Filing Scope and Business Context
This Form 10-Q is for ZAIS Financial Corp., not Ready Capital Corp., for the quarter and six months ended June 30, 2015. The filing describes a Maryland REIT that originates, acquires, finances, sells, services and manages residential mortgage loans, invests in non-Agency RMBS and owns mortgage servicing rights. Its externally managed operations include the GMFS mortgage-banking platform acquired in October 2014.
The company operated two segments during 2015: residential mortgage loans held for investment and residential mortgage banking. The filing states that it had 7,970,886 common shares outstanding as of August 4, 2015.
Financial Results and Key Metrics
| Metric | Q2 2015 | Q2 2014 | Six months 2015 | Six months 2014 |
|---|---|---|---|---|
| Interest income | $9.6 million | $10.8 million | $19.2 million | $20.3 million |
| Interest expense | $4.7 million | $4.4 million | $9.5 million | $8.3 million |
| Net interest income | $4.8 million | $6.4 million | $9.8 million | $12.0 million |
| Non-interest income | $17.4 million | None reported | $26.8 million | None reported |
| Net income | $6.7 million | $25.9 million | $7.1 million | $28.4 million |
| Net income attributable to common stockholders | $6.1 million | $23.2 million | $6.4 million | $25.4 million |
| Diluted EPS | $0.65 | $2.47 | $0.79 | $2.79 |
| Core Earnings | $3.4 million | $3.2 million | $8.0 million | $4.7 million |
| Core Earnings per diluted share | $0.38 | $0.36 | $0.89 | $0.53 |
Q2 2015 revenue was driven substantially by the GMFS platform: mortgage banking activities contributed $12.1 million, loan servicing fee income contributed $1.7 million, and the change in fair value of MSRs contributed $3.6 million. The effective tax rate was 30.18% in Q2 and 27.88% for the six-month period, primarily reflecting taxes at taxable REIT subsidiaries.
Balance Sheet, Liquidity and Leverage
- Total assets were $782.6 million at June 30, 2015, compared with $792.4 million at December 31, 2014.
- Total equity was $193.4 million, including $173.3 million attributable to ZAIS stockholders and $20.2 million of non-controlling interests.
- Cash was $28.6 million and restricted cash was $2.3 million.
- Investment assets included $406.1 million of mortgage loans held for investment, $131.4 million of non-Agency RMBS, $104.8 million of mortgage loans held for sale and $42.7 million of MSRs.
- Debt and financing liabilities included $96.1 million of warehouse lines, $296.2 million of loan repurchase facilities, $86.2 million of securities repurchase agreements and $56.0 million carrying value of Exchangeable Senior Notes.
- Management reported a 2.76x leverage ratio at June 30, 2015, versus 2.84x at year-end 2014, and book value per common share and OP unit of $21.74 versus $21.73.
- Warehouse facilities had $165.0 million of total availability and $96.1 million outstanding. Loan repurchase facilities had $425.0 million of total facility size, $175.0 million committed and $296.2 million outstanding.
- The company stated that it was in compliance with significant debt covenants and had satisfied all margin calls during the periods presented.
Cash Flow and Distributions
- Six-month operating cash flow was negative $11.4 million, compared with negative $1.8 million in the prior-year period.
- Investing activities provided $27.4 million, versus $91.0 million used in the prior-year period.
- Financing activities used $21.2 million, versus $63.3 million provided in the prior-year period.
- Cash declined by $5.2 million to $28.6 million during the first six months.
- The company declared quarterly dividends of $0.40 per common share for both March and June 2015, or $0.80 per share for the six-month period.
Material Changes Versus Prior Comparable Period
- GAAP net income fell sharply, from $25.9 million to $6.7 million in Q2 and from $28.4 million to $7.1 million for the six months. The prior-year results benefited from large unrealized gains on mortgage loans held for investment: $22.0 million in Q2 2014 and $22.7 million in the first six months of 2014, compared with $1.2 million and $0.05 million in 2015.
- Net interest income declined 25% in Q2 and 19% for the six-month period as RMBS assets were reduced and capital was reallocated toward whole loans and the GMFS platform. Higher financing balances also increased interest expense.
- Mortgage banking and servicing activities were new contributors in 2015 following the GMFS acquisition. GMFS originated $502.4 million of loans and sold $512.0 million during Q2.
- Q2 operating expenses increased to $13.7 million from $3.2 million, primarily because GMFS added salaries, commissions, benefits and other operating costs. Six-month expenses increased to $25.9 million from $7.3 million.
- Non-Agency RMBS fair value declined to $131.4 million from $148.6 million at year-end 2014, while MSRs increased to $42.7 million from $33.4 million and mortgage loans held for sale increased to $104.8 million from $97.7 million.
- The company’s non-GAAP Core Earnings increased despite lower GAAP earnings, reflecting the exclusion of fair-value volatility and other non-core items.
Outlook, Commentary, Risks and Unusual Items
- Management reported that interest rates moved higher during Q2, reducing refinancing activity and potentially reducing mortgage origination volumes in subsequent periods. Higher rates may increase borrowing costs, reduce the value of fixed-rate assets and affect mortgage banking production, while generally supporting MSR values.
- A 50-basis-point increase in LIBOR was estimated to increase quarterly interest expense by approximately $0.6 million on $461.2 million of variable-rate debt, assuming no balance-sheet changes.
- Liquidity depends heavily on warehouse lines, repurchase facilities and other secured financing. Borrowings are subject to collateral haircuts, margin calls, renewals and counterparty credit risk.
- The $57.5 million aggregate principal amount of 8.0% Exchangeable Senior Notes matures in November 2016 and has an effective interest rate of 10.2%.
- The GMFS acquisition includes contingent consideration estimated at $12.3 million at June 30, 2015, up from $11.4 million at acquisition. Additional earn-out payments may reach $20 million, subject to profitability and production targets.
- GMFS faces a potential counterparty claim related to representations and warranties on mortgage loans sold servicing released between approximately 1999 and 2006. The company stated that it could not reasonably estimate probable losses and that losses exceeding existing reserves and contingent consideration could be material.
- The loan indemnification reserve was $2.9 million at June 30, 2015. Management said the reasonably possible loss above the reserve was not considered material, but the separate counterparty matter remained unquantified.
- Mortgage loans held for investment, RMBS and MSRs are substantially valued using models or other Level 3 inputs. Fair values are sensitive to prepayments, defaults, loss severity, home prices, discount rates and servicing costs.
- The company intends to maintain REIT status, which generally requires distribution of at least 90% of annual REIT taxable income. Failure to qualify could result in material tax consequences.
- Subsequent to quarter-end, GMFS amended a warehouse line to increase availability from $50 million to $60 million; the facility expires September 28, 2015.
Investor Verification Priorities
- Verify the issuer identity: the supplied filing is for ZAIS Financial Corp., whereas the request identifies Ready Capital Corp.
- Reconcile GAAP earnings, Core Earnings and dividend coverage, particularly the effect of fair-value gains and losses, MSR valuation changes, contingent consideration and acquisition-related expenses.
- Review the maturity, renewal and covenant terms of warehouse and repurchase facilities, including collateral haircuts and potential margin-call requirements.
- Assess the potential magnitude and indemnification coverage of the GMFS representations-and-warranties claim, which was not quantifiable at the filing date.
- Evaluate sensitivity to LIBOR, mortgage prepayments, defaults, home prices and MSR assumptions, given the large Level 3 asset balance.
- Confirm the company’s ability to preserve REIT qualification while funding operations and paying required distributions.