

 

Balance

 

value

 

Interest Rate

 

 

Balance

 

value

 

Interest Rate

 

Waterfall Victoria Mortgage Trust 2011-SBC2

 

$

16,010

 

$

16,010

 

5.3

%

 

$

24,472

 

$

24,472

 

5.2

%

Sutherland Commercial Mortgage Loans 2015-SBC4

 

 

10,049

 

 

9,687

 

4.0

 

 

 

39,464

 

 

38,402

 

3.9

 

Sutherland Commercial Mortgage Trust 2017-SBC6

 

 

119,784

 

 

117,868

 

3.3

 

 

 

 —

 

 

 —

 

 —

 

ReadyCap Commercial Mortgage Trust 2014-1

 

 

33,953

 

 

33,951

 

3.6

 

 

 

84,320

 

 

83,885

 

3.4

 

ReadyCap Commercial Mortgage Trust 2015-2

 

 

151,993

 

 

147,271

 

4.1

 

 

 

166,232

 

 

160,699

 

4.0

 

ReadyCap Commercial Mortgage Trust 2016-3

 

 

98,733

 

 

95,907

 

3.5

 

 

 

133,774

 

 

129,914

 

3.5

 

Ready Capital Mortgage Financing 2017-FL1

 

 

158,978

 

 

154,721

 

2.8

 

 

 

 —

 

 

 —

 

 —

 

ReadyCap Lending Small Business Trust 2015-1

 

 

25,057

 

 

22,733

 

2.5

 

 

 

56,055

 

 

55,570

 

2.0

 

Total

 

$

614,557

 

$

598,148

 

3.4

%

 

$

504,317

 

$

492,942

 

3.6

%

Repayment of our securitized debt will be dependent upon the cash flows generated by the loans in the securitization trust that collateralize such debt. The actual cash flows from the securitized loans are comprised of coupon interest, scheduled principal payments, prepayments and liquidations of the underlying loans. The actual term of the securitized debt may differ significantly from our estimate given that actual interest collections, mortgage prepayments and/or losses on liquidation of mortgages may differ significantly from those expected.

Third-party sponsored securitizations

For Freddie Mac sponsored securitizations, we determined that we are not the primary beneficiary because we do not have the power to direct the activities that most significantly impact the economic performance of these entities. Specifically, we do not service or manage these entities or otherwise solely hold decision making powers that are significant, which include special servicing decisions. As a result of this assessment, we do not consolidate any of the underlying assets and liabilities of these trusts, we only account for our specific interests in them.

Other VIEs

Other VIEs include a variable interest that we hold in an acquired joint venture investment that we account for as an equity method investment. We do not consolidate these entities because we do not have the power to direct the activities that most significantly impact their economic performance, we only account for our specific interest in them.

Assets and Liabilities of Consolidated VIEs

The following table reflects the securitized assets and liabilities for VIEs that we consolidate on our consolidated balance sheets:

 

 

 

 

 

 

 

(In Thousands)

    

December 31, 2017

    

December 31, 2016

Assets:

 

 

 

 

 

 

Cash and cash equivalents

 

$

25

 

$

131

Restricted cash

 

 

15,838

 

 

808

Loans, net

 

 

836,180

 

 

655,559

Real estate acquired in settlement of loans

 

 

3,443

 

 

4,103

Accrued interest

 

 

4,261

 

 

2,835

Due from servicers

 

 

1,915

 

 

27,660

Total assets

 

 

861,662

 

 

691,096

Liabilities:

 

 

 

 

 

 

Securitized debt obligations of consolidated VIEs, net

 

 

598,148

 

 

492,942

Total liabilities

 

 

598,148

 

 

492,942

Equity

 

$

263,514

 

$

198,154

165


Assets of Unconsolidated VIEs

The following table reflects our variable interests in identified VIEs, of which we are not the primary beneficiary, as of December 31, 2017:

 

 

 

 

 

 

 

(In Thousands)

    

                     Carrying
                      Amount

    

Maximum
Exposure to Loss
(1)

Assets:

 

 

 

 

 

 

Mortgage backed securities, at fair value(2)

 

$

38,568

 

$

38,568

Investment in unconsolidated joint venture

 

 

55,369

 

 

55,369

Total assets in unconsolidated VIEs

 

$

93,937

 

 

93,937

 

(1) Maximum exposure to loss is limited to the greater of the fair value or carrying value of the assets as of the consolidated balance sheet date.

(2) Retained interest in Freddie Mac sponsored securitizations.

Note 23 – Stockholders’ Equity

Common stock dividends

The following table presents cash dividends declared by our board of directors on our common stock from January 1, 2016 through December 31, 2017:

 

 

 

 

 

 

 

 

 

 

    

 

    

 

    

Dividend per

Declaration Date

 

Record Date

 

Payment Date

 

Share

May 20, 2016

 

June 3, 2016

 

June 17, 2016

 

$

0.45

(1)

August 23, 2016

 

September 2, 2016

 

September 16, 2016

 

$

0.45

(1)

October 11, 2016

 

October 14, 2016

 

October 25, 2016

 

$

0.36

(1)

December 21, 2016

 

December 30, 2016

 

January 27, 2017

 

$

0.35

 

March 14, 2017

 

March 31, 2017

 

April 13, 2017

 

$

0.37

 

June 15, 2017

 

June 30, 2017

 

July 31, 2017

 

$

0.37

 

September 12, 2017

 

September 29, 2017

 

October 20, 2017

 

$

0.37

 

December 13, 2017

 

December 29, 2017

 

January 31, 2018

 

$

0.37

 

(1) Retrospectively adjusted for the equivalent number of shares after the reverse merger.

 

 

 

 

Incentive fee stock issuance

On January 8, 2016, the Company issued 27,199 shares at $17.74 per share to the Manager for the incentive distribution fee earned for the second and third quarters of 2015. As discussed above, the Manager is entitled to an incentive distribution fee as defined in the Management Agreement. 

Stock incentive plan

In connection with the reverse merger, the Company adopted ZAIS Financial’s 2012 equity incentive plan (“the 2012 Plan”). The 2012 Plan authorizes the Compensation Committee to approve grants of equity-based awards to our officers, directors, and employees of the Manager and its affiliates. The equity incentive plan provides for grants of equity-based awards up to an aggregate of 5% of the shares of the Company’s common stock issued and outstanding from time to time on a fully diluted basis.

During the first quarter of 2017, the Company issued restricted stock units (“RSUs”) to its independent directors as compensation for their service on the board of directors. RSUs are awarded at no cost to the recipient upon their grant. Each of our four independent directors received a one-time grant of 5,000 RSUs vesting immediately on a one-for-one basis for 5,000 shares of our common stock. Each independent director also received an annual grant of 5,000 RSUs that vested or will vest on a one-for-one basis for shares of our common stock in equal quarterly installments over a one year period ending December 31, 2017. The shares of stock associated with RSUs are not issued and are unvested until the directors, officers or employees meet certain vesting conditions and earn the right to those shares. Dividend equivalent rights will be paid on unvested RSUs at the same rate and at the same time as dividends on the Company’s common stock.

During the second quarter of 2017, the Company issued restricted stock awards (“RSAs”) to certain employees as compensation for their employment services. The RSAs are awarded at no cost to the recipient upon their grant. A total of

166


25,851 shares were awarded and will vest in equal installments over a three year period ending May 9, 2020. The shares of stock were issued during the second quarter of 2017, but remain unvested until those service conditions are met, where upon such employees will then earn the right to such shares. Dividend equivalent rights will be paid on unvested RSAs at the same rate and at the same time as dividends on the Company’s common stock.

The Company’s current policy for issuing shares upon settlement of stock-based incentive awards is to issue new shares.

The fair value of the RSUs and RSAs granted, which is determined based upon the stock price on the grant date, is recorded as compensation expense on a straight-line basis over the vesting periods for the awards, with an offsetting increase in stockholders’ equity.

The following table summarizes the Company’s RSU and RSA activity for the year ended December 31, 2017:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Independent Director RSUs

 

Employee RSAs

(In Thousands, except share data)

Number of
Shares

    

Weighted-average grant date fair value

Weighted-average grant date fair value (per share)

    

Number of
Shares

    

Weighted-average grant date fair value

Weighted-average grant date fair value (per share)

Outstanding, January 1

 —

 

$

 —

$

 —

 

 —

 

$

 —

$

 —

Granted

40,000

 

 

580

 

14.50

 

 —

 

 

 —

 

 —

Vested

(25,000)

 

 

(363)

 

14.50

 

 —

 

 

 —

 

 —

Forfeited

 —

 

 

 —

 

 —

 

 —

 

 

 —

 

 —

Canceled

 —

 

 

 —

 

 —

 

 —

 

 

 —

 

 —

Outstanding, March 31, 2017

15,000

 

$

217

$

14.50

 

 —

 

$

 —

$

 —

Granted

 —

 

 

 —

 

 —

 

25,851

 

 

380

 

14.70

Vested

(5,000)

 

 

(72)

 

14.50

 

 —

 

 

 —

 

 —

Forfeited

 —

 

 

 —

 

 —

 

 —

 

 

 —

 

 —

Canceled

 —

 

 

 —

 

 —

 

 —

 

 

 —

 

 —

Outstanding, June 30, 2017

10,000

 

$

145

$

14.50

 

25,851

 

$

380

$

14.70

Granted

 —

 

 

 —

 

 —

 

 —

 

 

 —

 

 —

Vested

(5,000)

 

 

(72)

 

14.50

 

 —

 

 

 —

 

 —

Forfeited

 —

 

 

 —

 

 —

 

 —

 

 

 —

 

 —

Canceled

 —

 

 

 —

 

 —

 

 —

 

 

 —

 

 —

Outstanding, September 30, 2017

5,000

 

$

73

$

14.50

 

25,851

 

$

380

$

14.70

Granted

 —

 

 

 —

 

 —

 

 —

 

 

 —

 

 —

Vested

(5,000)

 

 

(73)

 

14.50

 

 —

 

 

 —

 

 —

Forfeited

 —

 

 

 —

 

 —

 

 —

 

 

 —

 

 —

Canceled

 —

 

 

 —

 

 —

 

 —

 

 

 —

 

 —

Outstanding, December 31, 2017

 —

 

$

 —

$

 —

 

25,851

 

$

380

$

14.70

During the year ended December 31, 2017, the Company recognized $0.7 million of noncash compensation expense related to its stock-based incentive plan in our consolidated statements of income.

As of December 31, 2017, approximately $0.3 million of noncash compensation expense related to unvested awards had not yet been charged to net income. These costs are expected to be amortized into compensation expense ratably over the course of the remainder of the respective vesting periods.

Litigation settlement

On May 2, 2017, the Company issued approximately $4.0 million in shares of the Company's common stock (275,862 shares issued) to a counterparty in connection with a litigation settlement. 

167


Note 24 – Earnings per Share of Common Stock

The number of shares of common stock used in the computation of basic income per share. This reconciliation has been retrospectively adjusted for the equivalent number of shares after the reverse acquisition.

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31, 

(In Thousands, except for share and per share amounts)

    

2017

    

2016

2015

Basic Earnings

 

 

 

 

 

 

 

 

 

 

Continuing Operations

 

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

$

45,814

 

$

55,564

 

$

45,421

 

Less: Income attributable to non-controlling interest

 

 

2,524

 

 

4,237

 

 

4,385

 

Less: Income attributable to participating shares

 

 

62

 

 

 -

 

 

 -

 

  Basic - Income from continuing operations

 

$

43,228

 

$

51,327

 

$

41,036

 

 

 

 

 

 

 

 

 

 

 

 

Discontinued Operations

 

 

 

 

 

 

 

 

 

 

Loss from discontinued operations

 

 

 -

 

 

(2,158)

 

 

(653)

 

  Basic — Net income attributable to common stockholders after allocation to participating shares

 

$

43,228

 

$

49,169

 

$

40,383

 

 

 

 

 

 

 

 

 

 

 

 

Diluted Earnings

 

 

 

 

 

 

 

 

 

 

Continuing Operations

 

 

 

 

 

 

 

 

 

 

Basic — Income from continuing operations

 

$

45,814

 

$

55,564

 

$

45,421

 

Less: Income attributable to non-controlling interest

 

 

2,524

 

 

4,237

 

 

4,385

 

Less: Income attributable to participating shares

 

 

62

 

 

 -

 

 

 -

 

  Diluted — Income from continuing operations

 

$

43,228

 

$

51,327

 

$

41,036

 

 

 

 

 

 

 

 

 

 

 

 

Discontinued Operations

 

 

 

 

 

 

 

 

 

 

Basic — Loss from discontinued operations

 

 

 -

 

 

(2,158)

 

 

(653)

 

  Diluted  — Net income attributable to common stockholders after allocation to participating shares

 

$

43,228

 

$

49,169

 

$

40,383

 

 

 

 

 

 

 

 

 

 

 

 

Number of Shares

 

 

 

 

 

 

 

 

 

 

Basic — Average shares outstanding

 

 

31,350,102

 

 

26,647,981

(1)

 

25,287,277

(1)

Effect of dilutive securities — Unvested participating shares

 

 

1,509

 

 

 -

 

 

 -

 

  Diluted — Average shares outstanding

 

 

31,351,611

 

 

26,647,981

 

 

25,287,277

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

$

1.38

 

$

1.93

 

$

1.62

 

Loss from discontinued operations

 

 

 -

 

 

(0.08)

 

 

(0.03)

 

 

 

 

 

 

 

 

 

 

 

 

Diluted

 

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

$

1.38

 

$

1.93

 

$

1.62

 

Loss from discontinued operations

 

 

 -

 

 

(0.08)

 

 

(0.03)

 

(1) Retroactively adjusted for the equivalent number of shares after the reverse acquisition using an exchange rate of 0.8356.

 

Participating unvested RSUs were excluded from the computation of diluted shares as their effect was already considered under the more dilutive two-class method used above.

Additionally, as of December 31, 2017, there are potential shares of common stock contingently issuable upon the conversion of the Convertible Notes in the future. The Company has asserted its intent and ability to settle the principal amount of the Convertible Notes in cash.Based on this assessment, the Company determined that it would be appropriate to apply a method similar to the treasury stock method, such that contingently issuable common stock is assessed quarterly along with our other potentially dilutive instruments. In order to compute the dilutive effect, the number of shares included in the denominator of diluted EPS is determined by dividing the “conversion spread value” of the share-settled portion (value above accreted value of face value and interest component) of the instrument by the share price. The “conversion spread value” is the value that would be delivered to investors in shares based on the terms of the bond upon an assumed conversion. As of December 31, 2017, the conversion spread value is currently zero, since the closing price of our common stock does not exceed the conversion rate (strike price) and is “out-of-the-money”, resulting in no impact on diluted EPS.

Certain investors own OP units in our operating partnership. An OP unit and a share of common stock of the Company have substantially the same economic characteristics in as much as they effectively share equally in the net income or loss of the operating partnership. OP unit holders have the right to redeem their OP units, subject to certain restrictions. The redemption is required to be satisfied in shares of common stock or cash at the Company's option, calculated as follows:

168


one share of the Company's common stock, or cash equal to the fair value of a share of the Company's common stock at the time of redemption, for each OP unit. When an OP unit holder redeems an OP unit, non-controlling interests in the Operating Partnership is reduced and the Company's equity is increased. At December 31, 2017 and 2016, the non-controlling interest OP unit holders owned 1,150,827 and 2,349,561, OP units, respectively, or 3.5% and 7.1% of the OP units issued by our operating partnership.

Note 25 – Interest Income and Interest Expense

Interest income and interest expense are recorded in the consolidated statements of income and classified based on the nature of the underlying asset or liability.

The following table presents the components of interest income and expense:

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31, 

(In Thousands)

    

2017

    

2016

    

2015

Interest income

 

 

 

 

 

 

 

 

 

Loans

 

 

 

 

 

 

 

 

 

   Acquired SBA 7(a) loans

 

$

37,110

 

$

46,417

 

$

54,565

   Acquired loans

 

 

34,720

 

 

44,122

 

 

50,920

   Originated Transitional loans

 

 

25,323

 

 

8,608

 

 

1,698

   Originated SBC loans, at fair value

 

 

7,769

 

 

13,457

 

 

14,858

   Originated SBC loans

 

 

22,564

 

 

17,902

 

 

14,793

   Originated SBA 7(a) loans

 

 

998

 

 

 —

 

 

 —

   Originated Residential Agency loans

 

 

255

 

 

 —

 

 

 —

Total loans (1)

 

$

128,739

 

$

130,506

 

$

136,834

Held for sale, at fair value, loans

 

 

 

 

 

 

 

 

 

   Originated Residential Agency loans

 

$

3,723

 

$

709

 

$

 —

   Originated Freddie loans

 

 

1,507

 

 

619

 

 

 —

   Originated SBA 7(a) loans

 

 

 —

 

 

 —

 

 

40

   Acquired loans

 

 

993

 

 

299

 

 

 —

Total loans, held for sale, at fair value

 

$

6,223

 

$

1,627

 

$

40

Mortgage backed securities, at fair value

 

 

3,343

 

 

4,890

 

 

12,081

Total interest income

 

$

138,305

 

$

137,023

 

$

148,955

Interest expense

 

 

 

 

 

 

 

 

 

Secured borrowings

 

$

(26,092)

 

$

(25,839)

 

$

(24,481)

Securitized debt obligations of consolidated VIEs

 

 

(23,387)

 

 

(17,619)

 

 

(11,018)

Guaranteed loan financing

 

 

(13,435)

 

 

(13,971)

 

 

(12,307)

Senior secured note

 

 

(8,069)

 

 

 —

 

 

 —

Convertible note

 

 

(3,427)

 

 

 —

 

 

 —

Promissory note

 

 

(236)

 

 

(164)

 

 

 —

Exchangeable senior notes

 

 

 —

 

 

(179)

 

 

 —

Total interest expense

 

$

(74,646)

 

$

(57,772)

 

$

(47,806)

Net interest income before provision for loan losses

 

$

63,659

 

$

79,251

 

$

101,149

(1)  Includes interest income on loans in consolidated VIEs.

 

 

 

 

 

 

 

 

 

Note 26 – Segment Reporting

The Company reports its results of operations through the following four business segments: i) Loan Acquisitions, ii) SBC Originations, iii) SBA Originations, Acquisitions and Servicing, and iv) Residential Mortgage Banking. The Company’s organizational structure is based on a number of factors that the Chief Operating Decision Maker (“CODM”), the Chief Executive Officer (“CEO”), uses to evaluate, view, and run its business operations, which includes customer base and nature of loan program types. The segments are based on this organizational structure and the information reviewed by CODM and management to evaluate segment results.

Loan Acquisitions

Through the Loan Acquisitions segment, the Company acquires performing and non-performing SBC loans and intends to continue to acquire these loans as part of the Company’s business strategy.

SBC Originations

Through the SBC Originations segment, the Company originates SBC loans secured by stabilized or transitional investor properties using multiple loan origination channels. Additionally, as part of this segment, we originate and service

169


multi-family loan products under the Freddie Mac program. This segment also reflects the impact of our SBC securitization activities.

SBA Originations, Acquisitions, and Servicing

Through the SBA Originations, Acquisitions, and Servicing segment, the Company acquires, originates and services loans guaranteed by the SBA under the SBA Section 7(a) Program. This segment also reflects the impact of our SBA securitization activities.

Residential Mortgage Banking

Through the Residential Mortgage Banking segment, the Company originates residential mortgage bankingloans eligible to be purchased, guaranteed or insured by Fannie Mae, Freddie Mac, FHA, USDA and VA through retail, correspondent and broker channels.

Corporate - Other

Corporate - Other consists primarily of unallocated corporate financing, including interest expense relating to our senior secured and convertible notes on funds yet to be deployed, allocated employee compensation from our Manager, management and incentive fees paid to our Manager and other general corporate overhead expenses, as well as the provision for income taxes.

Segment Realignment

Effective at the beginning of the third quarter of 2017, the Company implemented organizational changes to align its segment financial reporting more closely with its current business practices. Securitization activities on originated SBC and SBA loans were transferred out of the Loan Acquisitions segment and into either the SBC originations or SBA originations, acquisitions, and servicing segment, based on loan type. The other change presents Corporate- Other amounts separately and no longer reflecting these amounts as part of the four business segments. Prior period numbers were revised to conform to the operations of GMFS:new segment alignment and to be consistent with our current period’s presentation.

 

  Year Ended 
  

December 31,

2015

  

December 31,

2014

 
Net income (loss) of the residential mortgage banking segment $6,639,512  $(1,276,495)
Add back (deduct) expenses incurred by ZFC        
Honeybee TRS, LLC:        
Advisory fee – related party  542,842   143,674 
Amortization of deferred premiums, production and profitability earn-outs included in salaries, commission and benefits  855,900    
Operating expenses (including change in contingent consideration)  237,279   257,883 
Other expenses  852,992   131,390 
Transaction costs relating to the acquisition of GMFS     2,177,617 
Income tax expense (benefit)  4,415,474   (850,996)
Net income of GMFS $13,543,999  $583,073 

In accordance with ASC 280, Segment Reporting, the Company has not included discontinued operations in the segment reporting. The Company uses segment income from continuing operations before provision for income taxes as the measure of profitability of its reportable segments.

Supplemental Disclosures

170


Results of Business Segments and All Other

Reportable business segments, along with remaining unallocated amounts recorded within Corporate- Other, for the year ended December 31, 2017 are summarized in the below table.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    

 

    

 

    

SBA Originations,

    

Residential

    

 

    

 

 

 

Loan

 

SBC

 

Acquisitions,

 

Mortgage

 

Corporate-

 

 

(In Thousands)

 

Acquisitions

 

Originations

 

and Servicing

 

Banking

 

Other

 

Consolidated

Interest income

 

$

37,198

 

$

59,021

 

$

38,108

 

$

3,978

 

$

 —

 

$

138,305

Interest expense

 

 

(16,741)

 

 

(35,121)

 

 

(16,098)

 

 

(3,145)

 

 

(3,541)

 

 

(74,646)

Net interest income before provision for loan losses

 

$

20,457

 

$

23,900

 

$

22,010

 

$

833

 

$

(3,541)

 

$

63,659

Provision for loan losses

 

 

(2,026)

 

 

(195)

 

 

(142)

 

 

 —

 

 

 —

 

 

(2,363)

Net interest income after provision for loan losses

 

$

18,431

 

$

23,705

 

$

21,868

 

$

833

 

$

(3,541)

 

$

61,296

Non-interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gains on residential mortgage banking activities, net of variable loan expenses

 

$

 —

 

$

 —

 

$

 —

 

$

41,700

 

$

 —

 

$

41,700

Other income

 

 

2,814

 

 

3,983

 

 

1,513

 

 

148

 

 

 —

 

 

8,458

Servicing income

 

 

197

 

 

824

 

 

4,624

 

 

17,349

 

 

 —

 

 

22,994

Gain on bargain purchase

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

Total non-interest income

 

$

3,011

 

$

4,807

 

$

6,137

 

$

59,197

 

$

 —

 

$

73,152

Non-interest expense

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Employee compensation and benefits

 

 

(576)

 

 

(8,509)

 

 

(10,505)

 

 

(34,601)

 

 

(848)

 

 

(55,039)

Allocated employee compensation and benefits from related party

 

 

(384)

 

 

 —

 

 

 —

 

 

 —

 

 

(3,459)

 

 

(3,843)

Professional fees

 

 

(1,501)

 

 

(1,351)

 

 

(1,973)

 

 

(865)

 

 

(3,231)

 

 

(8,921)

Management fees – related party

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

(8,059)

 

 

(8,059)

Loan servicing expense

 

 

(2,981)

 

 

(2,355)

 

 

1,454

 

 

(6,441)

 

 

 —

 

 

(10,323)

Other operating expenses

 

 

(4,285)

 

 

(9,666)

 

 

(4,076)

 

 

(6,677)

 

 

(2,235)

 

 

(26,939)

Total non-interest expense

 

$

(9,727)

 

$

(21,881)

 

$

(15,100)

 

$

(48,584)

 

$

(17,832)

 

$

(113,124)

Net realized (loss) gain on financial instruments

 

 

(323)

 

 

9,665

 

 

9,509

 

 

 —

 

 

478

 

 

19,329

Net unrealized gain (loss) on financial instruments

 

 

1,628

 

 

8,125

 

 

1,315

 

 

(4,000)

 

 

(68)

 

 

7,000

Income from continuing operations before provision for income taxes

 

$

13,020

 

$

24,421

 

$

23,729

 

$

7,446

 

$

(20,963)

 

$

47,653

Total Assets

 

$

511,427

 

$

1,154,509

 

$

510,006

 

$

324,392

 

$

23,169

 

$

2,523,503

 

 Selected

171


Reportable segments for the year ended December 31, 2016 are summarized in the below table.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    

 

    

 

    

SBA Originations,

    

Residential

    

 

    

 

 

 

Loan

 

SBC

 

Acquisitions,

 

Mortgage

 

Corporate-

 

 

(In Thousands)

 

Acquisitions

 

Originations

 

and Servicing

 

Banking

 

Other

 

Consolidated

Interest income

 

$

49,311

 

$

40,586

 

$

46,417

 

$

709

 

$

 —

 

$

137,023

Interest expense

 

 

(18,327)

 

 

(20,347)

 

 

(17,397)

 

 

(557)

 

 

(1,144)

 

 

(57,772)

Net interest income before provision for loan losses

 

$

30,984

 

$

20,239

 

$

29,020

 

$

152

 

$

(1,144)

 

$

79,251

Provision for loan losses

 

 

(6,419)

 

 

(86)

 

 

(1,314)

 

 

 —

 

 

 —

 

 

(7,819)

Net interest income after provision for loan losses

 

$

24,565

 

$

20,153

 

$

27,706

 

$

152

 

$

(1,144)

 

$

71,432

Non-interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gains on residential mortgage banking activities, net of variable loan expenses

 

$

 —

 

$

 —

 

$

 —

 

$

7,033

 

$

 —

 

$

7,033

Other income

 

 

2,246

 

 

5,059

 

 

1,845

 

 

11

 

 

 —

 

 

9,161

Servicing income

 

 

49

 

 

518

 

 

5,555

 

 

2,536

 

 

 —

 

 

8,658

Gain on bargain purchase

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

15,218

 

 

15,218

Total non-interest income

 

$

2,295

 

$

5,577

 

$

7,400

 

$

9,580

 

$

15,218

 

$

40,070

Non-interest expense

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Employee compensation and benefits

 

 

(337)

 

 

(9,359)

 

 

(9,391)

 

 

(5,578)

 

 

(162)

 

 

(24,827)

Allocated employee compensation and benefits from related party

 

 

(366)

 

 

 —

 

 

 —

 

 

 —

 

 

(3,302)

 

 

(3,668)

Professional fees

 

 

(2,735)

 

 

(1,537)

 

 

(3,693)

 

 

359

 

 

(5,814)

 

 

(13,420)

Management fees – related party

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

(7,432)

 

 

(7,432)

Loan servicing expense

 

 

(2,743)

 

 

(1,348)

 

 

479

 

 

(999)

 

 

 —

 

 

(4,611)

Other operating expenses

 

 

(3,604)

 

 

(6,864)

 

 

(3,798)

 

 

(1,074)

 

 

(1,840)

 

 

(17,180)

Total non-interest expense

 

$

(9,785)

 

$

(19,108)

 

$

(16,403)

 

$

(7,292)

 

$

(18,550)

 

$

(71,138)

Net realized (loss) gain on financial instruments

 

 

(293)

 

 

2,290

 

 

4,604

 

 

 —

 

 

313

 

 

6,914

Net unrealized gain on financial instruments

 

 

4,528

 

 

6,424

 

 

 —

 

 

6,917

 

 

68

 

 

17,937

Income from continuing operations before provision for income taxes

 

$

21,310

 

$

15,336

 

$

23,307

 

$

9,357

 

$

(4,095)

 

$

65,215

Total Assets

 

$

542,643

 

$

796,408

 

$

593,091

 

$

353,141

 

$

319,984

 

$

2,605,267

172


Reportable segments for the year ended December 31, 2015 are summarized in the below table.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    

 

    

 

    

SBA Originations,

    

Residential

    

 

    

 

 

 

Loan

 

SBC

 

Acquisitions,

 

Mortgage

 

Corporate-

 

 

(In Thousands)

 

Acquisitions

 

Originations

 

and Servicing

 

Banking

 

Other

 

Consolidated

Interest income

 

$

63,001

 

$

31,349

 

$

54,605

 

$

 —

 

$

 —

 

$

148,955

Interest expense

 

 

(17,404)

 

 

(11,538)

 

 

(18,233)

 

 

 —

 

 

(631)

 

 

(47,806)

Net interest income before provision for loan losses

 

$

45,597

 

$

19,811

 

$

36,372

 

$

 —

 

$

(631)

 

$

101,149

Provision for loan losses

 

 

(13,153)

 

 

 —

 

 

(6,490)

 

 

 —

 

 

 —

 

 

(19,643)

Net interest income after provision for loan losses

 

$

32,444

 

$

19,811

 

$

29,882

 

$

 —

 

$

(631)

 

$

81,506

Non-interest income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gains on residential mortgage banking activities, net of variable loan expenses

 

$

 —

 

$

 —

 

$

 —

 

$

 —

 

$

 —

 

$

 —

Other income

 

 

583

 

 

2,938

 

 

10,910

 

 

 —

 

 

 —

 

 

14,431

Servicing income

 

 

418

 

 

139

 

 

4,576

 

 

 —

 

 

 —

 

 

5,133

Total non-interest income

 

$

1,001

 

$

3,077

 

$

15,486

 

$

 —

 

$

 —

 

$

19,564

Non-interest expense

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Employee compensation and benefits

 

 

 —

 

 

(9,291)

 

 

(9,510)

 

 

 —

 

 

(148)

 

 

(18,949)

Allocated employee compensation and benefits from related party

 

 

(333)

 

 

 —

 

 

 —

 

 

 —

 

 

(2,990)

 

 

(3,323)

Professional fees

 

 

(651)

 

 

(714)

 

 

(3,319)

 

 

 —

 

 

(2,270)

 

 

(6,954)

Management fees – related party

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

(7,260)

 

 

(7,260)

Incentive fees – related party

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

(965)

 

 

(965)

Loan servicing expense

 

 

(4,829)

 

 

(969)

 

 

1,451

 

 

 —

 

 

 —

 

 

(4,347)

Other operating expenses

 

 

832

 

 

(5,578)

 

 

(3,402)

 

 

 —

 

 

(3,806)

 

 

(11,954)

Total non-interest expense

 

$

(4,981)

 

$

(16,552)

 

$

(14,780)

 

$

 —

 

$

(17,439)

 

$

(53,752)

Net realized (loss) gain on financial instruments

 

 

2,388

 

 

(3,534)

 

 

1,317

 

 

 —

 

 

10

 

 

181

Net unrealized gain on financial instruments

 

 

(4,617)

 

 

10,353

 

 

 —

 

 

 —

 

 

(4)

 

 

5,732

Income from continuing operations before provision for income taxes

 

$

26,235

 

$

13,155

 

$

31,905

 

$

 —

 

$

(18,064)

 

$

53,231

Total Assets

 

$

711,618

 

$

623,043

 

$

745,131

 

$

 —

 

$

249,989

 

$

2,329,781

Note 27 – Discontinued Operations

In the fourth quarter of 2015, the Company determined Silverthread should be classified as held-for-sale due to management’s intent to sell the segment, the availability and active marketing of the segment for immediate sale and the high probability of a successful sale.

The sale of Silverthread closed in May of 2016, with an effective economic date of March 1, 2016. We negotiated an agreement with the buyer to receive $4.0 million. The net estimated receivable of $2.3 million is included in Receivable from Third Parties on the consolidated balance sheet informationas of December 31, 2017. Through the reporting date, $0.2 million of the balance has been received, and the remaining balance is as follows:expected in April of 2018. The operating results during the years ended December, 2017, 2016, and 2015 did not have a material impact on our consolidated financial statements.

 

  Residential
Mortgage
Investments
  Residential
Mortgage
Banking
  Corporate/Other  Total 
December 31, 2015                
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     115,942,230      115,942,230 
Real estate securities  109,339,281         109,339,281 
Other investment securities  12,804,196         12,804,196 
Mortgage servicing rights     48,209,016      48,209,016 
Goodwill     14,183,537      14,183,537 
Intangible assets     4,880,270      4,880,270 
Total assets  543,337,289   227,689,257   4,112,375   775,138,921 
                 
December 31, 2014                
Mortgage loans held for investment, at fair value $415,959,838  $  $  $415,959,838 
Mortgage loans held for investment, at cost     1,338,935      1,338,935 
Mortgage loans held for sale     97,690,960      97,690,960 
Real estate securities  148,585,733         148,585,733 
Other investment securities  2,040,532         2,040,532 
Mortgage servicing rights     33,378,978      33,378,978 
Goodwill     16,512,680      16,512,680 
Intangible assets     5,668,611      5,668,611 
Total assets  596,553,227   194,700,643   1,144,735   792,398,605 

As of December 31, 2017 and 2016, there were no assets or liabilities of the discontinued segment.

173


 

The primary components of discontinued operations are detailed in the table below:

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Year Ended December 31,

(In Thousands)

    

 

2017

 

    

2016

 

    

2015

Non-interest income (expense)

 

 

 

 

 

 

 

 

 

Commission income

 

$

 —

 

$

2,984

 

$

16,208

Property management income

 

 

 —

 

 

263

 

 

2,034

Other

 

 

 —

 

 

16

 

 

386

Total other income

 

$

 —

 

$

3,263

 

$

18,628

Employee compensation and benefits

 

 

 —

 

 

(1,071)

 

 

(5,038)

Professional fees

 

 

 —

 

 

(138)

 

 

(599)

Management fees – related party

 

 

 —

 

 

 —

 

 

 —

Operating expenses

 

 

 

 

 

 

 

 

 

Acquisition costs

 

 

 —

 

 

 —

 

 

 —

Commission expense

 

 

 —

 

 

(1,844)

 

 

(10,596)

Technology expense

 

 

 —

 

 

(171)

 

 

(871)

Rent expense

 

 

 —

 

 

(268)

 

 

(1,607)

Tax expense

 

 

 —

 

 

(3)

 

 

(33)

Recruiting, training, and travel expenses

 

 

 —

 

 

(46)

 

 

(164)

Marketing expense

 

 

 —

 

 

(29)

 

 

(70)

Insurance expense

 

 

 —

 

 

 —

 

 

 —

Other

 

 

 —

 

 

(536)

 

 

(3,103)

Total other operating expenses

 

$

 —

 

$

(2,897)

 

$

(16,444)

Loss on sale

 

 

 —

 

 

(2,695)

 

 

(1,650)

Loss before income tax benefit

 

 

 —

 

 

(3,538)

 

 

(5,103)

Income tax benefit

 

 

 —

 

 

1,380

 

 

4,450

Loss on discontinued operations presented on the statements of income

 

$

 —

 

$

(2,158)

 

$

(653)

 

27.

Note 28 – Quarterly ResultsFinancial Data (Unaudited)

 

The following istable summarizes our quarterly financial data which, in the opinion of management, reflects all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the quarterlyour results of operations (amounts in thousands, except per share amounts):

 

 

 

 

 

 

 

 

 

 

 

 

 

March 31

 

June 30

 

September 30

 

December 31

2017

 

 

 

 

 

 

 

 

 

 

 

Interest income

$

33,884

 

$

33,248

 

$

35,038

 

$

36,135

Net interest income after provision for loan losses

$

16,211

 

$

15,859

 

$

14,664

 

$

14,562

Non-interest income (expense)

$

(9,868)

 

$

(9,102)

 

$

(11,003)

 

$

(9,999)

Net income from continuing operations

$

9,557

 

$

11,153

 

$

12,374

 

$

12,730

Net income

$

9,557

 

$

11,153

 

$

12,374

 

$

12,730

Net income attributable to Sutherland Asset Management Corporation

$

8,856

 

$

10,496

 

$

11,841

 

$

12,097

Earnings per share - Basic and diluted (1)

$

0.29

 

$

0.34

 

$

0.37

 

$

0.38

 

 

 

 

 

 

 

 

 

 

 

 

2016

 

 

 

 

 

 

 

 

 

 

 

Interest income

$

37,866

 

$

34,526

 

$

31,890

 

$

32,741

Net interest income after provision for loan losses

$

21,381

 

$

18,864

 

$

17,305

 

$

13,882

Non-interest income (expense)

$

(9,685)

 

$

(12,332)

 

$

(11,863)

 

$

2,703

Net income from continuing operations

$

9,390

 

$

8,724

 

$

9,569

 

$

27,881

Net income

$

9,039

 

$

8,724

 

$

9,569

 

$

26,074

Net income attributable to Sutherland Asset Management Corporation

$

8,302

 

$

8,021

 

$

8,792

 

$

24,054

Earnings per share - Basic and diluted (1)

$

0.32

 

$

0.31

 

$

0.34

 

$

0.83

(1) Retroactively adjusted for the equivalent number of shares after reverse acquisition using an exchange rate of 0.8356

Annual EPS may not equal the sum of each quarter’s EPS due to rounding and other computational factors.

Note 29 – Subsequent Events

On January 30, 2018, ReadyCap Holdings, LLC, an indirect wholly owned subsidiary of the Company, issued $40 million in 7.50% Senior Secured Notes due 2022 (the “Notes”) with identical terms (other than issue date, issue price, the

174


first interest payment date and the date from which interest shall initially accrue) to the notes issued on February 13, 2017 (in an aggregate principal amount of $75 million) and June 13, 2017 (in an aggregate principal amount of $65 million). 

In February 2018, the Company extended its borrowings pursuant to a repurchase agreement with Deutsche Bank AG through February 14, 2020. The Fifth Amended and Restated Master Repurchase Agreement has a $300 million maximum advance amount and a pricing rate of LIBOR plus 2.5% - 3.5% depending on asset type.

In March 2018, the Company extended one of our borrowings pursuant to a committed warehouse line of credit agreement used within our Residential mortgage banking business. The amended agreement has a maximum advance amount of $125 million and a pricing rate of LIBOR plus 2.1%.

In March 2018, the Company declared a first quarter cash dividend of $0.37 per share of common stock and OP unit for the quarter ended March 31, 2018 to common stockholders and OP unit holders of record as of March 31, 2018. The dividend is payable on April 30, 2018.

In March 2018, the Company completed the securitization of $165.0 million of fixed-rate SBC loans and issued $148.5  million of senior bonds at a weighted average pass-through rate of 3.8%.

175


Sutherland Asset Management Corporation

Schedule IV – Mortgage Loans on Real Estate

There are no individual loans that exceed 1% of the total carrying amount of all mortgages. For applicable information on our loan portfolio for the years ended December 31, 20152017 and December 31, 2014:2016, such as description, interest rates, maturities, payment terms, face amount, carrying amount, delinquencies, and geographic locations, refer to the loan disclosures in Note 6 of our Consolidated Financial Statements.

 

  For the Three Months Ended 
  

December 31,
2015

  September 30,
2015
  June 30,
2015
  March 31,
2015
 
Total interest income $8,902,859  $9,650,952  $9,561,348  $9,687,397 
Total interest expense  4,664,825   4,711,854   4,727,749   4,745,477 
Net interest income  4,238,034   4,939,098   4,833,599   4,941,920 
Non-interest income  13,126,246   8,943,047   17,430,551   9,376,430 
Total other gain/(loss)  (5,192,110)  (7,986,942)  1,082,596   (1,881,728)
Total expenses  12,095,213   12,857,112   13,737,314   12,164,905 
Income tax expense (benefit)  1,911,578   (250,491)  2,899,916   (145,529)
Net (loss)/income  (1,834,621)  (6,711,418)  6,709,516   417,246 
Net (loss)/income attributable to ZAIS Financial Corp. common stockholders $(1,647,554) $(6,040,746) $6,053,811  $373,780 
Net income/(loss) per share applicable to common stockholders – basic $(0.21) $(0.76) $0.76  $0.05 
Net income/(loss) per share applicable to common stockholders – diluted $(0.21) $(0.76) $0.65  $0.05 
Weighted average number of shares:                
Basic  7,970,886   7,970,886   7,970,886   7,970,886 
Diluted  8,897,800   8,897,800   10,677,360   8,897,800 

Reconciliation of mortgage loans on real estate:

 

  For the Three Months Ended 
  

December 31,
2014(1)

  September 30,
2014
  June 30,
2014
  March 31,
2014
 
Total interest income $10,267,875  $11,000,619  $10,831,220  $9,493,033 
Total interest expense  4,447,530   4,491,678   4,416,385   3,903,952 
Net interest income  5,820,345   6,508,941   6,414,835   5,589,081 
Non-interest income  4,730,212          
Total other gain/(loss)  (2,944,631)  (1,805,117)  22,688,696   992,101 
Total expenses  8,239,984   3,424,026   3,231,396   4,098,323 
Income tax (benefit)  (850,996)         
Net income/(loss)  216,938   1,279,798   25,872,135   2,482,859 
Net income/(loss) attributable to ZAIS Financial Corp. common stockholders $194,337  $1,149,497  $23,173,931  $2,224,205 
Net income/(loss) per share applicable to common stockholders – basic $0.02  $.14  $2.91  $.28 
Net income/(loss) per share applicable to common stockholders – diluted $0.02  $.14  $2.47  $.28 
Weighted average number of shares:                
Basic  7,970,886   7,970,886   7,970,886   7,970,886 
Diluted  8,897,800   8,897,800   10,677,360   8,897,800 

The following tables reconcile mortgage loans on real estate, including loans in consolidated VIEs, from December 31, 2015 to December 31, 2017 ($ in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

Loans, net

 

Loans, held for sale,

at fair value

 

Total Loan Receivables

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2015

 

$

1,716,072

 

$

 -

 

$

1,716,072

Origination of loan receivables

 

 

315,339

 

 

621,343

 

 

936,682

Purchases of loan receivables

 

 

98,683

 

 

 -

 

 

98,683

Loans acquired in connection with reverse merger

 

 

 -

 

 

189,197

 

 

189,197

Proceeds from disposition and principal payment of loan receivables

 

 

(479,965)

 

 

(645,954)

 

 

(1,125,919)

Net realized gain (loss) on sale of loan receivables

 

 

6,349

 

 

14,342

 

 

20,691

Net unrealized gain (loss) on loan receivables

 

 

4,131

 

 

(2,982)

 

 

1,149

Non-cash proceeds on creation of MSR

 

 

(951)

 

 

(5,166)

 

 

(6,117)

Accretion/amortization of discount, premium and other fees

 

 

26,809

 

 

 -

 

 

26,809

Transfers

 

 

(11,968)

 

 

11,017

 

 

(951)

Provision for loan losses

 

 

(7,819)

 

 

 -

 

 

(7,819)

Balance at December 31, 2016

 

$

1,666,680

 

$

181,797

 

$

1,848,477

 

 

 

 

 

 

 

 

 

 

 

 

Loans, net

 

Loans, held for sale, at fair value

 

Total Loan Receivables

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2016

 

$

1,666,680

 

$

181,797

 

$

1,848,477

Origination of loan receivables

 

 

454,975

 

 

2,508,153

 

 

2,963,128

Purchases of loan receivables

 

 

147,327

 

 

11,195

 

 

158,522

Proceeds from disposition and principal payment of loan receivables

 

 

(422,059)

 

 

(2,571,583)

 

 

(2,993,642)

Net realized gain (loss) on sale of loan receivables

 

 

(3,203)

 

 

78,798

 

 

75,595

Net unrealized gain (loss) on loan receivables

 

 

5,328

 

 

3,537

 

 

8,865

Accretion/amortization of discount, premium and other fees

 

 

13,825

 

 

 -

 

 

13,825

Transfers

 

 

(6,410)

 

 

4,124

 

 

(2,286)

Provision for loan losses

 

 

(2,363)

 

 

 -

 

 

(2,363)

Balance at December 31, 2017

 

$

1,854,100

 

$

216,021

 

$

2,070,121

 

176

(1)On October 31, 2014 the Company, completed the acquisition of GMFS. The Company has recognized the revenues and earnings related to its investment in GMFS for the period from the acquisition date to December 31, 2014 in its consolidated statements of operations.

28. Subsequent Events

In light of the strategic review and in order to reduce current market risk in its investment portfolio,the Company has recently begun the process of selling its seasoned, re-performing mortgage loans from its residential mortgage investments segment. A sale of these assets is expected to be completed early in the second quarter of 2016. Additionally, as part of the strategic review, the Company has made the decision to cease the purchase of newly originated residential mortgage loans as part of its mortgage conduit program and will begin the unwinding of the Company’s mortgage conduit business. Also, See Note 1 - Formation and Organization.

131

 

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

 

None.

 

Item 9A. Controls and Procedures.

 

A review and evaluation was performed by the Company’s management, including the Company’s Chief Executive Officer (the “CEO”) and Chief Financial Officer (the “CFO”), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), as of the end of the period covered by this annual report on Form 10-K. Based on that review and evaluation, the CEO and CFO have concluded that the Company’s current disclosure controls and procedures, as designed and implemented, were effective. Notwithstanding the foregoing, a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that it will detect or uncover failures within the Company to disclose material information otherwise required to be set forth in the Company’s periodic reports.

 

Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is defined in Rules 13a-15(f) and 15d-15(f) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. GAAP and includes those policies and procedures that:

 

·

pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company;

 

·

provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and

 

·

provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.

 

The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2015.2017. In making this assessment, the Company’s management used criteria set forth by the 2013 Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework.

 

Based on its assessment, the Company’s management believes that, as of December 31, 2015,2017, the Company’s internal control over financial reporting was effective based on those criteria.

 

There have been no changes to the Company’s internal control over financial reporting as defined in Exchange Act Rule 13a-15(f) during the quarter ended December 31, 20152017 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting pursuant to rules of the SEC that permit the Company to provide only management’s report in this annual report.

 

Item 9B.  Other Information.

 

None.None noted.

132

177


 

PART III

 

Item 10.  Directors, Executive Officers and Corporate Governance.

 

The information regarding the Company’sour executive officers required by Item 401 of Regulation S-K is located under Part I, Item 1 within the caption “Executive"Executive Officers of the Company”Company" of this annual report on Form 10-K.

 

The information regarding the Company’sour directors and certain other matters required by Item 401 of Regulation S-K is incorporated herein by reference to the Company’sour definitive proxy statement relating to itsour 2017 annual meeting of stockholders to be held on or about May 5, 2016 (the “Proxy Statement”"Proxy Statement"), to be filed with the SEC within 120 days after December 31, 2015.2017.

 

The information regarding compliance with Section 16(a) of the Exchange Act required by Item 405 of Regulation S-K is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2015.2017.

 

The information regarding the Company’sour Code of Business Conduct and Ethics required by Item 406 of Regulation S-K is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2015.2017.

 

The information regarding certain matters pertaining to the Company’sour corporate governance required by ItemItems 407(c)(3), (d)(4) and (d)(5) of Regulation S-K is incorporated by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2015.2017.

 

Item 11.  Executive Compensation.

 

The information regarding executive compensation and other compensation related matters required by Items 402 and 407(e)(4) and (e)(5) of Regulation S-K is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2015.2017.

 

Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

 

The tables on our equity compensation plan information and beneficial ownership of the Company required by Items 201(d) and 403 of Regulation S-K are incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2015.2017.

 

Item 13.  Certain Relationships and Related Transactions and Director Independence.

 

The information regarding transactions with related persons, promoters and certain control persons and director independence required by Items 404 and 407(a) of Regulation S-K is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2015.2017.

 

Item 14.  Principal Accountant Fees and Services.

 

The information concerning principal accounting fees and services and the Audit Committee’sCommittee's pre-approval policies and procedures required by Item 14 is incorporated herein by reference to the Proxy Statement to be filed with the SECU.S. Securities and Exchange Commission within 120 days after December 31, 2015.

133

PART IV2017.

 

178


PART IV

Item 15.  Exhibits and Financial Statement Schedules.

 

Documents filed as part of the report

 

The following documents are filed as part of this annual report on Form 10-K:

 

(1)

(1) Financial Statements:

 

TheOur consolidated financial statements, of the Company, together with the independent registered public accounting firm’sfirm's report thereon, are set forth on pages 82111 through 131176 of this annual report on Form 10-K and are incorporated herein by reference.  See Item 8, “Financial"Financial Statements and Supplementary Data," filed herewith, for a list of financial statements.

 

(2)

(2) Financial Statement Schedule:

 

All financial statement schedules have been omitted because the required information is not applicable or deemed not material, or the required information is presented in the consolidated financial statements and/or in the notes to consolidated financial statements filed in response to Item 8 of this annual report on Form 10-K.

 

(3)

(3)

Exhibits Files:

Exhibit
number

Exhibit description

3.1*

2.1*

Agreement and Plan of Merger, dated as of April 6, 2016, by and among ZAIS Financial Corp., ZAIS Financial Partners, L.P., ZAIS Merger Sub, LLC, Sutherland Asset Management Corporation and Sutherland Partners, L.P. (incorporated by reference to Exhibit 2.1 of the Registrant’s Current Report on Form 8-K filed April 7, 2016)

2.2*

Amendment No. 1 to the Agreement and Plan of Merger, dated as of May 9, 2016, by and among ZAIS Financial Corp., ZAIS Financial Partners, L.P., ZAIS Merger Sub, LLC, Sutherland Asset Management Corporation and Sutherland Partners, L.P. (incorporated by reference to Exhibit 2.1 of the Registrant's Current Report on Form 8-K filed May 9, 2016)

2.3*

Amendment No. 2 to the Agreement and Plan of Merger, dated as of August 4, 2016, by and among ZAIS Financial Corp., ZAIS Financial Partners, L.P., ZAIS Merger Sub, LLC, Sutherland Asset Management Corporation and Sutherland Partners, L.P. (incorporated by reference to Exhibit 2.3 of the Registrant's Current Report on Form 8-K filed November 4, 2016)

3.1*

Articles of Amendment and Restatement of ZAIS Financial Corp., incorporated (incorporated by reference to Exhibit 3.1 of the Registrant’s Form S-11, as amended (Registration No. 333-185938).

3.2*

3.2*

Articles Supplementary of ZAIS Financial Corp., incorporated (incorporated by reference to Exhibit 3.2 of the Registrant’s Form S-11, as amended (Registration No. 333-185938).

3.3*

3.3*

Articles of Amendment and Restatement of Sutherland Asset Management Corporation (incorporated by reference to Exhibit 3.1 of the Registrant’s Current Report on Form 8-K filed November 4, 2016)

3.4*

Amended and Restated Bylaws of ZAIS Financial Corp., incorporated (incorporated by reference to Exhibit 3.3 of the Registrant’s Annual Report on Form S-11, as amended (Registration No. 333-185938).10-K filed on March 13, 2014)

3.5

*

Amended and Restated Bylaws of Sutherland Asset Management Corporation (incorporated by reference to Exhibit 3.5 to the Registrant’s Form 10-K filed on March 15, 2017)

4.1*

4.1

*

Specimen Common Stock Certificate of ZAIS Financial Corp.Sutherland Asset Management Corporation (incorporated by reference to Exhibit 3.5 to the Registrant’s Form 10-K filed on March 15, 2017)

179


4.2*

Indenture, dated February 13, 2017, by and among ReadyCap Holdings, LLC, as issuer, Sutherland Asset Management Corporation, Sutherland Partners, L.P., incorporatedSutherland Asset I, LLC and ReadyCap Commercial, LLC, each as guarantors, and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.1 of the Registrant’sRegistrant's Current Report on Form S-11, as amended (Registration No. 333-185938).8-K filed February 13, 2017)

4.3*

4.2*

First Supplemental Indenture, dated November 25, 2013,February 13, 2017, by and among ZAIS FinancialReadyCap Holdings, LLC, as issuer, Sutherland Asset Management Corporation, Sutherland Partners, L.P., ZAIS Financial Corp.Sutherland Asset I, LLC, ReadyCap Commercial, LLC, each as guarantors and U.S. Bank National Association, as trustee and as collateral agent, including the form of 8.0% Exchangeable7.5% Senior Secured Notes due 20162022 and the related guarantee, incorporatedguarantees (incorporated by reference to Exhibit 4.14.2 of the Registrant’sRegistrant's Current Report on Form 8-K filed November 25, 2013.February 13, 2017)

4.4*

10.1*

Second Amended and Restated Investment Advisory Agreement,

Indenture, dated as of December 13, 2012,August 9, 2017, by and among ZAIS Financial Corp., ZAIS Financial Partners, L.P., ZAISbetween Sutherland Asset Management Corporation and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.2 of the Registrant's Current Report on Form 8-K filed August 9, 2017)

4.5*

First Supplemental Indenture, dated as of August 9, 2017, by and between Sutherland Asset Management Corporation and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.3 of the Registrant's Current Report on Form 8-K filed August 9, 2017)

10.1*

Master Repurchase Agreement, dated May 8, 2014, between Waterfall Commercial Depositor LLC, Sutherland Asset I, LLC ZAIS Asset II, LLC, ZAIS Asset III, LLC, ZAIS Asset IV, LLC and ZAIS REIT Management, LLC, incorporatedCitibank, N.A. (incorporated by reference to Exhibit 10.1 ofto the Registrant’s Form S-11, as amended (Registration No. 333-185938).10-K filed on March 15, 2017)

10.2*

10.2*

Amendment Number Four to the Master Repurchase Agreement, of Limited Partnership, dated as of July 29, 2011, of ZAIS Financial Partners, L.P., as amended on August 3, 2011, October 11, 2012,June 17, 2016, between Waterfall Commercial Depositor LLC, Sutherland Asset I, LLC and December 13, 2012, incorporatedCitibank, N.A. (incorporated by reference to Exhibit 10.2 of the Registrant’s Form S-11, as amended (Registration No. 333-185938).

10.3*Amendment to Agreement of Limited Partnership, dated as of February 13, 2013, of ZAIS Financial Partners, L.P., incorporated by reference to Exhibit 10.3 of the Registrant’s Form 10-K filed on March 28, 2013.15, 2017)

10.4*

10.3*

Registration Rights Agreement, dated August 3, 2011, among ZAIS Financial Corp., ZAIS Group, LLC and certain persons listed on Schedule I thereto, incorporated by reference to Exhibit 10.3 of the Registrant’s Form S-11, as amended (Registration No. 333-185938).
10.5*First Amended and Restated Registration Rights Agreement, dated October 11, 2012, among ZAIS Financial Corp., ZAIS Group, LLC and certain persons listed on Schedule I thereto, incorporated by reference to Exhibit 10.4 of the Registrant’s Form S-11, as amended (Registration No. 333-185938).

134

10.6*First Amended and Restated Registration Rights Agreement, dated December 13, 2012, among ZAIS Financial Corp., ZAIS REIT Management, LLC and certain persons listed on Schedule I thereto, incorporated by reference to Exhibit 10.5 of the Registrant’s Form S-11, as amended (Registration No. 333-185938).
10.7*Form of Indemnification Agreement, incorporated by reference to Exhibit 10.12 of the Registrant’s Form S-11, as amended (Registration No. 333-185938).
10.8*ZAIS Financial Corp. 2012 Equity Incentive Plan incorporated by reference to Exhibit 10.13 of the Registrant’s Form S-11, as amended (Registration No. 333-185938).
10.9*License Agreement, dated February 5, 2013, between ZAIS Financial Corp. and ZAIS Group, LLC.

 

10.10*Master Repurchase Agreement, dated as of May 30, 2013, between Citibank, N.A. and ZFC Trust, incorporated by reference to Exhibit 10.1 of the Registrant’s Form 8-K, filed on June 4, 2013.
10.11*Guaranty, dated as of May 30, 2013, by ZAIS Financial Corp. in favor of Citibank, N.A., incorporated by reference to Exhibit 10.2 of the Registrant’s Form 8-K, filed on June 4, 2013.
10.12*Master Mortgage Loan Sale Agreement (“MMLSA”), dated as of May 31, 2013, between Citigroup Global Markets Realty Corp. and ZFC Trust, incorporated by reference to Exhibit 10.5 of the Registrant’s Form 10-Q, filed on August 13, 2013.
10.13*Trade Confirmation pursuant to the MMLSA, dated as of May 31, 2013, between Citigroup Global Markets Realty Corp. and ZFC Trust, incorporated by reference to Exhibit 10.6 of the Registrant’s Form 10-Q, filed on August 13, 2013.
10.14*Trade Confirmation pursuant to the MMLSA, dated as of July 29, 2013, between Citigroup Global Markets Realty Corp. and ZFC Trust, incorporated by reference to Exhibit 10.3 of the Registrant’s Form 10-Q, filed on November 12, 2013.
10.15*Trade Confirmation pursuant to the MMLSA, dated as of August 29, 2013, between Citigroup Global Markets Realty Corp. and ZFC Trust, incorporated by reference to Exhibit 10.4 of the Registrant’s Form 10-Q, filed on November 12, 2013.
10.16*Registration Rights Agreement, dated November 25, 2013, among ZAIS Financial Partners, L.P., ZAIS Financial Corp. and Credit Suisse Securities (USA) LLC, incorporated by reference to Exhibit 10.1 of the Registrant’s Form 8-K, filed on November 25, 2013.
10.17*Purchase Agreement, dated November 19, 2013, by and among ZAIS Financial Partners, L.P., ZAIS Financial Corp., ZAIS REIT Management, LLC and Credit Suisse Securities (USA) LLC, incorporated by reference to Exhibit 10.28 of the Registrant’s Form S-11, filed on December 12, 2013.
10.18*Trade Confirmation, dated March 27, 2014, pursuant to the MMLSA, dated as of May 31, 2013, between Citigroup Global Markets Realty Corp. and ZFC Trust, incorporated by reference to Exhibit 10.3 of the Registrant’s Form 10-Q, filed May 14, 2014.
10.19*Amendment Number One, dated March 27, 2014, to the Pricing Side Letter, dated as of May 30, 2013, between Citibank, N.A. and ZFC Trust, incorporated by reference to Exhibit 10.4 of the Registrant’s Form 10-Q, filed May 14, 2014.
10.20*Amendment Number One, dated May 23, 2014, to the Master Loan Repurchase Agreement dated as of May 30, 2013 among ZFC Trust and Citibank, N.A., incorporated by reference to Exhibit 10.3 of the Registrant’s Form 10-Q, filed August 12, 2014.
10.21*

Agreement and Plan of Merger dated August 5, 2014, by and among ZFC Honeybee TRS, LLC, ZFC Honeybee Acquisitions, LLC, GMFS LLC, Honeyrep, LLC, solely in its capacity as the Securityholder Representative and ZAIS Financial Corp., as guarantor incorporated(incorporated by reference to Exhibit 2.1 to the Registrant’s Form 8-K (No. 001-35808), filed on August 6, 2014.2014)

10.22*
10.4

*

Master Loan and Security Agreement, dated June 27, 2014, by and among ReadyCap Lending, LLC, Sutherland Asset I, LLC, Sutherland Asset Management Corporation and JPMorgan Chase Bank, N.A. (incorporated by reference to Exhibit 10.4 to the Registrant’s Form 10-K filed on March 15, 2017)

10.5*

Termination Agreement, dated as of April 6, 2016, among ZAIS Financial Corp., ZAIS Financial Partners, L.P., ZAIS Asset I, LLC, ZAIS Asset II, LLC, ZAIS Asset III, LLC, ZAIS Asset IV, LLC, ZFC Funding, Inc., ZFC Trust, ZFC Trust TRS I, LLC, ZAIS REIT Management, LLC and Sutherland Asset Management Corporation (incorporated by reference to Exhibit 10.3 of the Registrant's Current Report on Form 8-K filed April 7, 2016)

10.6*

Amended and Restated Management Agreement, dated as of May 9, 2016, among ZAIS Financial Corp, ZAIS Financial Partners, L.P., ZAIS Merger Sub, LLC, Sutherland Asset I, LLC, Sutherland Asset II, LLC, SAMC REO 2013-01, LLC, ZAIS Asset I, LLC, ZAIS Asset II, LLC, ZAIS Asset III, LLC, ZAIS Asset IV, LLC, ZFC Funding, Inc., ZFC Trust, ZFC Trust TRS I, LLC, and Waterfall Asset Management, LLC (incorporated by reference to Exhibit 10.1 of the Registrant's Current Report on Form 8-K filed May 9, 2016)

10.7*

Master Repurchase Agreement, dated June 30, 2016, by and among Sutherland Asset I, LLC, Sutherland 2016-1 JPM Grantor Trust, Sutherland Asset Management Corporation and JPMorgan Chase Bank, N.A. (incorporated by reference to Exhibit 10.7 to the Registrant’s Form 10-K filed on March 15, 2017)

10.8*

Amended and Restated Agreement of Limited Partnership of Sutherland Partners, L.P., dated as of October 31, 2016, by and among Sutherland Asset Management Corporation, as General Partner, and the limited partners listed on Exhibit A thereto (incorporated by reference to Exhibit 10.1 of the Registrant's Current Report on Form 8-K filed November 4, 2016)

180


10.9*

Form of Indemnification Agreement (incorporated by reference to Exhibit 10.4 of the Registrant's Current Report on Form 8-K filed November 4, 2016)

10.10*

Sutherland Asset Management Corporation 2012 Equity Incentive Plan (incorporated by reference to Exhibit 10.5 of the Registrant's Current Report on Form 8-K filed November 4, 2016)

10.11*

Form of Restricted Stock Unit Award Agreement (incorporated by reference to Exhibit 10.2 of the Registrant's Form S-8 (Registration No. 333-216988))

10.12

Form of Restricted Stock Award Agreement

10.13*

Third Amended and Restated Master Repurchase Agreement, dated as of AugustFebruary 14, 2014,2017, by and among Credit Suisse First Boston Mortgage CapitalReadyCap Commercial, LLC, ZFC Funding, Inc.,Sutherland Warehouse Trust II, Sutherland Asset I, LLC, as sellers, U.S. Bank National Association, not in its individual capacity but solely as trustee for ZFC Funding Pass-Through Trust I,depository and paying agent and Deutsche Bank AG, Cayman Island Branch, as pass-through trust, and ZAIS Financial Corp., incorporatedbuyer (incorporated by reference to Exhibit 10.1 toof the Registrant’s Current Report on Form 8-K (No. 001-35808), filed on August 15, 2014.February 21, 2017)

10.14*

10.23*

Second Amended and Restated Guaranty, dated as of August 14, 2014, by ZAIS Financial Corp. in favor of Credit Suisse First Boston Mortgage Capital LLC, incorporatedOctober 31, 2016, from Sutherland Partners, L.P. to Deutsche Bank AG, Cayman Islands Branch (incorporated by reference to Exhibit 10.2 toof the Registrant’s Current Report on Form 8-K (No. 001-35808), filed on August 15, 2014.

February 21, 2017)

135

 

10.24*
21.1

Amendment No. 1 to Master Repurchase Agreement, dated as of June 29, 2015, incorporated by reference to Exhibit 10.1 to the

Registrant’s Form 8-K (No. 001-35808), filed on June 30, 2015.

21.1

List of Subsidiaries of ZAIS Financial Corp.Sutherland Asset Management Corporation

23.1

Consent of PricewaterhouseCoopers LLP.Deloitte & Touche LLP

31.1
24.1

Power of Attorney (included on signature page)

31.1

Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2

Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1**

Certification of the Chief Executive Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2**

Certification of the Chief Financial Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101.INS

XBRL Instance Document

101.SCH

101.SCH

XBRL Taxonomy Extension Scheme Document

101.CAL

XBRL Taxonomy Calculation Linkbase Document

101.DEF

XBRL Extension Definition Linkbase Document

101.LAB

101.LAB

XBRL Taxonomy Extension Linkbase Document

101.PRE

101.PRE

XBRL Taxonomy Presentation Linkbase Document

*Previously filed.
**This exhibit is being furnished rather than filed, and shall not be deemed incorporated by reference into any filing, in accordance with Item 601 of Regulation S-K.

136

*      Previously filed.

**    This exhibit is being furnished rather than filed, and shall not be deemed incorporated by reference into any filing, in accordance with Item 601 of Regulation S-K.

181


 

SIGNATURESSIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

ZAIS Financial Corp.Sutherland Asset Management Corporation

 

Date:  March 10, 201616, 2018

By:

/s/ Michael SzymanskiThomas E. Capasse

Michael Szymanski

Thomas E. Capasse

Chief Executive Officer, President and Director
(principal executive officer)
Date: March 10, 2016By: /s/ Donna Blank
Donna Blank
Chief Financial Officer and Treasurer
(principal financial officer)
Date: March 10, 2016By: /s/ Christian Zugel
Christian Zugel

Chairman of the Board and Chief Executive

Date: March 10, 2016By: /s/ Nisha Motani
Nisha Motani
Chief Accounting

Officer

(principal accounting officer)
Date: March 10, 2016By: /s/ Daniel Mudge
Daniel Mudge
Director
Date: March 10, 2016By:/s/ Marran Ogilvie
Marran Ogilvie
Director
Date: March 10, 2016By:/s/ David Holman
David Holman
Director

POWER OF ATTORNEY

Each person whose signature appears below constitutes and appoints Thomas E. Capasse, Jack J. Ross and Frederick C. Herbst, and each of them, with full power to act without the other, as such person’s true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign this Form 10-K and any and all amendments thereto, and to file the same, with exhibits and schedules thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing necessary or desirable to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his or her substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

Date:  March 16, 2018

137

By:

/s/ Thomas E. Capasse

Thomas E. Capasse

Chairman of the Board and Chief Executive

Officer

(Principal Executive Officer)

Date:  March 16, 2018

By:

/s/ Jack J. Ross

Jack J. Ross

President and Director

Date:  March 16, 2018

By:

/s/ Frederick C. Herbst

Frederick C. Herbst

Chief Financial Officer

(Principal Accounting and Financial Officer)

Date:  March 16, 2018

By:

/s/ Frank P. Filipps

Frank P. Filipps

Director

Date:  March 16, 2018

By:

/s/ Todd M. Sinai

Todd M. Sinai

Director

Date:  March 16, 2018

By:

/s/ J. Mitchell Reese

J. Mitchell Reese

Director

Date:  March 16, 2018

By:

/s/ David Holman

David Holman

Director

 

182