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ZFC > SEC Filings for ZFC > Form 10-Q on 14-May-2014All Recent SEC Filings

Show all filings for ZAIS FINANCIAL CORP.

Form 10-Q for ZAIS FINANCIAL CORP.


14-May-2014

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the Company's consolidated financial statements and accompanying Notes included in Item 1, "Financial Statements," of this quarterly report on Form 10-Q.

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 8% Exchangeable Senior Notes (the "Exchangeable Senior Notes") in a private transaction on November 25, 2013.

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As of March 31, 2014, the Company held a diversified portfolio of fixed rate mortgage loans and adjustable rate mortgage loans ("ARMs") with an estimated fair value of $415.6 million. As of March 31, 2014, the Company also held RMBS assets with an estimated fair value of $231.8 million, consisting primarily of senior tranches of non-Agency RMBS that were originally highly rated but subsequently downgraded and other investment securities ("FMRT Notes" or "Other Investment Securities") with an estimated fair value of $11.1 million. The borrowings the Company used to fund the purchase of its portfolio totaled approximately $512.9 million as of March 31, 2014 under the loan repurchase facility used to finance the Company's residential mortgage loan portfolio (the "Loan Repurchase Facility"), master securities repurchase agreements with four counterparties and the Exchangeable Senior Notes. The Exchangeable Senior Notes were issued and sold by the Operating Partnership in a private transaction on November 25, 2013. See Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources" of this quarterly report on Form 10-Q, for a discussion of the terms of the Exchangeable Senior Notes.

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 three months ended March 31, 2014.

Financial Overview

A summary of the Company's first quarter 2014 results is below, followed by an overview of the market conditions that impacted our results during the quarter:

The quarter ended March 31, 2014 was the fourth full quarter in which the Company operated as a public mortgage REIT following its initial public offering ("IPO") completed on February 13, 2013;

GAAP net income for the three months ended March 31, 2014 was $2.5 million, or $0.28 per weighted average share outstanding compared with net income of $2.0 million, or $0.32 per weighted average share outstanding for the three months ended March 31, 2013;

Core Earnings (which excludes changes in unrealized gains or losses on mortgage loans, real estate securities and other investment securities, realized gains or losses on mortgage loans and real estate securities, gains or losses on derivative instruments and certain non-recurring adjustments) was $1.5 million, or $0.17 per weighted average share outstanding for the three months ended March 31, 2014 compared with Core Earnings of $0.8 million, or $0.13 per weighted average share outstanding for the quarter ended March 31, 2013. Core Earnings is a non-GAAP financial measure;

At March 31, 2014 the Company's book value was $19.86 per share of common stock and OP unit, compared with book value per share of common stock and OP unit of $19.98 as of December 31, 2013;

2.90x leverage ratio as of March 31, 2014

The Company's results of operations for the quarter ended March 31, 2014, were impacted by a number of factors. In the first quarter of 2014 the market experienced a rally in interest rates from the 2013 highs, due primarily to perceived weakness in the economic environment. This weakness was confirmed with the recent first quarter GDP release estimating annualized growth of 0.1%. At the same time volatility in the fixed income markets continued to decline, largely looking past the first quarter weakness. As a result, market conditions remained quite supportive of risk assets. Despite the first quarter slowdown, economic conditions seem to have improved meaningfully late in the first quarter and subsequent to quarter end. Importantly, the housing market remains strong and continues to benefit from tight supply conditions.

Investments

   The following table sets forth certain information regarding the Company's
mortgage loan portfolio at March 31, 2014:

                            Unpaid                                                    Gross Unrealized(1)                               Weighted Average
                          Principal           Premium           Amortized
                           Balance           (Discount)            Cost            Gains            Losses           Fair Value       Coupon       Yield(2)
Mortgage Loans
Performing
    Fixed               $  251,746,179    $  (47,755,347 )    $  203,990,832    $  9,565,952    $  (2,750,993 )    $  210,805,791      4.73 %         7.07 %
    ARM                    218,006,277       (33,133,709 )       184,872,568       4,853,505       (2,269,336 )       187,456,737      3.64           6.73
Total performing           469,752,456       (80,889,056 )       388,863,400      14,419,457       (5,020,329 )       398,262,528      4.22           6.91
Non-performing(3)           26,234,674        (7,310,449 )        18,924,225         544,555       (2,117,597 )        17,351,183      5.00           7.58
Total Mortgage Loans    $  495,987,130    $  (88,199,505 )    $  407,787,625    $ 14,964,012    $  (7,137,926 )    $  415,613,711      4.26 %         6.94 %


____________________

(1) The Company has elected the fair value option pursuant to ASC 825 for its mortgage loans. The Company recorded a gain of $0.7 million and a loss of $0.03 million for the three months ended March 31, 2014 and March 31, 2013, respectively, 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.

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The following table sets forth certain information regarding the Company's RMBS and Other Investment Securities at March 31, 2014:

                              Principal or                                                Gross Unrealized(1)                              Weighted Average
                                Notional           Premium           Amortized
                                Balance           (Discount)            Cost            Gains           Losses          Fair Value        Coupon      Yield(2)
Real estate securities
Non-Agency RMBS
    Alternative - A(3)       $  164,764,296    $  (78,482,420 )    $   86,281,876    $  2,963,208    $  (327,637 )    $   88,917,447        4.09 %       7.11 %
    Pay option adjustable
        rate                     33,700,568        (6,646,540 )        27,054,028         605,224       (228,195 )        27,431,057        0.74         6.83
    Prime                       105,995,923       (13,051,352 )        92,944,571       4,113,891       (235,413 )        96,823,049        4.71         6.59
    Subprime                     19,867,136        (1,701,070 )        18,166,066         689,080       (181,800 )        18,673,346        1.06         5.97
        Total RMBS           $  324,327,923    $  (99,881,382 )    $  224,446,541    $  8,371,403    $  (973,045 )    $  231,844,899        3.71 %       6.77 %

Other investment
securities                   $   10,000,000    $      716,744      $   10,716,744    $    370,764    $         -      $   11,087,508        5.40 %       6.66 %


____________________

(1) The Company has elected the fair value option pursuant to ASC 825 for its real estate securities and Other Investment Securities. The Company recorded a gain of $2.7 million and $0.9 million for the three months ended March 31, 2014 and 2013, respectively, as change in unrealized gain or loss on real estate securities in the consolidated statements of operations. The Company also recorded a gain of $0.4 million for the three months ended March 31, 2014 as change in unrealized gain or loss on other investment securities in the consolidated statements of operations.
(2) Unleveraged yield.
(3) Alternative-A RMBS includes an IO with a notional balance of $61.4 million.

Investment Activity

Mortgage Loans. During the three months ended March 31, 2014, the Company acquired fixed rate mortgage loans and ARMs with an unpaid principal balance of $100.4 million. During the three months ended March 31, 2014, the Company did not sell any mortgage loans. The fair value of the Company's mortgage loans at March 31, 2014 was approximately $415.6 million.

RMBS. During the three months ended March 31, 2014, the Company acquired non-Agency RMBS with a principal balance of $14.5 million and also sold non-Agency RMBS with a principal balance of $2.7 million. During the same period, the Company did not acquire any Agency RMBS. The fair value of the Company's non-Agency RMBS at March 31, 2014 was $231.8 million. The Company did not own any Agency RMBS as of March 31, 2014.

Other Investment Securities. During the three months ended March 31, 2014, the Company acquired the FMRT Notes with a principal balance of $10.0 million. The fair value of the Company's Other Investment Securities at March 31, 2014 was $11.1 million.

TBA Securities. During the three months ended March 31, 2014, the Company did not have any exposure to TBA contracts to purchase or sell Agency RMBS.

Financing and Other Liabilities. As of March 31, 2014, the Company had the Loan Repurchase Facility outstanding totaling $297.4 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. On March 27, 2014, the Company entered into an amendment of the Loan Repurchase Facility providing it with an additional $75 million of uncommitted borrowing capacity. As of March 31, 2014, the Company's total borrowing capacity is $325.0 million. As of March 31, 2014, the Company also had 49 securities repurchase agreements outstanding with four counterparties totaling $159.2 million, which was used to finance investments in non-Agency RMBS and Other Investment Securities. These agreements are secured by cash collateral and a portion of the Company's non-Agency RMBS and Other Investment Securities and bear interest at rates that have historically moved in close relationship to LIBOR. As of March 31, 2014, the Company had Exchangeable Senior Notes outstanding totaling $57.5 million of aggregate principal balance. As of March 31, 2014, the Company was fully invested in its target assets contemplated by its long term business plan. However, for a portion of the three months ended March 31, 2014, 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 March 31, 2014, by remaining maturity and collateral type:

                                                              Mortgage loans
                                                                           Weighted
                                                        Balance          Average Rate
Loan Repurchase Facility borrowings maturing within
31-60 days                                          $    297,401,891            2.90 %
    Total/weighted average                          $    297,401,891            2.90 %

The following table presents certain information regarding the Company's securities repurchase agreements as of March 31, 2014 by remaining maturity:

                                                   Non-Agency RMBS                 Other Investment Securities
                                                                 Weighted                             Weighted
                                              Balance          Average Rate         Balance         Average Rate
Repurchase agreements maturing within
30 days or less                           $    125,330,562            1.89 %     $    7,560,000            1.90 %
31-60 days                                       6,104,000            1.84                    -               -
61-90 days                                      20,186,000            1.83                    -               -
Greater than 90 days                                     -               -                    -               -
    Total/weighted average                $    151,620,562            1.88 %     $    7,560,000            1.90 %

Derivative Instruments

As of March 31, 2014, the Company had outstanding interest rate swap agreements designed to mitigate the effects of increases in interest rates under a portion of its repurchase agreements. These interest rate swap agreements provide for the Company to pay fixed interest rates and receive floating interest rates indexed to LIBOR. The swap agreements effectively fixed the floating interest rates on $17.2 million of borrowings under the Company's repurchase agreements at March 31, 2014. At March 31, 2014, the Company also had an interest rate swaption agreement outstanding which gives the Company the right, but not the obligation, to enter into a previously agreed upon swap contract on a future date. If exercised the Company will enter into an interest rate swap agreement and is obligated to pay a fixed rate of interest and receive a floating rate of interest.

The following table presents information about the Company's interest rate swap agreements as of March 31, 2014:

                                                                     Weighted       Weighted
                                                     Weighted         Average       Average
                                  Notional         Average Pay        Receive       Years to
Maturity                           Amount              Rate            Rate         Maturity
2023                           $    17,200,000           2.72 %          0.24 %          9.3
    Total/Weighted average     $    17,200,000           2.72 %          0.24 %          9.3

The following table presents information about the Company's interest rate swaption agreement as of March 31, 2014:

                           Notional                            Swap
Swaption Expiration         Amount          Strike Rate      Maturity
2015                    $   225,000,000           3.64 %         2025

The following analysis focuses on the results generated during the three months ended March 31, 2014 and March 31, 2013.

Net Interest Income

For the three months ended March 31, 2014, the Company's interest income was $9.5 million as compared with $3.4 million for the three months ended March 31, 2013. The increase in interest income was mainly due to the deployment of capital raised in the Company's February 2013 IPO and November 2013 issuance of the Exchangeable Senior Notes, which is now primarily allocated to whole loans. This allocation to whole loans increased interest income by $5.6 million. Other factors contributing to the increase in interest income included increases in the average RMBS portfolio yield and the purchase of Other Investment Securities, which increased interest income by $1.0 million and $0.1 million, respectively. These increases were partially offset by a decrease in the Company's average RMBS portfolio balance which decreased interest income by $0.6 million. For the three months ended March 31, 2014 the Company's interest expense was $3.9 million as compared to $0.5 million for the three months ended March 31, 2013. The increase in interest expense was due to an increase in borrowings from the Loan Repurchase Facility, securities repurchase agreements used to finance the Company's RMBS portfolio and the issuance of the Exchangeable Senior Notes.

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As of March 31, 2014, 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 3.97% for the Company's mortgage loans and 4.82% for the Company's non-Agency RMBS and Other Investment Securities. As of March 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 1.58% for the Company's Agency RMBS and 3.97% for the Company's non-Agency RMBS.

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 March 31, 2014 were 12.3% and 14.2%, respectively, for the Company's non-Agency RMBS. The Company held no Agency RMBS at March 31, 2014. The three-month average and the six-month average CPR for the period ended March 31, 2013 of the Company's Agency RMBS were 5.2% and 7.3%, respectively, and were 16.7% and 18.2%, respectively, for the Company's non-Agency RMBS. The non-Agency RMBS CPR includes both voluntary and involuntary amounts. The three-month average and the six-month average CPR for the period ended March 31, 2014 were 2.14% and 3.25%, respectively, for the Company's mortgage loans.

Expenses

Professional Fees. For the three months ended March 31, 2014, the Company incurred professional fees of $1.8 million as compared to $1.3 million for the three months ended March 31, 2013 (primarily related to legal fees, audit fees and consulting fees). The increase in professional fees was primarily due to procedures performed by the independent auditors for the 2013 annual financial statements audit and additional legal and accounting expenses related to the Company's registration statement filings on Form S-3.

Advisory Fee Expense (Related Party). Pursuant to the terms of the Investment Advisory Agreement, the Company incurred advisory fee expense of $0.7 million for the three months ended March 31, 2014, as compared to $0.5 million for the three months ended March 31, 2013. The increase in advisory fee expense over these periods was due to an increase in stockholders' equity resulting from the Company's February 2013 IPO.

General and Administrative Expenses. For the three months ended March 31, 2014, general and administrative expenses were $1.2 million as compared to $0.4 million for the three months ended March 31, 2013. The increase in general and administrative expenses was primarily attributable to due diligence costs and professional fees related to the Company's evaluation of a potential acquisition.

Loan Servicing Fees. For the three months ended March 31, 2014, loan servicing fees were $0.4 million. The increase in loan servicing fees was due to the acquisition of whole loans as the Company executed on its investment strategy. There were no loan servicing fees for the three months ended March 31, 2013.

Realized and Change in Unrealized Gain or Loss

   The following amounts related to realized gains and losses, as well as
changes in estimated fair value of the Company's mortgage loan portfolio, RMBS
portfolio, Other Investment Securities and derivative instruments are included
in the Company's unaudited consolidated statements of operations.

                                                                            Three Months Ended
                                                                   March 31, 2014        March 31, 2013
Change in unrealized gain or loss on mortgage loans              $        689,604       $       (28,906 )
Change in unrealized gain or loss on real estate securities             2,736,058               903,277
Change in unrealized gain or loss on other investment securities          370,764                     -
Realized gain on mortgage loans                                           230,737                     -
Realized gain on real estate securities                                    73,619                     -
Loss/(gain) on derivative instruments                                  (3,108,681 )             281,144
    Total other gains/(losses)                                   $        992,101       $     1,155,515

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The Company's interest rate swap agreements and interest rate swaption agreement have not been designated as hedging instruments.

The Company recorded the change in estimated fair value related to an interest rate swaption agreement held during the three months ended March 31, 2014, interest rate swaps held during the three months ended March 31, 2014 and March 31, 2013 and TBAs held during the three months ended March 31, 2013 in earnings as (loss)/gain on derivative instruments. Included in (loss)/gain on derivative instruments are the net interest rate swap payments and net TBA payments for the derivative instruments.

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

Factors Impacting Operating Results

The Company held a diversified portfolio of mortgage loans with a fair value of $415.6 million, RMBS assets with a fair value of $231.8 million and Other Investment Securities with a fair value of $11.1 as of March 31, 2014, and mortgage loans with a fair value of $331.8 million and RMBS assets with a fair value of $226.2 million as of December 31, 2013. In addition, the Company is in negotiations with counterparties and anticipates having additional available borrowing capacity from which it expects to be able to acquire additional assets. The Company's operating results will be impacted by the Company's actual available borrowing capacity.

The Company expects that the results of its operations will also be affected by a number of other factors, including the level of its net interest income, the fair value of its assets and the supply of, and demand for, the target assets in which it may invest. The Company's net interest income, which includes the amortization of purchase premiums and accretion of purchase discounts, varies, primarily as a result of changes in market interest rates and prepayment speeds, as measured by CPR on the Company's target assets. Interest rates and prepayment speeds vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty. The Company's operating results may also be impacted by credit losses in excess of initial anticipations or unanticipated credit events experienced by borrowers whose mortgage loans are held directly by the Company or included in its non-Agency RMBS or Other Investment Securities or in other assets it may originate or acquire in the future.

Changes in Fair Value of the Company's Assets

The Company's mortgage loans, RMBS and Other Investment Securities are carried at fair value and future mortgage-related assets may also be carried at fair value. Accordingly, changes in the fair value of the Company's assets may impact the results of its operations for the period in which such change in value occurs. The expectation of changes in real estate prices is a major determinant of the value of mortgage loans and, therefore, of RMBS and Other Investment Securities. This factor is beyond the Company's control.

Changes in Market Interest Rates

With respect to the Company's business operations, increases in interest rates, in general, may, over time, cause: (i) the interest expense associated with the Company's borrowings to increase; (ii) the value of its fixed-rate portfolio to decline; (iii) coupons on its ARMs and hybrid ARMs (including RMBS secured by such collateral) and on its residential mortgage loans and other floating rate securities to reset, although on a delayed basis, to higher interest rates; (iv) prepayments on its residential mortgage loans and RMBS to slow, thereby slowing the amortization of the Company's purchase premiums and the accretion of its purchase discounts and (v) the value of its interest rate swap agreements to increase.

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Conversely, decreases in interest rates, in general, may, over time, cause:
(i) prepayments on the Company's residential mortgage loans and RMBS to increase, thereby accelerating the amortization of its purchase premiums and the . . .

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