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ZFC > SEC Filings for ZFC > Form 10-K on 13-Mar-2014All Recent SEC Filings

Show all filings for ZAIS FINANCIAL CORP.

Form 10-K for ZAIS FINANCIAL CORP.


13-Mar-2014

Annual Report


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's financial statements and accompanying notes included in Item 8, "Financial Statements and Supplementary Data," of this annual report on Form 10-K.

Overview

The Company primarily invests in, finances and manages performing and re-performing residential mortgage loans, which may be seasoned or recently originated. 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 more of the nationally recognized statistical rating organizations. The Company also has the discretion to invest in MSRs, Agency RMBS, including through TBA contracts, and in other real estate-related and financial assets, such as IOs, CMBS and ABS.

The Company plans over time to evolve its whole loan strategy to include newly originated residential mortgage loans, which the Company expects to become a core component of its strategy. While the Company has not yet begun originating or purchasing newly originated loans, it has taken steps to build out its capabilities. The Company believes that this business will benefit from the Advisor's existing expertise in mortgage product development, loan pricing, hedging and analytics, due diligence, risk management and servicing oversight. The Company may pursue opportunities for the origination and purchase of newly originated mortgage loans through a loan seller network or through the acquisition or establishment of a mortgage origination platform.

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. 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 completed its formation transaction and commenced operations on July 29, 2011. On February 13, 2013, the Company successfully completed its IPO, pursuant to which the Company sold 5,650,000 shares of its common stock to the public at a price of $21.25 per share for gross proceeds of $120.1 million. Net proceeds after the payment 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. The Company did not pay any underwriting fees, discounts or commissions in connection with the IPO. The Operating Partnership issued and sold the Exchangeable Senior Notes in a private transaction on November 25, 2013.

As of December 31, 2013, the Company held a diversified portfolio of fixed rate mortgage loans and ARMs with an estimated fair value of $331.8 million and RMBS assets with an estimated fair value of $226.2 million, consisting primarily of senior tranches of non-Agency RMBS that were originally highly rated but subsequently downgraded. The borrowings the Company used to fund the purchase of its portfolio totaled approximately $374.7 million as of December 31, 2013 under the Loan Repurchase Facility, as well as under master securities repurchase agreements with four counterparties. The Operating Partnership issued and sold the Exchangeable Senior Notes in a private transaction on November 25, 2013. 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.

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The Company has elected to be taxed as a REIT for U.S. federal income tax purposes commencing with its taxable year ended December 31, 2011. The Company is organized in a format pursuant to which it serves as the general partner of, and conducts substantially all of its business through, its Operating Partnership subsidiary, ZAIS Financial Partners, L.P., a Delaware limited partnership. The Company also expects to operate its business so that it is not required to register as an investment company under the 1940 Act.

Results of Operations

The following discussion of the Company's consolidated results of operations highlights the Company's performance for the years ended December 31, 2013 and 2012. The Company does not believe that a comparison of the Company's consolidated results of operations for the year ended December 31, 2012 with the period ended December 31, 2011 is meaningful because the Company commenced operations on July 29, 2011 and did not have a full calendar year of operations during the calendar year ended December 31, 2011.

The Company's results of operations for the quarter ended December 31, 2013, were impacted by a number of factors. After the December Federal Reserve announcement to begin the tapering of bond purchases, interest rates finished at the highest level of the year, with 10-year treasury yields closing above 3% on December 31, 2013. However, interest rate volatility during the fourth quarter was considerably lower than the levels experienced earlier in 2013 and in particular during the May to June, 2013 timeframe. This subdued volatility was supportive of risk asset valuations, including those in the mortgage credit markets. Strength in the housing market continued, with home prices nationwide increasing 11.0% in December 2013 compared to December 2012, according to CoreLogic®'s December 2013 Home Price Index report. This trend in home price appreciation remained strong during the fourth quarter despite concerns over the impact of higher mortgage rates over the course of 2013. Economic fundamentals were positive during the quarter but subdued, with continued modest growth in output and employment.

Investment Activity during the years ended, and as of, December 31, 2013 and 2012

Investments

   The following table sets forth certain information regarding the Company's
mortgage loan portfolio at December 31, 2013:

                          Unpaid
                         Principal        Premium        Amortized        Gross Unrealized(1)                         Weighted Average
                          Balance       (Discount)         Cost          Gains          Losses       Fair Value      Coupon     Yield(2)
                                                                     (dollars in thousands)
Mortgage Loans
Performing
    Fixed               $   212,701    $   (43,531 )    $   169,170    $    7,843    $   (3,558 )    $   173,455      4.56 %       7.05 %
    ARM                     170,178        (25,618 )        144,560         5,088        (1,556 )        148,092      3.76         6.67
Total performing            382,879        (69,149 )        313,730        12,931        (5,114 )        321,547      4.20         6.88
Non-performing(3)            15,949         (5,030 )         10,919           456        (1,136 )         10,239      5.06         8.03
Total Mortgage Loans    $   398,828    $   (74,179 )    $   324,649    $   13,387    $   (6,250 )    $   331,786      4.24 %       6.91 %


________________________

(1) The Company has elected the fair value option pursuant to ASC 825 for its mortgage loans. The Company recorded a gain of $7.1 million for the year ended December 31, 2013, as change in unrealized gain or loss on mortgage loans in the consolidated statements of operations.
(2) Unleveraged yield.
(3) Loans that are delinquent for 60 days or more are considered non-performing.

The following table sets forth certain information regarding the Company's RMBS portfolio at December 31, 2013:

                                   Principal or
                                     Notional          Premium                               Gross Unrealized(1)                        Weighted Average
                                     Balance          (Discount)       Amortized Cost       Gains         Losses       Fair Value      Coupon     Yield(2)
                                                                                   (dollars in thousands)
Real estate securities
Non-Agency RMBS
    Alternative - A(3)            $      160,591    $    (80,208 )    $         80,383    $   2,415    $   (1,112 )    $    81,686      4.26 %       6.77 %
    Pay option adjustable rate            34,374          (7,057 )              27,317          465          (346 )         27,436      0.76         6.80
    Prime                                109,136         (13,590 )              95,546        3,751          (768 )         98,529      4.77         6.45
    Subprime                              20,141          (1,894 )              18,247          536          (279 )         18,504      1.07         5.97
Total RMBS                        $      324,242    $   (102,749 )    $        221,493    $   7,167    $   (2,505 )    $   226,155      3.80 %       6.57 %


______________________

(1) The Company has elected the fair value option pursuant to ASC 825 for its real estate securities. The Company recorded a loss of $7.2 million for the year ended December, 31 2013 as change in unrealized gain or loss on real estate securities in the consolidated statements of operations.
(2) Unleveraged yield.
(3) Alternative-A RMBS includes an IO with a notional balance of $64.3 million.

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The following table sets forth certain information regarding the Company's RMBS at December 31, 2012:

                                     Principal
                                    or Notional         Premium          Amortized           Gross Unrealized(1)                             Weighted Average
                                      Balance          (Discount)           Cost            Gains          Losses         Fair Value       Coupon       Yield(2)
                                                                                       (dollars in thousands)
Real Estate Securities
Agency RMBS
    30-year adjustable
       mortgage                     $      3,084     $        351       $      3,435     $         -     $    (195 )     $      3,240        2.84 %        2.28 %
    30-year fixed rate mortgage           61,034            3,057             64,091           2,443           (14 )           66,520        3.82          3.44
Non-Agency RMBS
    Alternative A                         38,550           (8,607 )           29,943           3,437             -             33,380        5.69          7.95
    Pay option adjustable rate             1,249             (378 )              871              95             -                966        1.19          8.67
    Prime                                 64,979           (8,075 )           56,904           5,668            (2 )           62,570        5.79          7.34
    Subprime                               4,420             (825 )            3,595             401             -              3,996        0.98          9.10
       Real Estate Securities       $    173,316     $    (14,477 )     $    158,839     $    12,044     $    (211 )     $    170,672        4.81 %        5.89 %


____________________

(1) The Company has elected the fair value option pursuant to ASC 825 for its RMBS. The Company recorded a gain of $17.8 million for the year ended December 31, 2012, as change in unrealized gain or loss on real estate securities in the consolidated statements of operations.
(2) Unlevered yield.

Mortgage Loans. During the year ended December 31, 2013, the Company acquired fixed rate mortgage loans and ARMs with a principal balance of $412.8 million for $334.2 million. During the year ended December 31, 2013, the Company did not sell any mortgage loans. The Company did not acquire any fixed rate mortgage loans or ARMs during the year ended December 31, 2012.

RMBS. During the year ended December 31, 2013, the Company acquired Agency RMBS with a principal balance of $159.2 million for $165.8 million and non-Agency RMBS with a principal balance of $375.4 million for $234.3 million. During the same period, the Company sold Agency RMBS with a principal balance of $215.5 million for $215.9 million and non-Agency RMBS with a principal balance of $89.5 million for $68.3 million. During the year ended December 31, 2013, the Company acquired RMBS with a principal balance of $17.4 million for $15.7 million from a fund managed by ZAIS. During the year ended December 31, 2012, the Company acquired Agency RMBS with a principal balance of $34.0 million for $35.6 million and non-Agency RMBS with a principal balance of $78.6 million for $68.7 million. During the same period, the Company sold Agency RMBS for $31.6 million in net proceeds and non-Agency RMBS for $42.6 million in net proceeds, and recognized a net realized loss of $0.2 million. The Company did not own any Agency RMBS at December 31, 2013 and the fair market value of its Agency RMBS at December 31, 2012 was $69.8 million. The fair market value of the Company's non-Agency RMBS at December 31, 2013 was $226.2 million, compared to $100.9 million at December 31, 2012.

TBA Securities. As of December 31, 2013, the Company did not have any exposure to TBA contracts to purchase or sell Agency RMBS. 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.

Financing and Other Liabilities. As of December, 31 2013, the Company had the Loan Repurchase Facility outstanding totaling $236.1 million which was used to finance mortgage loans. The Loan Repurchase Facility is secured by a portion of the Company's mortgage loan portfolio and bears interest at a rate that has historically moved in close relationship to LIBOR. As of December, 31 2013, the Company also had 44 securities repurchase agreements outstanding with four real estate securities repurchase agreement counterparties totaling $138.6 million, which was used to finance investments in non-Agency RMBS and 35 securities repurchase agreements outstanding with three counterparties totaling $116.1 million for the year ended December 31, 2012, which was used to finance Agency RMBS and non-Agency RMBS. These agreements are secured by cash collateral and a portion of the Company's non-Agency RMBS or Agency RMBS and bear interest at rates that have historically moved in close relationship to LIBOR. As of December 31, 2013, the Company had Exchangeable Senior Notes outstanding totaling $57.5 million. As of December, 31 2013, excluding the cash held from the issuance of the Exchangeable Senior Notes, the Company was fully invested in its target assets contemplated by its long term business plan. However, for a portion of the year ended December, 31 2013, the Company was not fully invested in its long-term target assets.

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The following table presents certain information regarding the Company's Loan Repurchase Facility as of December 31, 2013 by remaining maturity and collateral type:

                                                                Mortgage Loans
                                                                           Weighted
                                                          Balance        Average Rate
                                                        (dollars in
                                                         thousands)
Loan repurchase facility borrowings maturing within
91-180 days                                             $    236,059            2.92 %
   Total/weighted average                               $    236,059            2.92 %

The following table presents certain information regarding the Company's securities repurchase agreements as of December 31, 2013 by remaining maturity:

                                                            Non-Agency RMBS
                                                                        Weighted
                                                       Balance        Average Rate
                                                     (dollars in
                                                      thousands)
Securities repurchase agreements maturing within
30 days or less                                      $    121,914            1.90 %
31-60 days                                                  6,415            1.84
61-90 days                                                 10,263            1.85
Greater than 90 days                                            -               - %
   Total/weighted average                            $    138,592            1.89 %

The following table presents certain information regarding the Company's securities repurchase agreements as of December 31, 2012 by remaining maturity and collateral type:

                                                               Agency RMBS                     Non-Agency RMBS
                                                                        Weighted                          Weighted
                                                        Balance       Average Rate        Balance       Average Rate
                                                                          (dollars in thousands)
Securities repurchase agreements maturing within:
30 days or less                                       $    44,175            0.49 %     $    49,441            2.15 %
31 - 60 days                                               10,866            0.49                 -               -
61 - 90 days                                               11,598            0.47                 -               -
Greater than 90 days                                            -               -                 -               -
   Total/Weighted average                             $    66,639            0.49 %     $    49,441            2.15 %

Derivative Instruments. As of December 31, 2013 and 2012, 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 $17.2 million of borrowings under the Company's repurchase agreements at December 31, 2013 as compared to $32.6 million of borrowings under its repurchase agreements at December 31, 2012.

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The following table presents certain information about the Company's interest rate swap agreements as of December 31, 2013:

                                                       Weighted         Weighted          Weighted
                                                     Average Pay         Average        Average Years
Maturity                        Notional Amount          Rate         Receive Rate       to Maturity
                                  (dollars in
                                  thousands)
2023                           $          17,200           2.72 %            0.24 %               9.6
    Total/Weighted average     $          17,200           2.72 %            0.24 %               9.6

The following table presents certain information about the Company's interest rate swap agreements as of December 31, 2012:

                                                      Weighted Average      Weighted Average      Weighted Average
Maturity                         Notional Amount          Pay Rate            Receive Rate        Years to Maturity
                                  (dollars in
                                   thousands)
2016                           $           12,102                1.21 %                0.31 %                   3.7
2017                                       11,050                1.28                  0.31                     4.3
2021                                        9,448                2.16                  0.31                     8.7
    Total/Weighted average     $           32,600                1.51 %                0.31 %                   5.3

The following analysis focuses on the results generated during the years ended December 31, 2013 and 2012.

Net Interest Income

For the year ended December 31, 2013, the Company's interest income was $26.4 million as compared to $9.4 million for the year ended December 31, 2012. The increase in interest income was primarily due to the acquisition of whole loans, which increased interest income by $10.5 million, an increase in the Company's average RMBS portfolio, which increased interest income by $6.2 million, and an increase in the average RMBS portfolio yield, which increased interest income by $0.3 million. For the year ended December 31, 2013, the Company's interest expense was $7.1 million as compared to $1.4 million for the year ended December 31, 2012. The increase in interest expense was due to interest on the Exchangeable Senior Notes, an increase in borrowings from securities repurchase agreements on non-Agency RMBS and the Loan Repurchase Facility.

As of December 31, 2013, the weighted average net interest spread between the yield on the Company's assets and the cost of funds, including the impact of interest rate hedging, was 3.91% for the Company's mortgage loans and 4.61% for the Company's non-Agency RMBS. As of December 31, 2012, the weighted average net interest spread between the yield on the Company's assets and the cost of funds, including the impact of interest rate hedging, was 2.28% for the Company's Agency RMBS and 5.47% for the Company's non-Agency RMBS.

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 Company's net interest income is also impacted by prepayment speeds, as measured by the weighted average Constant Prepayment Rate ("CPR") on its assets. The three-month average and the six-month average CPR for the period ended December 31, 2013 were 15.9% and 19.8%, respectively, for the Company's non-Agency RMBS. The Company held no Agency RMBS at December 31, 2013. The three-month average and the six-month average CPR for the period ended December 31, 2012 of the Company's Agency RMBS were 5.7% and 5.6%, respectively, and were 18.8% and 18.6%, respectively, for the Company's non-Agency RMBS. The Company held no residential mortgage loans at December 31, 2012. The non-Agency RMBS CPR includes both voluntary and involuntary amounts.

Expenses

Professional Fees. For the year ended December 31, 2013, the Company incurred professional fees of $3.5 million as compared to $1.2 million for the year ended December 31, 2012 (primarily related to legal fees, audit fees and consulting fees). The increase in professional fees was primarily due to an increase in internal and external audit fees of $1.7 million and increased legal fees of $0.7 million, which reflects the increased reporting requirements of being a public company. The increase in professional fees was partially offset by a decrease of $0.1 million in consulting fees related to general corporate matters.

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Advisory Fee Expense (Related Party). Pursuant to the terms of the Investment Advisory Agreement, the Company incurred advisory fee expense of $2.6 million for the year ended December 31, 2013, as compared to $0.9 million for the year ended December 31, 2012. The increase in advisory fee expense over these periods was due to the Company's increased capitalization as a result of its IPO.

General and Administrative Expenses. For the year ended December 31, 2013, general and administrative expenses were $2.6 million as compared to $0.2 million for the year ended December 31, 2012 (primarily related to insurance). The increase in general and administrative expenses was primarily due to increased insurance expense of $0.7 million, mortgage loan transaction costs of $0.6 million, additional public company expenses of $0.2 million, research fees of $0.2 million, directors' fees of $0.3 million related to the independent directors who joined the Company in connection with the Company's IPO in February 2013 and other corporate expenses of $0.4 million.

Interest on Common Stock Repurchase Liability. The Company incurred interest cost of $1.8 million for the year ended December 31, 2012, which was due to dividends paid of $1.6 million on 515,035 shares of common stock, which were reported as a common stock repurchase liability at December 31, 2012 and an increase in the liability of $0.2 million, which was due to the increase in value of the common stock repurchase liability from the initial measurement at December 31, 2012.

Realized and Unrealized Gain (Loss)

For the year ended December 31, 2013, the Company sold certain of its RMBS and recognized a net loss of $7.9 million. During this period, the Company also recognized $1.1 million in OTTI as realized losses. The Company recognized a change in unrealized gain or loss on its RMBS of a loss of $7.2 million due to changes in the fair value of its RMBS. The Company also recognized a gain of $7.1 million as a change in unrealized gain or loss on its mortgage loans and realized a gain of $1.3 million on its mortgage loans for pay-offs in excess of cost. During the year ended December 31, 2012, the Company sold certain of its RMBS and recognized a net loss of $0.2 million. During this period, the Company's change in unrealized gain or loss on its RMBS was a gain of $17.8 million due to changes in the fair value of the Company's RMBS.

The Company has not designated its interest rate swaps as hedging instruments.

The Company recorded the change in estimated fair value related to interest rate swaps held during the years ended December 31, 2013 and 2012, and TBAs held during the year ended December 31, 2013 in earnings as gain/(loss) on derivative instruments. Included in gain/(loss) on derivative instruments are the net swap payments and net TBA payments for the derivative instruments.

The Company has elected to record the change in estimated fair value related to its RMBS and mortgage loans in earnings by electing the fair value option.

The following amounts related to realized gains and losses, as well as changes in estimated fair value of the Company's RMBS portfolio, mortgage loans and derivative instruments are included in the Company's audited consolidated statements of operations for the years ended December 31, 2013 and 2012:

                                                                 Year Ended December 31, 2013        Year Ended December 31, 2012
                                                                                      (dollars in thousands)
Other gain/(loss)
Change in unrealized gain or loss on mortgage loans             $                       7,136       $                          -
Change in unrealized gain or loss on real estate securities                            (7,171 )                           17,793
Realized gain on mortgage loans                                                         1,299                                  -
. . .
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