Business Context and Reporting Period
This Form 10-Q was filed by ZAIS Financial Corp. for the quarter and nine months ended September 30, 2016. The request identifies Ready Capital Corp., but the filing itself identifies the registrant as ZAIS Financial Corp.; the corporate identity and subsequent merger history should be verified.
The company operated two segments: residential mortgage investments and residential mortgage banking through GMFS, LLC. It was externally managed by ZAIS REIT Management, LLC, elected REIT status, and had 8,836,902 common shares outstanding as of October 24, 2016. GMFS had 260 employees at September 30, 2016.
Key Financial Metrics
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Interest income | $3.0 million | $9.7 million | $16.9 million | $28.9 million |
| Interest expense | $3.1 million | $4.7 million | $12.0 million | $14.2 million |
| Net interest income | $(0.1) million | $4.9 million | $4.9 million | $14.7 million |
| Non-interest income | $16.8 million | $8.9 million | $34.0 million | $35.8 million |
| Total expenses | $14.8 million | $12.9 million | $45.3 million | $38.8 million |
| Net income attributable to common stockholders | $4.1 million | $(6.0) million | $33,938 | $386,845 |
| Diluted earnings per share | $0.46 | $(0.76) | Less than $0.01 | $0.05 |
| Core Earnings | $(0.03) million | $4.8 million | $(0.7) million | $12.8 million |
Q3 2016 net income was $4.2 million, compared with a $6.7 million net loss in Q3 2015. The filing does not provide a consolidated operating margin; net income divided by total reported income is not presented as a company-defined margin measure.
Balance Sheet, Liquidity and Leverage
- Total assets were $588.6 million at September 30, 2016, down from $775.1 million at December 31, 2015.
- Cash and cash equivalents were $185.0 million, including approximately $70.0 million of Treasury bills; restricted cash was $4.2 million.
- Total liabilities were $421.8 million and total equity was $166.8 million. Book value per common share and OP unit was $18.73, compared with $19.98 at year-end 2015.
- Reported leverage was 2.02x, compared with 2.97x at December 31, 2015.
- Debt and financing included $125.7 million of warehouse lines, $70.0 million of Treasury securities repurchase agreements, $15.0 million under the Credit Suisse loan repurchase facility, $68.1 million of securities repurchase agreements, and $57.4 million carrying value of Exchangeable Senior Notes.
- Warehouse and repurchase facilities had aggregate availability of $200.0 million for the mortgage banking platform. Management stated that significant debt covenants were satisfied and all margin calls had been met.
Cash Flow and Portfolio Metrics
- Operating cash flow was negative $23.6 million for the nine months ended September 30, 2016, compared with negative $15.4 million in the prior-year period.
- Investing activities provided $390.4 million, primarily reflecting proceeds from the sale of seasoned, re-performing mortgage loans.
- Financing activities used $202.7 million, including $281.8 million of net repayments under loan repurchase facilities and $10.7 million of dividends and OP-unit distributions.
- Mortgage loans held for investment at fair value were $40.0 million, compared with $397.7 million at year-end 2015. Mortgage loans held for sale were $134.3 million.
- Real estate securities were $84.8 million and Other Investment Securities were $13.9 million. Mortgage servicing rights were $50.2 million, supported by $5.1 billion of unpaid principal balance.
- Mortgage banking activities generated $15.9 million in Q3 and $43.1 million for the nine months. GMFS originated $625.8 million and sold $605.5 million of mortgage loans during Q3.
Material Changes Versus Prior Comparable Period
- The company sold its seasoned, re-performing mortgage loans and related REO on May 26, 2016. The portfolio had an unpaid principal balance of $430.7 million; net proceeds after repayment of the Citi facility were $94.6 million. The sale materially reduced interest income and investment-portfolio leverage.
- Net interest income fell by $5.0 million in Q3 and $9.8 million for the nine-month period, primarily because of the loan portfolio sale and lower RMBS balances.
- Other gains shifted from a $8.0 million loss in Q3 2015 to a $4.0 million gain in Q3 2016, reflecting tighter credit spreads, lower rates, and the absence of the prior-year loan valuation loss.
- Mortgage banking income increased, but higher production-related compensation and taxes offset part of the benefit. Salaries, commissions and benefits rose to $9.8 million in Q3 from $7.7 million.
- MSR fair value declined by $1.2 million in Q3 and $15.5 million year to date, although the MSR balance increased from $48.2 million at year-end 2015 to $50.2 million.
- Transaction costs increased materially in connection with the proposed Sutherland merger, contributing to a $6.5 million increase in year-to-date total expenses.
- The company issued 866,016 common shares to satisfy the redemption of OP units, increasing common shares outstanding from 7,970,886 at year-end 2015 to 8,836,902.
Guidance, Outlook, Commentary and Risks
Sutherland Merger and Tender Offer
Stockholders of ZAIS and Sutherland approved the proposed merger. The final exchange ratio was 0.8356 ZAIS shares or OP units for each Sutherland share or unit, and closing was expected on or after October 31, 2016, subject to remaining conditions. Upon closing, the combined company was expected to be renamed Sutherland Asset Management Corporation and managed by Waterfall Asset Management, LLC.
The company commenced a tender offer for up to 4,185,497 shares at $15.37 per share, with potential cash funding of approximately $64.3 million. A termination fee of $8.0 million would be payable to the existing advisor upon closing, and the filing also identifies $4.1 million of GMFS intangible assets and $0.3 million of merger-related litigation expenses and reserves as adjustments used in determining the tender price.
Risks and Contingencies
- GMFS faces potential claims relating to representations and warranties on historical loan sales. The recorded loan indemnification reserve was $2.6 million, and an escrow account held $4.0 million. Management could not estimate the probability or range of potential losses; losses exceeding available protections could materially affect results.
- A merger-related class action was resolved except for possible attorneys' fees, for which the company could not estimate an amount.
- The Exchangeable Senior Notes had $57.5 million principal outstanding and matured November 15, 2016. If the merger did not close, management intended to settle the obligation with cash.
- The Credit Suisse loan repurchase facility matured November 11, 2016, had been reduced to $15.0 million, and had no remaining lender commitment.
- Repurchase and warehouse financing is subject to renewal risk, collateral haircuts and margin calls. Declines in asset values or higher interest rates could require additional collateral or deleveraging.
- A 50-basis-point increase in LIBOR was estimated to increase quarterly interest expense on variable-rate debt by approximately $0.2 million, assuming no balance-sheet changes.
- MSR values are sensitive to prepayment speeds, interest rates, servicing costs, defaults and loss severity. Management expected Louisiana flooding could increase delinquencies and forbearance but did not expect a significant operational impact.
- The company depended on its external advisor for essential investment and administrative services and was required to distribute at least 90% of annual REIT taxable income, limiting retained capital.
Important Facts for Investors to Verify
- Confirm the registrant’s identity and corporate successor history, because the filing is for ZAIS Financial Corp., while the request references Ready Capital Corp.
- Verify the closing, accounting treatment and final capitalization of the Sutherland merger, including the tender offer, advisor termination fee and Waterfall management agreement.
- Verify repayment or refinancing of the Exchangeable Senior Notes and the Credit Suisse facility after their November 2016 maturities.
- Assess whether the reduced investment portfolio and negative Core Earnings were temporary effects of the strategic asset sale or reflected a lasting change in earnings capacity.
- Review the valuation sensitivity of the $50.2 million MSR portfolio and the $84.8 million non-Agency RMBS portfolio.
- Monitor GMFS loan indemnification claims, the $2.6 million reserve, the $4.0 million escrow and any related litigation developments.
- Reconcile reported liquidity with collateral requirements, financing renewals, the tender offer funding requirement and quarterly dividend obligations.