Quarterly Report (10-q)

PART I.  FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

SUTHERLAND ASSET MANAGEMENT CORPORATION

unaudited CONS OLIDATED BALANCE SHEETS

 

(In Thousands)		March 31, 2018			December 31, 2017
Assets
Cash and cash equivalents		$	86,773		$	63,425
Restricted cash			13,964			11,666
Loans, net (including $40,430 and $188,150 held at fair value)			1,057,034			1,017,920
Loans, held for sale, at fair value			160,999			216,022
Mortgage backed securities, at fair value			47,181			39,922
Loans eligible for repurchase from Ginnie Mae			81,484			95,158
Investment in unconsolidated joint venture			50,229			55,369
Derivative instruments			5,022			4,725
Servicing rights (including $81,591 and $72,295 held at fair value)			104,613			94,038
Receivable from third parties			11,064			6,756
Other assets			53,592			56,840
Assets of consolidated VIEs			968,999			861,662
Total Assets		$	2,640,954		$	2,523,503
Liabilities
Secured borrowings			657,233			631,286
Promissory note			5,883			6,107
Securitized debt obligations of consolidated VIEs, net			679,871			598,148
Convertible notes, net			109,226			108,991
Senior secured notes, net			178,688			138,078
Guaranteed loan financing			278,500			293,045
Contingent consideration			10,732			10,016
Liabilities for loans eligible for repurchase from Ginnie Mae			81,484			95,158
Derivative instruments			756			282
Dividends payable			12,335			12,289
Accounts payable and other accrued liabilities			64,490			74,636
Total Liabilities		$	2,079,198		$	1,968,036
Stockholders’ Equity
Common stock, $0.0001 par value, 500,000,000 shares authorized, 31,996,440 and 31,996,440 shares issued and outstanding, respectively			3			3
Additional paid-in capital			539,457			539,455
Retained earnings (deficit)			2,559			(3,385)
Total Sutherland Asset Management Corporation equity			542,019			536,073
Non-controlling interests			19,737			19,394
Total Stockholders’ Equity		$	561,756		$	555,467
Total Liabilities and Stockholders’ Equity		$	2,640,954		$	2,523,503

 

See Notes To Unaudited Consolidated Financial Statements

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SUTHERLAND ASSET MANAGEMENT CORPORATION

Unaudited CONSO LIDATED STATEMENTS OF INCOME

 

		Three Months Ended March 31,
(In Thousands, except share data)		2018			2017
Interest income		$	37,150		$	33,884
Interest expense			(22,666)			(16,441)
Net interest income before provision for loan losses		$	14,484		$	17,443
Provision for loan losses			(167)			(1,232)
Net interest income after provision for loan losses		$	14,317		$	16,211
Non-interest income
Gains on residential mortgage banking activities, net of variable loan expenses			11,734			10,509
Other income			1,334			840
Income on unconsolidated joint venture			5,739			—
Servicing income, net of amortization and impairment of $1,350 and $2,765			6,410			4,442
Total non-interest income		$	25,217		$	15,791
Non-interest expense
Employee compensation and benefits			(15,320)			(13,464)
Allocated employee compensation and benefits from related party			(1,200)			(1,012)
Professional fees			(2,648)			(2,159)
Management fees – related party			(2,013)			(1,977)
Incentive fees – related party			(408)			—
Loan servicing expense			(4,093)			(1,513)
Other operating expenses			(8,011)			(5,534)
Total non-interest expense		$	(33,693)		$	(25,659)
Net realized gain on financial instruments			12,232			2,966
Net unrealized gain on financial instruments			3,008			1,282
Income before provision for income taxes		$	21,081		$	10,591
Provision for income taxes			(2,563)			(1,034)
Net income		$	18,518		$	9,557
Less: Net income attributable to non-controlling interest			664			701
Net income attributable to Sutherland Asset Management Corporation		$	17,854		$	8,856
Earnings per basic common share		$	0.56		$	0.29
Earnings per diluted common share		$	0.56		$	0.29
Weighted-average shares outstanding
Basic			32,036,504			30,549,806
Diluted			32,045,844			30,549,806
Dividends declared per share of common stock		$	0.37		$	0.37

 

See Notes To Unaudited Consolidated Financial Statements

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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SUTHERLAND ASSET MANAGEMENT CORPORATION

Unaudited CO NSOLIDATED 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, 2017		30,549,084		$	3		—		$	—		$	513,295		$	(201)		$	513,097		$	39,005		$	552,102
Dividend declared on common stock ($0.37 per share)		—			—		—			—			—			(11,303)			(11,303)			—			(11,303)
Dividend declared on OP units		—			—		—			—			—			—			—			(859)			(859)
Stock-based compensation		—			—		—			—			363			—			363			—			363
Net Income		—			—		—			—			—			8,856			8,856			701			9,557
Balance at March 31, 2017		30,549,084		$	3		—		$	—		$	513,658		$	(2,648)		$	511,013		$	38,847		$	549,860

 

										Retained			Total Sutherland
		Common Stock					Additional Paid-			Earnings			Asset Management			Non-controlling			Total Stockholders'
(in thousands, except share data)		Shares		Par Value			In Capital			(Deficit)			Corporation equity			Interests			Equity
Balance at January 1, 2018		31,996,440		$	3		$	539,455		$	(3,385)		$	536,073		$	19,394		$	555,467
Dividend declared on common stock ($0.37 per share)		—			—			—			(11,910)			(11,910)			—			(11,910)
Dividend declared on OP units		—			—			—			—			—			(425)			(425)
Contributions, net		—			—			—			—			—			107			107
Equity component of 2017 convertible note issuance		—			—			(78)			—			(78)			(3)			(81)
Stock-based compensation		—			—			80			—			80			—			80
Net Income		—			—			—			17,854			17,854			664			18,518
Balance at March 31, 2018		31,996,440		$	3		$	539,457		$	2,559		$	542,019		$	19,737		$	561,756

 

See Notes To Unaudited Consolidated Financial Statements

 

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SUTHERLAND ASSET MANAGEMENT CORPORATION

Unaudited CO NSOLIDATED STATEMENT OF CASH FLOWS

 

		Three Months Ended March 31,
(In Thousands, except share information)		2018			2017
Cash Flows From Operating Activities:
Net income		$	18,518		$	9,557
Adjustments to reconcile net income to net cash provided  (used in) operating activities:
Discount accretion and premium amortization of financial instruments, net			(2,038)			(2,476)
Amortization of guaranteed loan financing, deferred financing costs, and intangible assets			3,492			4,948
Provision for loan losses			167			1,232
Charge off of real estate acquired in settlement of loans			19			103
Increase (decrease) in repair and denial reserve			110			(263)
Purchase of short-term investments			—			(639,481)
Proceeds from sale or maturity of short-term investments			—			719,948
Net settlement of derivative instruments			4,556			(225)
Purchase of loans, held for sale, at fair value			—			(5,909)
Origination of loans, held for sale, at fair value			(610,502)			(550,084)
Proceeds from disposition and principal payments of loans, held for sale, at fair value			677,401			594,875
Income on unconsolidated joint venture			1,048			—
Gain on sale of mortgages held for sale included in Gains on residential mortgage banking activities, net of variable loan expenses			(6,279)			(13,394)
Gain (loss) on derivatives included in Gains on residential mortgage banking activities, net of variable loan expenses			(1,162)			1,576
Creation of servicing rights, net of payoffs			(4,408)			(3,803)
Net realized gains on financial instruments			(12,232)			(2,966)
Net unrealized gains on financial instruments			(3,008)			(1,282)
Net changes in operating assets and liabilities
Assets of consolidated VIEs (excluding loans, net), accrued interest and due from servicers			(8,261)			24,675
Receivable from third parties			(4,308)			(104,001)
Other assets			5,122			(11,576)
Accounts payable and other accrued liabilities			(10,013)			(5,998)
Net cash provided by operating activities			48,222			15,456
Cash Flow From Investing Activities:
Origination of loans			(118,945)			(79,349)
Purchase of loans			(142,000)			(5,577)
Purchase of mortgage backed securities, at fair value			(10,419)			—
Purchase of real estate			(191)			—
Proceeds on unconsolidated joint venture in excess of earnings recognized			4,092			—
Payment of liability under participation agreements, net of proceeds received			(81)			(487)
Proceeds from disposition and principal payment of loans			116,836			106,989
Proceeds from sale and principal payment of mortgage backed securities, at fair value			3,662			1,224
Proceeds from sale of real estate			614			577
Net cash (used in) provided by investing activities			(146,432)			23,377
Cash Flows From Financing Activities:
Proceeds from secured borrowings			938,671			1,733,946
Proceeds from issuance of securitized debt obligations of consolidated VIEs			155,951			—
Proceeds from senior secured note offering			41,328			75,000
Payment of secured borrowings			(912,724)			(1,762,134)
Payment of securitized debt obligations of consolidated VIEs			(65,161)			(59,512)
Payment of guaranteed loan financing			(17,360)			(31,903)
Payment of promissory note			(224)			(332)
Payment of deferred financing costs			(4,443)			(2,377)
Contributions, net			107			—
Dividend payments			(12,289)			(11,505)
Net cash (used in) provided by financing activities			123,856			(58,817)
Net increase (decrease) in cash, cash equivalents, and restricted cash			25,646			(19,984)
Cash, cash equivalents, and restricted cash at beginning of period			75,091			79,756
Cash, cash equivalents, and restricted cash at end of period		$	100,737		$	59,772
Supplemental disclosure of operating cash flow
Cash paid for interest		$	23,135		$	14,632
Cash paid for income taxes		$	796		$	480
Stock-based compensation		$	151		$	363
Supplemental disclosure of non-cash investing activities
Loans transferred from Loans, held for sale, at fair value to Loans, net		$	333		$	—
Loans transferred from Loans, net to Loans, held for sale, at fair value		$	—		$	5,606

 

See Notes to Unaudited Consolidated Financial Statements

 

 

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SUTHERLAND ASSET MANAGEMENT CORPORATION

NOTES TO the CONS OLIDATED 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 Financial”), with ZAIS Financial 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”.

 

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 March 31, 2018 and December 31, 2017, the Company owned approximately 96.5%, 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 hold performing SBC loans to term, and we seek to maximize the value of the non-performing 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 generally held-for-investment or placed into securitization structures.

 

·

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 guarantees subordinated, long-term financing. These originated loans are either held-for-investment, placed into securitization structures, or sold.

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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.

 

 

 

Note 2 – Basis of Presentation

 

The unaudited interim consolidated financial statements presented herein are as of March 31, 2018 and December 31, 2017 and for the three months ended March 31, 2018 and 2017.  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 years ended December 31, 2017 and 2016, and for each of the three years in the period ended December 31, 2017, disclosed within the most recently filed 2017 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.

 

 

 

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.

 

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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.

 

As described in Note 4, the impact of the retrospective adoption of Accounting Standards Update (“ASU”) 2016-18, Statement of Cash Flows: Restricted Cash , resulted in revisions to prior period numbers to conform with the updated accounting standard and our current period’s presentation.

 

As described in Note 9, 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 25, 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.

 

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 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 March 31, 2018 and December 31, 2017, the Company had $0.6 million 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, borrowings under credit facilities with counterparties, construction and mortgage escrows, as well as cash held for remittance on loans serviced for third parties. 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 restriction requirements no longer exist or at the maturity of the swap or repurchase agreement.

 

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.

 

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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. 

 

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 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,

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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 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 shows a minimal number of 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.

 

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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.

 

 

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.

 

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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 March 31, 2018 there was no cash collateral receivable held for derivatives. As of December 31, 2017, the cash collateral receivable held for derivative instruments is $0.8 million 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 (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 Fannie Mae, Freddie Mac, and the Government National Mortgage Association ((“Ginnie Mae”), collectively, “GSEs”) 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.

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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 net realized gain/(loss) 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 and servicing rights related to the Freddie Mac 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 are evaluated 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.

 

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.

 

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

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estimation of the fair value of MSRs include prepayment rates, discount rates, default rates, and cost of servicing rates. Residential 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 March 31, 2018 and December 31, 2017, the Company’s identifiable intangible assets include SBA license for our lending operations as well as a trade name, a favorable lease, and other licenses relating to our residential mortgage banking segement, obtained as part of the ZAIS Financial merger transaction. The Company determined that its SBA license has an indefinite life, while the other intangibles acquired as part of the ZAIS Financial 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.

 

Investment in unconsolidated joint venture

 

In November of 2017, the Company acquired an interest in an SBC loan pool through a joint venture, WFLLA, LLC, which the Company has a 50% interest. According to ASC 323, Equity Method and Joint Ventures , investors in unincorporated entities such as partnerships and unincorporated joint ventures generally shall account for their investments using the equity method of accounting if the investor has the ability to exercise significant influence over the investee. Under the equity method, we recognize our share of the earnings or losses of the investment monthly in earnings and adjust the carrying amount for our share of the earnings or losses based on our equity ownership.

 

Pursuant to the consolidation guidance, we determined our interest in the entity is a VIE, however, we do not consolidate the entity as we determined that we are not the primary beneficiary. The Company is determined to be the primary beneficiary only when it has a controlling financial interest in the VIE, which is defined as possessing both (i) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (ii) the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.

 

Deferred financing costs

 

Costs incurred in connection with our secured borrowings 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. Pursuant to the adoption of ASU 2015-03, 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 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.

 

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Secured borrowings

 

      Secured borrowings include 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, net 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 March 31, 2018, 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

 

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.

 

Securitized debt obligations of consolidated VIEs, net

 

Since 2011, we have engaged in several securitization transactions, which the Company accounts for under ASC 810. 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. The entity that has a controlling financial interest in a VIE is referred to as the primary beneficiary and is required to consolidate the VIE. 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 consolidated balance sheets.

 

Debt issuance costs related to securitizations are presented as a direct deduction from the carrying value of the related debt liability. Debt issuance costs are amortized using the effective interest method and are included in interest expense from securitized debt obligations on the unaudited interim consolidated financial statements.

 

 

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 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.

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    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.

 

 

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

 

 

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 proceeds from 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 represents 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.

 

Variable Interest Entities

 

VIEs are entities that, by design, either (i) lack sufficient equity to permit the entity to finance its activities without additional subordinated financial support from other parties; or (ii) have equity investors that do not have the ability to make significant decisions relating to the entity’s operations through voting rights, or do not have the obligation to absorb the expected losses, or do not have the right to receive the residual returns of the entity. The entity that has a financial interest in a VIE is referred to as the primary beneficiary and is required to consolidate the VIE. An entity is deemed to be the primary beneficiary of a VIE if the entity has both (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.

 

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In determining whether we are the primary beneficiary of a VIE, we consider both qualitative and quantitative factors regarding the nature, size and form of our involvement with the VIE, such as our role establishing the VIE and our ongoing rights and responsibilities, the design of the VIE, our economic interests, servicing fees and servicing responsibilities, and other factors.

 

We perform ongoing reassessments to evaluate whether changes in the entity’s capital structure or changes in the nature of our involvement with the entity result in a change to the VIE designation or a change to our consolidation conclusion.

 

 

Non-controlling Interests

 

Non-controlling interests, which 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., which is managed by our Manager, 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 statements of income. 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”), as well as “in-the-money” conversion options associated with our outstanding convertible senior notes. Potential dilutive shares are excluded from the calculation if they have an anti-dilutive effect in the period..

 

All of the Company’s unvested RSUs and unvested RSAs contain rights to receive non-forfeitable dividends and, thus, are participating securities. Due to the existence of these participating securities, the two-class method of computing EPS is required, unless another method is determined to be more dilutive. Under the two-class method, undistributed earnings are reallocated between shares of common stock and participating securities.

 

 

Income Taxes

 

GAAP establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current period and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s unaudited interim consolidated financial statements or tax returns. We assess the recoverability of deferred tax assets through evaluation of carryback availability, projected taxable income and other factors as applicable. Significant judgment is required in

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assessing the future tax consequences of events that have been recognized in our unaudited interim consolidated financial statements or tax returns as well as the recoverability of amounts we record, including deferred tax assets.

 

We provide for exposure in connection with uncertain tax positions, which requires significant judgment by management including determination, based on the weight of the tax law and available evidence, that it is more-likely-than-not that a tax result will be realized. Our policy is to recognize interest and/or penalties related to income tax matters in income tax expense on our unaudited interim consolidated statements of income. As of March 31, 2018 and December 31, 2017, we accrued no taxes, interest or penalties related to uncertain tax positions. In addition, we do not anticipate a change in this position in the next 12 months.

 

Revenue Recognition

 

On January 1, 2018, new accounting rules regarding revenue recognition became effective for public companies with a calendar fiscal year.  Under the new accounting rules regarding revenue, revenue is recognized upon the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Revenue is recognized through the following five-step process:

 

Step 1: Identify the contract(s) with a customer.

Step 2: Identify the performance obligations in the contract.

Step 3: Determine the transaction price.

Step 4: Allocate the transaction price to the performance obligations in the contract.

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

 

Since the updated guidance does not apply to revenue associated with financial instruments, including interest income, realized or unrealized gains on financial instruments, loan servicing fees, loan origination fees, among other revenue streams, the adoption of this standard did not have a material impact on our unaudited interim consolidated financial statements. The revenue recognition guidance also included revisions to existing accounting rules regarding the determination of whether a company is acting as a principal or agent in an arrangement and accounting for sales of nonfinancial assets where the seller has continuing involvement.  These additional revisions also did not materially impact the Company.

 

Interest Income

 

Interest income on non-PCI loans, held-for-investment, loans, held at fair value, loans, held for sale, at fair value, and MBS, at fair value is accrued based on the outstanding principal amount and contractual terms of the instrument. Discounts or premiums associated with the loans and investment securities are amortized or accreted into interest income as a yield adjustment on the effective interest method, based on contractual cash flows through the maturity date of the investment. On at least a quarterly basis, we review and, if appropriate, make adjustments to the accrual status of the asset. If the asset has been delinquent for the previous 90 days, the asset status will turn to non-accrual, and recognition of interest income will be suspended until the asset resumes contractual payments for three consecutive months.

 

Realized Gains (Losses)

 

Upon the sale or disposition (not including the prepayment of outstanding principal balance) of loans or securities, the excess (or deficiency) of net proceeds over the net carrying value or cost basis of such loans or securities is recognized as a realized gain/loss.

 

Origination Income and Expense

 

Origination income represents fees received for origination of either loans, held at fair value, loans, held for sale, at fair value, or loans, held-for-investment. For loans held, at fair value, and loans, held for sale, at fair value, pursuant to ASC 825, the Company reports origination fee income as revenue and fees charged and costs incurred as expenses. These fees and costs are excluded from the fair value. For originated loans, held-for-investment, under ASC 310-10, the Company defers these origination fees and costs at origination and amortizes them under the effective interest method over the life of the loan. Origination fees and expenses for ReadyCap loans, held at fair value and loans, held for sale, at fair value, are presented in the unaudited interim consolidated statements of income in other income and operating expenses. Origination fees and expenses for residential mortgage loans originated by GMFS are presented in the unaudited interim consolidated

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statements of income in gains of residential mortgage banking activities, net of variable loan expenses. The amortization of net origination fees and expenses for loans, held-for-investment are presented in the unaudited interim consolidated statements of income in interest income.

 

Gains on Residential Mortgage Banking Activities, net of variable loan expenses

 

Gains on residential mortgage banking activities, net of variable loan expenses, reflects variable revenue and expense within our residential mortgage banking business directly related to loan origination and sale activity. This primarily consists of the realized gains on sales of residential loans held for sale and loan origination fee income, offset by direct costs, such as correspondent fee expenses and other direct expenses relating to these loans, which vary based on loan origination volumes. Gains on residential mortgage banking activities, net of variable loan expenses, also consists of unrealized gains and losses associated with the changes in fair value of the loans held for sale, the fair value of retained MSR additions, and the realized and unrealized gains and losses from derivative instruments.

 

       Gains and losses from the sale of mortgage loans held for sale are recognized based upon the difference between the sales proceeds and carrying value of the related loans upon sale and is included in gains on residential mortgage banking activities, net of variable loan expenses in the unaudited interim consolidated statements of income. Sales proceeds reflect the cash received from investors from the sale of a loan plus the servicing release premium if the related MSR is sold. Gains and losses also includes the unrealized gains and losses associated with the mortgage loans held for sale and the realized and unrealized gains and losses from IRLCs.

 

        Loan origination costs directly attributable to the processing, underwriting, and closing of a loan are included in the gain on sale of mortgage loans held for sale when loans are sold. Loan expenses include indirect costs related to loan origination activities, such as correspondent fees, and are expensed as incurred and are included in gains on residential mortgage banking activities, net of variable loan expenses, in the Company’s unaudited interim consolidated statements of income. The provision for loan indemnification includes the fair value of the incurred liability for mortgage repurchases and indemnifications recognized at the time of loan sale and any other provisions recorded against the loan indemnification reserve and are included in gains on residential mortgage banking activities, net of variable loan expenses, in the Company’s unaudited interim consolidated statements of income.

 

        Loan origination fee income represents revenue earned from originating mortgage loans held for sale and are reflected in gains on residential mortgage banking activities, net of variable loan expenses, when loans are sold.

 

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Note 4 – Recently Issued Accounting Pronouncements

 

Financial Accounting Standards Board ("FASB") Standards adopted during 2018

 

Standard	Summary of guidance				Effects on financial statements
ASU 2014-09, Revenue from Contracts with Customers (Topic 606)		Outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance.				Since the guidance does not apply to revenue associated with financial instruments, including loans and securities, and other contractual rights or obligations within the scope of ASC 860, Transfers and Servicing, the adoption of this standard on a modified retrospective basis on January 1, 2018 did not have a material impact on our consolidated financial statements.
Issued May 2014					
ASU 2017-09, Compensation—Stock Compensation (Topic 718) Scope of Modification Accounting		Provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Topic 718.				The adoption of this standard had no impact on our consolidated financial statements since there were no modifications. This ASU required prospective adoption, therefore, any future award changes will be evaluated under the amended guidance.
Issued May 2017					
ASU 2016-15, Statement of Cash Flows (Topic 230) – Classification of Certain Cash Receipts and Cash Payments		Provides guidance on the disclosure and classification of certain items within the statement of cash flows, including beneficial interests obtained in a securitization of financial assets, debt prepayment or extinguishment costs, and distributions received from equity-method investees.				The retrospective adoption of this standard did not have a material impact on our consolidated financial statements.  We chose the cumulative earnings approach for distributions received from equity method investees, which did not result in any changes in the way we account for such distributions.
Issued August 2016					
ASU 2016-16, Income Taxes (Topic 740) – Intra-Entity Transfers of Assets Other Than Inventory		Requires that an entity recognize the income tax consequences of intra-entity transfers of assets other than inventory at the time of the transfer instead of deferring the tax consequences until the asset has been sold to an outside party, as current GAAP requires.				The modified retrospective adoption of this standard did not have a material impact on our consolidated financial statements.
Issued October 2016					
ASU 2017-01, Business Combinations (Topic 805) – Clarifying the Definition of a Business		This ASU results in most real estate acquisitions no longer being considered business combinations and instead being accounted for as asset acquisitions.				The adoption of this standard did not have a material impact on our consolidated financial statements. This ASU required prospective adoption, therefore, any future acquisitions will be evaluated under the amended guidance.
Issued January 2017					
ASU 2017-05, Other Income – Gains and Losses from the De-recognition of Nonfinancial Assets		Requires that all entities account for the de-recognition of a business in accordance with ASC 810, including instances in which the business is considered in substance real estate.				The retrospective adoption of this standard did not have a material impact on our consolidated financial statements.
Issued February 2017					
ASU 2016-18, Statement of Cash Flows (Topic 230) - Restricted Cash		Requires that restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows.				The adoption of this standard on a retrospective basis resulted in reclassifying restricted cash out of investing activities and now is included within cash and cash equivalents on the consolidated statement of cash flows. The following table shows the impact of the adoption of this guidance.
Issued November 2016					

 

 

(In Thousands)	Three months ended March 31, 2017
As previously reported under GAAP applicable at the time
Cash and cash equivalents at beginning of the period	$	59,566
Net decrease in cash and cash equivalents		(19,566)
Cash and cash equivalents at end of the period	$	40,000
As currently reported under ASU 2016-18
Cash and cash equivalents and restricted cash at beginning of the period	$	79,756
Net decrease in cash and cash equivalents and restricted cash		(19,984)
Cash and cash equivalents and restricted cash at end of the period	$	59,772

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FASB Standards issued, but not yet adopted

 

Standard	Summary of guidance		Effects on financial statements
ASU 2016-13, Financial Instruments—Credit Losses (Topic 326) – Measurement of Credit Losses on Financial Instruments		Requires the use of an “expected loss” credit model for estimating future credit losses of certain financial instruments instead of the “incurred loss” credit model that existing GAAP currently requires.		Required effective date: Annual reporting periods, and interim periods therein, beginning after December 15, 2019. Early adoption is permitted for periods beginning after December 15, 2018.
Issued June 2016		The “expected loss” model requires the consideration of possible credit losses over the life of an instrument compared to only estimating credit losses upon the occurrence of a discrete loss event in accordance with the current “incurred loss” methodology.		The Company is evaluating the impact ASU 2016-13 will have on our consolidated financial statements.
ASU 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815)—Accounting for Certain Financial Instruments with Down Round Features		Provides guidance which changes the classification analysis of certain equity-linked financial instruments (or embedded features) with down round features.		Required effective date: Annual reporting periods, and interim periods therein, beginning after December 15, 2018. Early adoption is permitted.
Issued July 2017		When determining whether certain financial instruments should be classified as liabilities or equity instruments, a down round feature no longer precludes equity classification when assessing whether the instrument is indexed to an entity's own stock.		This standard currently would not have an impact on our consolidated financial statements. None of our issued equity or debt (in particular our convertible notes), contain down round features.
ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities		Provides guidance on simplifying the accounting and presentation for hedging activities.		This standard currently would not have an impact on our consolidated financial statements. We do not apply hedge accounting to any of our derivative instruments.
Issued August 2017			

 

 

 

 

Note 5 – Loans and Allowance for Loan Losses

 

 

       The accounting for a loan depends on management’s strategy for the loan, and on whether the loan was credit-impaired at the date of acquisition. The Company accounts for loans based on the following loan program categories:

 

 

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Loan Portfolio

    

       The following table summarizes the classification, unpaid principal balance (“UPB”), and carrying value of loans held by the Company including loans of consolidated VIEs:

 

		March 31, 2018							December 31, 2017
Loans (In Thousands)		Carrying Value			UPB				Carrying Value			UPB
Loans
Acquired SBA 7(a) loans		$	313,382		$	334,501			$	331,083		$	353,556
Acquired loans			316,938			334,143				191,327			209,694
Originated Transitional loans			297,863			300,123				246,076			248,190
Originated SBC loans, at fair value			40,430			39,833				188,150			182,045
Originated SBC loans			42,926			42,232				27,610			27,349
Originated SBA 7(a) loans			51,970			54,679				41,208			43,439
Originated Residential Agency loans			2,246			2,246				2,013			2,014
Total Loans, before allowance for loan losses		$	1,065,755		$	1,107,757			$	1,027,467		$	1,066,287
Allowance for loan losses		$	(8,721)			—			$	(9,547)			—
Total Loans, net		$	1,057,034		$	1,107,757			$	1,017,920		$	1,066,287
Loans in consolidated VIEs
Loans
Originated SBC loans		$	509,575		$	497,091			$	382,873		$	373,996
Acquired loans			176,366			190,021				189,545			204,497
Acquired SBA 7(a) loans			66,142			90,467				69,523			95,605
Originated Transitional loans			192,623			192,432				196,438			196,070
Total Loans, in consolidated VIEs, before allowance for loan losses		$	944,706		$	970,011			$	838,379		$	870,168
Allowance for loan losses on loans in consolidated VIEs		$	(1,812)			—			$	(2,199)			—
Total Loans, net, in consolidated VIEs		$	942,894		$	970,011			$	836,180		$	870,168
Total Loans, net, and Loans, net in consolidated VIEs		$	1,999,928		$	2,077,768			$	1,854,100		$	1,936,455
Loans, held for sale, at fair value
Originated Residential Agency loans		$	86,741		$	83,880			$	129,096		$	124,758
Originated Freddie Mac loans			49,270			48,519				67,591			66,642
Originated SBA 7(a) loans			23,776			21,927				16,791			15,472
Acquired loans			1,212			1,296				2,544			2,662
Total Loans, held for sale, at fair value		$	160,999		$	155,622			$	216,022		$	209,534
Total Loan portfolio		$	2,160,927		$	2,233,390			$	2,070,122		$	2,145,989

 

Credit Quality Indicators

 

      The Company monitors credit quality of our loan portfolio based on primary credit quality indicators. Delinquency rates are a primary credit quality indicator for our types of loans. Loans that are more than 30 days past due provide an