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Section 1: 10-Q (10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10‑Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2017

Commission File Number:  001‑35808

SUTHERLAND ASSET MANAGEMENT CORPORATION

(Exact Name of Registrant as Specified in its Charter)

 

 

Maryland

90‑0729143

(State or Other Jurisdiction of Incorporation or Organization)

(IRS Employer Identification No.)

 

1140 Avenue of the Americas, 7th Floor, New York, NY 10036

(Address of Principal Executive Offices, Including Zip Code)

(212) 257-4600

(Registrant's Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ☒   No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S‑T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ☒   No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

 

 

 

 

Large accelerated filer ☐

Accelerated filer ☒

Non-accelerated filer ☐

Smaller reporting company ☐

 

Emerging growth company  ☒

 

(Do not check if a smaller reporting company)

 

 

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 ☐   No ☒

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

The Company has 31,996,440 shares of common stock, par value $0.0001 per share, outstanding as of October 31, 2017.

 

 

 


 

Table of Contents

TABLE OF CONTENTS

 

 

 

 

PART I. 

FINANCIAL INFORMATION

3

Item 1. 

Financial Statements

3

Item 1A. 

Forward-Looking Statements

65

Item 2. 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

65

Item 3. 

Quantitative and Qualitative Disclosures about Market Risk

94

Item 4. 

Controls and Procedures

97

PART II. 

OTHER INFORMATION

98

Item 1. 

Legal Proceedings

98

Item 1A. 

Risk Factors

98

Item 2. 

Unregistered Sales of Equity Securities and Use of Proceeds

98

Item 3. 

Defaults Upon Senior Securities

98

Item 4. 

Mine Safety Disclosures

98

Item 5. 

Other Information

98

Item 6. 

Exhibits

99

SIGNATURES

101

EXHIBIT 31.1 CERTIFICATIONS

 

EXHIBIT 31.2 CERTIFICATIONS

 

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

 

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

 

 

 

 

2


 

Table of Contents

PART I.  FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

SUTHERLAND ASSET MANAGEMENT CORPORATION

unaudited CONSOLIDATED BALANCE SHEETS

 

 

 

 

 

 

 

 

(In Thousands)

    

September 30, 2017

    

December 31, 2016

Assets

 

 

 

 

 

 

Cash and cash equivalents

 

$

70,590

 

$

59,566

Restricted cash

 

 

16,057

 

 

20,190

Short-term investments

 

 

99,994

 

 

319,984

Loans, net (including $158,393 and $81,592 held at fair value)

 

 

892,896

 

 

1,011,121

Loans, held for sale, at fair value

 

 

200,318

 

 

181,797

Mortgage backed securities, at fair value

 

 

41,371

 

 

32,391

Loans eligible for repurchase from Ginnie Mae

 

 

101,408

 

 

137,986

Derivative instruments

 

 

4,131

 

 

5,785

Servicing rights (including $68,815 and $61,376 held at fair value)

 

 

89,372

 

 

83,854

Receivable from third parties

 

 

6,756

 

 

7,220

Other assets

 

 

35,356

 

 

54,277

Assets of consolidated VIEs

 

 

944,894

 

 

691,096

Total Assets

 

$

2,503,143

 

$

2,605,267

Liabilities

 

 

 

 

 

 

Secured short-term borrowings

 

 

522,767

 

 

927,462

Promissory note, net

 

 

6,494

 

 

7,378

Securitized debt obligations of consolidated VIEs, net

 

 

680,282

 

 

492,942

Convertible note, net

 

 

109,414

 

 

 —

Senior secured note, net

 

 

138,074

 

 

 —

Guaranteed loan financing

 

 

313,388

 

 

390,555

Contingent consideration

 

 

9,037

 

 

14,487

Liabilities for loans eligible for repurchase from Ginnie Mae

 

 

101,408

 

 

137,986

Derivative instruments

 

 

358

 

 

643

Dividends payable

 

 

12,289

 

 

11,505

Accounts payable and other accrued liabilities

 

 

54,579

 

 

70,207

Total Liabilities

 

$

1,948,090

 

$

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

 

 

539,664

 

 

513,295

Deficit

 

 

(3,952)

 

 

(201)

Total Sutherland Asset Management Corporation equity

 

 

535,715

 

 

513,097

Non-controlling interests

 

 

19,338

 

 

39,005

Total Stockholders’ Equity

 

$

555,053

 

$

552,102

Total Liabilities and Stockholders’ Equity

 

$

2,503,143

 

$

2,605,267

 

See Notes To Unaudited Consolidated Financial Statements

3


 

Table of Contents

SUTHERLAND ASSET MANAGEMENT CORPORATION

Unaudited CONSOLIDATED STATEMENTS OF INCOME

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30, 

 

Nine Months Ended September 30, 

(In Thousands, except share data)

    

2017

    

2016

    

2017

    

2016

Interest income

 

$

35,038

 

$

31,890

 

$

102,169

 

$

104,282

Interest expense

 

 

(19,908)

 

 

(14,097)

 

 

(53,579)

 

 

(42,043)

Net interest income before provision for loan losses

 

$

15,130

 

$

17,793

 

$

48,590

 

$

62,239

Provision for loan losses

 

 

(466)

 

 

(488)

 

 

(1,857)

 

 

(4,689)

Net interest income after provision for loan losses

 

$

14,664

 

$

17,305

 

$

46,733

 

$

57,550

Non-interest income (expense)

 

 

 

 

 

 

 

 

 

 

 

 

Gains on residential mortgage banking activities, net of variable loan expenses

 

 

10,735

 

 

 —

 

 

32,229

 

 

 —

Other income

 

 

1,853

 

 

1,729

 

 

4,281

 

 

5,335

Servicing income, net of amortization and impairment of $976 and $5,252 for the three and nine months ended September 30, 2017, and $1,850 and $6,079 for the three and nine months ended September 30, 2016, respectively

 

 

6,134

 

 

1,661

 

 

16,208

 

 

4,420

Employee compensation and benefits

 

 

(13,715)

 

 

(4,822)

 

 

(40,630)

 

 

(14,005)

Allocated employee compensation and benefits from related party

 

 

(990)

 

 

(900)

 

 

(3,010)

 

 

(2,700)

Professional fees

 

 

(2,151)

 

 

(3,120)

 

 

(6,334)

 

 

(8,573)

Management fees – related party

 

 

(2,034)

 

 

(1,793)

 

 

(6,018)

 

 

(5,464)

Loan servicing expense

 

 

(3,388)

 

 

(1,830)

 

 

(7,513)

 

 

(3,889)

Other operating expenses

 

 

(7,447)

 

 

(3,373)

 

 

(19,183)

 

 

(11,185)

Total non-interest income (expense)

 

$

(11,003)

 

$

(12,448)

 

$

(29,970)

 

$

(36,061)

Net realized gain on financial instruments

 

 

5,695

 

 

2,454

 

 

13,151

 

 

3,720

Net unrealized gain on financial instruments

 

 

2,678

 

 

3,557

 

 

4,933

 

 

5,800

Income from continued operations before provision for income (taxes) benefit

 

$

12,034

 

$

10,868

 

$

34,847

 

$

31,009

Provision for income (taxes) benefit

 

 

340

 

 

(1,297)

 

 

(1,763)

 

 

(3,326)

Net income from continuing operations

 

$

12,374

 

$

9,571

 

$

33,084

 

$

27,683

Discontinued operations

 

 

 

 

 

 

 

 

 

 

 

 

Loss from discontinued operations (including gain on disposal of $267 in the nine months ended September 30, 2016)

 

 

 —

 

 

 —

 

 

 —

 

 

(576)

Income tax benefit

 

 

 —

 

 

 —

 

 

 —

 

 

225

Loss from discontinued operations

 

 

 —

 

 

 —

 

 

 —

 

 

(351)

Net income

 

$

12,374

 

$

9,571

 

$

33,084

 

$

27,332

Less: Net income attributable to non-controlling interest

 

 

533

 

 

777

 

 

1,891

 

 

2,217

Net income attributable to Sutherland Asset Management Corporation

 

$

11,841

 

$

8,794

 

$

31,193

 

$

25,115

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per basic common share

 

 

 

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

0.37

 

$

0.34

 

$

1.00

 

$

0.98

Discontinued operations

 

 

 —

 

 

 —

 

 

 —

 

 

(0.01)

Earnings per basic common share

 

$

0.37

 

$

0.34

 

$

1.00

 

$

0.97

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per diluted common share

 

 

 

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

0.37

 

$

0.34

 

$

1.00

 

$

0.98

Discontinued operations

 

$

 —

 

$

 —

 

$

 —

 

$

(0.01)

Earnings per diluted common share

 

$

0.37

 

$

0.34

 

$

1.00

 

$

0.97

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted-average shares outstanding

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

32,026,494

 

 

25,870,485

 

 

31,120,476

 

 

25,870,485

Diluted

 

 

32,028,980

 

 

25,870,485

 

 

31,121,449

 

 

25,870,485

 

 

 

 

 

 

 

 

 

 

 

 

 

Dividends declared per share of common stock

 

$

0.37

 

$

0.45

 

$

1.11

 

$

0.90

 

See Notes To Unaudited Consolidated Financial Statements

 

 

 

 

 

 

 

 

4


 

Table of Contents

 

 

SUTHERLAND ASSET MANAGEMENT CORPORATION

Unaudited CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Retained

 

Total Sutherland

 

 

 

 

 

 

 

Common Stock

 

Preferred Stock

 

Additional Paid-

 

Earnings

 

Asset Management

 

Non-controlling

 

Total Stockholders'

(in thousands, except share data)

    

Shares

    

Par Value

    

Shares

    

Par Value

    

In Capital

    

(Deficit)

    

Corporation equity

    

Interests

    

Equity

Balance at January 1, 2016

 

25,739,847

 

$

 2

 

125

 

$

125

 

$

447,093

 

$

(5,899)

 

$

441,321

 

$

38,892

 

$

480,213

Dividend declared on common stock ($0.90 per share)

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

(23,484)

 

 

(23,484)

 

 

 —

 

 

(23,484)

Dividend reinvestment in common stock

 

103,440

 

 

 1

 

 —

 

 

 —

 

 

1,806

 

 

 —

 

 

1,807

 

 

 —

 

 

1,807

Incentive shares issued

 

27,199

 

 

 —

 

 —

 

 

 —

 

 

482

 

 

 —

 

 

482

 

 

 —

 

 

482

Dividend declared on preferred stock

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

(8)

 

 

(8)

 

 

 —

 

 

(8)

Dividend declared on OP units

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

(2,072)

 

 

(2,072)

Dividend reinvestment in OP units

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

359

 

 

359

Net Income

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

25,115

 

 

25,115

 

 

2,217

 

 

27,332

Balance at September 30, 2016

 

25,870,486

 

$

 3

 

125

 

$

125

 

$

449,381

 

$

(4,276)

 

$

445,233

 

$

39,396

 

$

484,629

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Retained

 

Total Sutherland

 

 

 

 

 

 

 

Common Stock

 

Preferred Stock

 

Additional Paid-

 

Earnings

 

Asset Management

 

Non-controlling

 

Total Stockholders'

(in thousands, except share data)

    

Shares

    

Par Value

    

Shares

    

Par Value

    

In Capital

    

(Deficit)

    

Corporation equity

    

Interests

    

Equity

Balance at January 1, 2017

 

30,549,084

 

$

 3

 

 —

 

$

 —

 

$

513,295

 

$

(201)

 

$

513,097

 

$

39,005

 

$

552,102

Dividend declared on common stock ($1.11 per share)

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

(34,944)

 

 

(34,944)

 

 

 —

 

 

(34,944)

Dividend declared on OP units

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

(1,811)

 

 

(1,811)

Shares issued in exchange of litigation settlement

 

275,862

 

 

 —

 

 —

 

 

 —

 

 

4,000

 

 

 —

 

 

4,000

 

 

 —

 

 

4,000

Equity component of 2017 convertible note issuance

 

 —

 

 

 —

 

 —

 

 

 —

 

 

2,147

 

 

 —

 

 

2,147

 

 

 —

 

 

2,147

Distributions, net

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

(34)

 

 

(34)

Stock-based compensation

 

 —

 

 

 —

 

 —

 

 

 —

 

 

509

 

 

 —

 

 

509

 

 

 —

 

 

509

Conversion of OP units into common stock

 

1,171,494

 

 

 —

 

 —

 

 

 —

 

 

19,713

 

 

 

 

 

19,713

 

 

(19,713)

 

 

 —

Net Income

 

 —

 

 

 —

 

 —

 

 

 —

 

 

 —

 

 

31,193

 

 

31,193

 

 

1,891

 

 

33,084

Balance at September 30, 2017

 

31,996,440

 

$

 3

 

 —

 

$

 —

 

$

539,664

 

$

(3,952)

 

$

535,715

 

$

19,338

 

$

555,053

 

See Notes To Unaudited Consolidated Financial Statements

 

5


 

Table of Contents

SUTHERLAND ASSET MANAGEMENT CORPORATION

Unaudited CONSOLIDATED STATEMENT OF CASH FLOWS

 

 

 

 

 

 

 

 

 

 

Nine Months Ended September 30, 

(In Thousands)

   

2017

  

2016

Cash Flows From Operating Activities:

 

 

 

 

 

 

Net income

 

$

33,084

 

$

27,332

Less: Loss from discontinued operations

 

 

 —

 

 

(351)

Net income from continuing operations

 

 

33,084

 

 

27,683

Adjustments to reconcile net income to net cash provided  (used in) operating activities:

 

 

 

 

 

 

Discount accretion and premium amortization of financial instruments, net

 

 

(7,372)

 

 

(14,656)

Amortization of guaranteed loan financing, deferred financing costs, and intangible assets

 

 

15,266

 

 

14,749

Provision for loan losses

 

 

1,857

 

 

4,689

Charge off of real estate acquired in settlement of loans

 

 

746

 

 

912

Decrease in repair and denial reserve

 

 

(289)

 

 

(1,222)

Purchase of short-term investments and trading securities

 

 

(839,425)

 

 

(749,805)

Proceeds from sale of short-term investments and trading securities

 

 

1,059,821

 

 

749,995

Net settlement of derivative instruments

 

 

(1,085)

 

 

(1,428)

Purchase of loans, held for sale, at fair value

 

 

(11,195)

 

 

 —

Origination of loans, held for sale, at fair value

 

 

(1,882,626)

 

 

(200,574)

Proceeds from disposition and principal payments of loans, held for sale, at fair value

 

 

1,943,508

 

 

190,674

Gain on sale of mortgages held for sale included in Gains on residential mortgage banking activities, net of variable loan expenses

 

 

(49,806)

 

 

 —

Loss on derivatives included in Gains on residential mortgage banking activities, net of variable loan expenses

 

 

2,043

 

 

 —

Creation of new mortgage servicing rights, net of payoffs

 

 

(11,392)

 

 

 —

Net realized gains on financial instruments

 

 

(13,151)

 

 

(3,720)

Net unrealized losses on financial instruments

 

 

(4,933)

 

 

(5,800)

Net changes in operating assets and liabilities

 

 

 

 

 

 

Assets of consolidated VIEs (excluding loans, net) , accrued interest and due from servicers

 

 

10,607

 

 

2,918

Receivable from third parties

 

 

464

 

 

801

Other assets

 

 

12,293

 

 

(8,179)

Accounts payable and other accrued liabilities

 

 

(10,210)

 

 

6,524

Net cash provided by operating activities

 

 

248,205

 

 

13,561

Net cash used in operating activities of discontinued operations

 

 

 —

 

 

(3,190)

Cash Flow From Investing Activities:

 

 

 

 

 

 

Origination of loans

 

 

(347,988)

 

 

(215,204)

Purchase of loans

 

 

(78,317)

 

 

(89,011)

Purchase of mortgage backed securities, at fair value

 

 

(14,448)

 

 

(17,388)

Payment of liability under participation agreements

 

 

(642)

 

 

(1,155)

Proceeds from disposition and principal payment of loans

 

 

303,304

 

 

330,006

Proceeds from sale and principal payment of mortgage backed securities, at fair value

 

 

7,415

 

 

197,147

Proceeds from sale of real estate

 

 

1,775

 

 

4,724

Decrease in restricted cash

 

 

(12,234)

 

 

(720)

Net cash (used in) provided by investing activities

 

 

(141,135)

 

 

208,399

Cash Flows From Financing Activities:

 

 

 

 

 

 

Proceeds from secured short-term borrowings

 

 

3,692,370

 

 

4,194,488

Proceeds from issuance of securitized debt obligations of consolidated VIEs

 

 

241,359

 

 

 —

Proceeds from promissory note

 

 

 —

 

 

9,164

Proceeds from senior secured note offering

 

 

141,917

 

 

 —

Proceeds from convertible note issuance

 

 

115,000

 

 

 —

Payment of secured short-term borrowings

 

 

(4,097,065)

 

 

(4,204,158)

Payment of securitized debt obligations of consolidated VIEs

 

 

(50,265)

 

 

(88,966)

Payment of guaranteed loan financing

 

 

(87,140)

 

 

(94,471)

Payment of promissory note

 

 

(884)

 

 

(124)

Payment of deferred financing costs

 

 

(15,263)

 

 

(1,050)

Payment of offering costs

 

 

(70)

 

 

 —

Dividend payments

 

 

(35,971)

 

 

(36,764)

Distributions

 

 

(34)

 

 

 —

Net cash used in financing activities

 

 

(96,046)

 

 

(221,881)

Net increase (decrease) in cash and cash equivalents

 

 

11,024

 

 

(3,111)

Cash and cash equivalents at beginning of period

 

 

59,566

 

 

41,569

Cash and cash equivalents at end of period

 

$

70,590

 

$

38,458

 

 

 

 

 

 

 

Supplemental disclosure of operating cash flow

 

 

 

 

 

 

Cash paid for interest

 

$

46,760

 

$

38,667

Cash paid for income taxes

 

$

2,503

 

$

5,918

Stock-based compensation

 

$

509

 

$

 —

 

 

 

 

 

 

 

Supplemental disclosure of non-cash investing activities

 

 

 

 

 

 

Loans transferred from Loans, held at fair value to Loans, held-for-investment

 

$

40,905

 

$

 —

Loans transferred from Loans, net to Loans, held for sale, at fair value

 

$

5,940

 

$

11,350

 

 

 

 

 

 

 

Supplemental disclosure of non-cash financing activities

 

 

 

 

 

 

Shares issued in exchange of litigation settlement

 

$

4,000

 

$

 —

Incentive shares issued

 

$

 —

 

$

482

Dividend reinvestment in common stock

 

$

 —

 

$

1,807

Dividend reinvestment in operating partnership units

 

$

 —

 

$

359

 

 

 

 

 

 

 

 

See Notes to Unaudited Consolidated Financial Statements

 

 

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SUTHERLAND ASSET MANAGEMENT CORPORATION

NOTES TO the CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

Note 1 – Organization

 

Sutherland Asset Management Corporation (the “Company” or “Sutherland” and together with its subsidiaries “we,” “us” and “our”) is 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 Financial Corp. (“ZAIS”), with ZAIS legally surviving the merger and changing its name to Sutherland Asset Management Corporation. On November 1, 2016, our common stock began trading on the New York Stock Exchange (“NYSE”) under ticker symbol “SLD”. See further discussion in Note 5, Business Combinations.

 

The Company is externally managed and advised by Waterfall Asset Management, LLC (“Waterfall” or the “Manager”), an investment advisor registered with the 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 September 30, 2017 and December 31, 2016, the Company owned 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 the 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 participate in the management activities of the Operating Partnership. Therefore, the Company consolidates the Operating Partnership.

 

The Company, together with its consolidated subsidiaries and variable 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 a 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 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 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 either held-for-investment, placed into securitization structures, or sold.

 

·

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 (“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

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guarantees 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 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 REIT, the Company distributes at least 90% of its taxable income in the form of distributions to shareholders.

 

In the fourth quarter of 2015, Silverthread Falls, LLC (“Silverthread”), a brokerage subsidiary, was classified as held-for-sale due to management’s intent to sell the business, and the Company has included Silverthread in discontinued operations. The trade date of the Silverthread sale was February 28, 2016 and the closing occurred in May of 2016.

 

 

Note 2 – Basis of Presentation

 

The unaudited interim consolidated financial statements presented herein are as of September 30, 2017 and December 31, 2016 and for the three and nine months ended September 30, 2017 and 2016.  These unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”)—as prescribed by the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) and the rules and regulations of the U.S. Securities and Exchange Commission.

 

The accompanying unaudited interim consolidated financial statements do not include all information and footnotes required by generally accepted accounting principles in the United States of America ("GAAP") for complete consolidated financial statements. These interim unaudited interim consolidated financial statements and related notes should be read in conjunction with the Company's audited financial statements for the year ended December 31, 2016, disclosed within the most recently filed 2016 annual report on Form 10-K.

 

In the opinion of management, the accompanying unaudited interim consolidated financial statements contain all adjustments, consisting of normal recurring adjustments necessary for a fair statement of the results for the interim periods presented. Such operating results may not be indicative of the expected results for any other interim periods or the entire year.

 

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, 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) are the historical financial statements following the consummation of the merger and are included in this quarterly report on Form 10-Q and the related unaudited interim consolidated financial statements and footnotes.

 

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 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 and unitholders in the ZAIS 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 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.

 

 

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Note 3 – Summary of Significant Accounting Policies

 

Use of Estimates

 

The preparation of the Company’s unaudited interim consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the unaudited interim consolidated financial statements and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates.

 

Basis of Consolidation

 

The accompanying unaudited interim 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 unaudited interim consolidated financial statements are prepared in accordance with ASC 810, Consolidations. Intercompany accounts and transactions have been eliminated.

 

Reclassifications

 

Certain amounts reported for the prior periods in the accompanying unaudited interim 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 unaudited interim consolidated balance sheets as Loans, net. These amounts have been presented by loan program type and accounting category, within Note 6.  The amounts reported for the prior periods have been reclassified in order to conform to the current period’s presentation. 

 

Servicing rights and residential mortgage servicing rights, at fair value, are now included on the unaudited interim 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 unaudited interim consolidated balance sheets as Secured short-term 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 unaudited interim 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 implemented 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 Loan 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 four business segments. Prior period numbers were revised to conform to the new segment alignment and to be consistent with our current period’s presentation.

 

 

As described in Note 27, the historical results of Silverthread has been reflected in the accompanying unaudited interim consolidated statements of income for the three and nine months ended September 30, 2016 as discontinued operations and financial information related to discontinued operations has been excluded from the notes to these unaudited interim 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

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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 September 30, 2017 and December 31, 2016, the Company had $0.6 million and $0.6 million, respectively, in money market mutual funds, and substantially all of the Company’s cash and cash equivalents not held in money market funds were comprised of cash balances with banks that are in excess of the Federal Deposit Insurance Corporation insurance limits.

 

Restricted Cash

 

Restricted cash represents cash held by the Company as collateral against its derivatives, borrowings under repurchase agreements, and borrowings under credit facilities with counterparties, as well as cash held for remittance on loans serviced for third parties and collateral related to the ReadyCap Commercial Freddie Mac program. Restricted cash is not available for general corporate purposes, but may be applied against amounts due to counterparties under existing swaps and repurchase agreement borrowings, or returned to the Company when the collateral requirements are exceeded or at the maturity of the swap or repurchase agreement. Restricted cash is returned to the Company when our collateral requirements are exceeded or at the maturity or termination of the derivative, borrowings under repurchase agreements and borrowings under credit facilities.

 

Short 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 unaudited interim consolidated statements of income. Changes in the fair value of short-term investments are recorded as net unrealized gain (loss) on the unaudited interim 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 and any related allowance for loan loss is not carried over at the acquisition date. 

 

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

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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 estimates expected cash flows to be collected 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 (“FICO”) 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 (“S&P”), 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.

 

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 extent it is received in cash or until it qualifies for return to accrual status. However, where there is doubt regarding the ultimate collectability of loan principal, all cash received is applied to reduce the carrying value of such loans. Loans are restored to accrual status only when contractually current and the collection of future payments is reasonably assured.

 

Loans, held at fair value

 

Loans, held at fair value are loans originated by ReadyCap. The Company has elected the fair value option because of the intent to transfer to securitizations in the near term. Interest is recognized as interest income on the unaudited interim consolidated statements of income when earned and deemed collectible. Changes in fair value are recurring and are reported as net unrealized gain (loss) on the unaudited interim consolidated statements of income.

 

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 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.

 

We determine the allowance for loan losses by measuring credit impairment on (1) an individual basis for non-accrual status loans, and (2) on a collective 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 recoverability of the loan is less than its carrying value. The Company considers the loans to be collateral dependent and relies on the current fair value of the collateral 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

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loans that were current as of November 4, 2013 when the Company was formed or acquired thereafter. We calculated the cumulative default and loss severity on the acquired loans with delinquency statuses of 90+ days and applied those factors to the current acquired loan population. For the originated loans, our historical data does not show any defaults, therefore we used an analysis performed on the latest ReadyCap securitization to determine the likelihood of default and to 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 2007 through their post-crisis low in 2010.

 

The 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 compared 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.

 

The determination of whether an allowance for loan loss is necessary is based on whether or not there is a decrease in cash flows based on consideration of factual information available at the time of assessment as well as management’s estimates of the future performance and projected amount and timing of cash flows expected to be collected on the loan.

 

While we have a formal methodology to determine the adequate and appropriate level of the allowance for loan losses, estimates of inherent loan losses involve judgment and assumptions as to 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 that full collection of contractual cash flows is not probable. Additionally, PCI loans for which the Company is unable to reasonably estimate the timing and amount of expected cash flows are considered to be non-accrual loans.

 

Troubled Debt Restructurings

 

In situations where, for economic or legal reasons related to the borrower’s financial difficulties, we grant concessions for a period of time to the borrower 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 minimize 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 loans. 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 expected.

 

Impaired loans

 

The Company considers a loan to be impaired when the Company does not expect to collect all of the contractual 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.

 

 

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Loans, held for sale, at fair value

 

Loans, held for sale, at fair value are loans that are expected to be sold to third parties in the near term. Interest is recognized as interest income on the unaudited interim consolidated statements of income 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 net unrealized gain (loss) on the unaudited interim consolidated statements of income. 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 on residential mortgage banking activities, net of variable loan expenses, on the unaudited interim consolidated statements of income.

 

The Company transfers loans held for sale, at 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 are carried 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 sales of MBS are recorded on the trade date. Our MBS securities pledged as collateral against borrowings under repurchase agreements are included in mortgage backed securities, at fair value on our unaudited interim consolidated balance sheets.

 

MBS are recorded at fair value as determined by market prices provided by independent broker dealers or other independent valuation service providers. The fair values assigned to these investments are based upon available information and may not reflect amounts that may be realized. We generally intend to hold our investment in MBS to generate interest income; however, we have and may continue to sell certain of our investment securities as part of the overall management of our assets and liabilities and operating our business.

 

Loans eligible for repurchase 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 unaudited interim consolidated balance sheets. Such amounts reflect the unpaid principal balance of the loans.

 

Derivative 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 credit default swaps (“CDSs”), interest rate swaps, and interest rate lock commitments (“IRLCs”) as part of our risk management. The Company accounts for derivative instruments under ASC 815, Derivatives and Hedges.

 

All derivatives are reported as either assets or liabilities on the unaudited interim consolidated balance sheets at the estimated fair value with the changes in the fair value recorded in earnings.

 

Although permitted under certain circumstances, generally the Company does not offset cash collateral receivable or payables against our gross derivative positions. As of September 30, 2017 and December 31, 2016, the cash collateral receivable held for derivative instruments is $1.6 million and $1.7 million, respectively, and is included in restricted cash on the unaudited interim consolidated balance sheets.

 

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 pre-determined dollar principal

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(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 (“GSE”, such as Fannie Mae, Freddie Mac, or Ginnie Mae) 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 unaudited interim 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 gain/ (loss) on financial instruments. CDS are classified as Level 2 in the fair value hierarchy.

 

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 other income on the unaudited interim 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 unaudited interim 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 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 is tested 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.

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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 residential mortgage servicing rights consist of conforming conventional residential loans sold to Fannie Mae and Freddie Mac or loans securitized in Ginnie Mae securities. Government insured loans serviced by the Company 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 Veterans Affairs.

 

As permitted by U.S. GAAP, the Company has elected to account for its portfolio of residential mortgage servicing rights (MSRs) at fair value. For these assets, the Company uses a third-party vendor to assist 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 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, and contractual servicing fees. MSRs are classified as Level 3 in the fair value hierarchy.

 

Intangible assets

 

Intangible assets are accounted for under ASC 350, Intangibles-Goodwill and Other. As of September 30, 2017 and December 31, 2016, the Company’s identifiable intangible assets include SBA license for our lending operations as well as a trade name, customer relationships, a favorable lease, and other licenses, obtained as part of the ZAIS merger transaction. The Company determined that its SBA license has an indefinite life, while the other intangibles acquired as part of the ZAIS 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. The Company initially records its intangible assets at cost and subsequently tests for impairment on an annual basis. Intangible assets are included within other assets on the unaudited interim consolidated balance sheets.

 

Deferred financing costs

 

Costs incurred in connection with our borrowings under credit facilities 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 unaudited interim 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. Unamortized deferred financing costs related to securitizations and note issuances are presented on the unaudited interim 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

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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 condition of the servicers with whom the Company conducts business and believes the likelihood of loss under the aforementioned circumstances is remote.

 

Secured short-term borrowings

 

      Secured short-term borrowings incudes 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, held-for-investment, and loans, held for sale, at fair value 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 unaudited interim 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 unaudited interim 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 September 30, 2017, none of our repurchase agreements have been accounted for as components of linked transactions. All securities financed through a repurchase agreement have remained on our unaudited interim consolidated balance sheets as an asset and cash received from the lender was recorded on our unaudited interim consolidated balance sheets as a liability. Interest paid and accrued in connection with our repurchase agreements is recorded as interest expense on the unaudited interim consolidated statements of income.

 

Promissory note, net

 

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 unaudited interim consolidated balance sheet date. Interest paid and accrued in connection with the promissory note is recorded as interest expense on the unaudited interim consolidated statements of income.

 

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 notes are collateralized by loans, MBS, and retained interests of consolidated VIE’s. Interest paid and accrued in connection with promissory notes is recorded as interest expense on the unaudited interim consolidated statements of income.

 

 

Convertible note, net

 

    ASC 470, Debt, requires the liability and equity components of convertible debt instruments that may 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 notes 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

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have been issued by the Company at such time. We measured the estimated fair value of the debt component of our convertible notes as of the issuance date based on our nonconvertible debt borrowing rate. The equity components of the convertible senior notes have been reflected within additional paid-in capital in our unaudited interim consolidated balance sheet, and the resulting debt discount is amortized over the period during which the convertible notes are expected to be 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 liability component immediately prior to repurchase.  The difference between the settlement consideration allocated to the liability component and the net carrying value of the liability component, including unamortized debt issuance costs, would be recognized as gain (loss) on extinguishment of debt in our unaudited interim consolidated statements of operations.  The remaining settlement consideration allocated to the equity component would be recognized as a reduction of additional paid-in capital in our unaudited interim consolidated balance sheets.

 

 

Securitized debt obligations of consolidated VIEs, net

 

Since 2011, we have engaged in several securitization transactions, which the Company accounts for under ASC 810. The Company is required to consolidate, as a VIE, the special purpose entity (“SPE”)/trust that was created to facilitate the transaction and to which the underlying loans in connection with the securitization were transferred. 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 unaudited interim consolidated balance sheets.

 

Pursuant to the adoption of ASU 2015-03, debt issuance costs related to securitizations are presented as a direct deduction from the carrying value of the related debt liability. These costs are amortized using the effective interest method. Amortization of debt issuance costs is amortized using the effective interest method and is included in interest expense from securitized debt obligations on the unaudited interim consolidated financial statements.

 

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 unaudited interim consolidated balance sheets and the portion sold is recorded as guaranteed loan financing in the liabilities section of the unaudited interim 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 accompanying unaudited interim consolidated statements of income.

 

Contingent consideration

 

Contingent consideration represent future payments of cash or equity interests to the former owners of GMFS, which was acquired on October 31, 2016. The contingent consideration was initially recorded on the date of acquisition at fair value in the unaudited interim 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 unaudited interim 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.

 

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Variable Interest Entities

 

VIEs are defined as entities in which equity investors (i) do not control the entity, and/or (ii) do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The entity that consolidates a VIE is known as its primary beneficiary and is generally the entity with (i) the power to direct the activities that most 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. For VIEs that do not have substantial ongoing activities, the power to direct the activities that most significantly impact the VIE’s economic performance may be determined by an entity’s involvement with the design of the VIE.

 

The Company is required to re-evaluate whether to consolidate a VIE each reporting period, based upon the facts and circumstances pertaining to the VIE during such period. The Company consolidates a VIE when it is determined to be the primary beneficiary of such VIE.

 

The Company uses special purpose entities to securitize financial assets. 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.

 

Non-controlling Interests

 

Non-controlling interests are presented on the unaudited interim consolidated balance sheets and the unaudited interim 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 unaudited interim 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 unaudited interim 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”), and as well as “in-the-money