Ready Capital Corp - Quarter Report: 2014 September (Form 10-Q)

ZAIS FINANCIAL CORP.
FORM 10-Q

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ZAIS Financial Corp. and Subsidiaries
Consolidated Balance Sheets

The accompanying notes are an integral part of these consolidated financial statements.

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ZAIS Financial Corp. and Subsidiaries
Consolidated Statements of Operations (unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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ZAIS Financial Corp. and Subsidiaries
Consolidated Statements of Stockholders' Equity

The accompanying notes are an integral part of these consolidated financial statements.

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ZAIS Financial Corp. and Subsidiaries
Consolidated Statements of Cash Flows (unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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ZAIS FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Formation and Organization

ZAIS Financial Corp. (the "Company") was incorporated in Maryland on May 24, 2011, and has elected to be taxed and to qualify as a real estate investment trust ("REIT") beginning with the taxable year ended December 31, 2011. The Company completed its formation transaction and commenced operations on July 29, 2011. On February 13, 2013, the Company completed its initial public offering ("IPO"), pursuant to which the Company sold 5,650,000 shares of its common stock at a price of $21.25 per share for gross proceeds of $120.1 million. Net proceeds after the payment of offering costs of $1.2 million were $118.9 million.

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 residential mortgage-backed securities ("RMBS") that are not issued or guaranteed by a federally chartered corporation, such as the Federal National Mortgage Association ("Fannie Mae"), or the Federal Home Loan Mortgage Corporation ("Freddie Mac"), or an agency of the U.S. Government, such as the Government National Mortgage Association ("Ginnie Mae") ("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 mortgage servicing rights ("MSRs"), RMBS that are issued or guaranteed by a federally chartered corporation or a U.S. Government agency ("Agency RMBS"), including through To-Be-Announced ("TBA") contracts, and in other real estate-related and financial assets, such as interest only strips created from RMBS ("IOs"), commercial mortgage-backed securities ("CMBS") and asset-backed securities ("ABS"). The Company refers collectively to the assets it targets for acquisition as its target assets.

The Company is externally managed by ZAIS REIT Management, LLC (the "Advisor"), a subsidiary of ZAIS Group, LLC ("ZAIS"), and has no employees. The Company is the sole general partner of, and conducts substantially all of its business through, ZAIS Financial Partners, L.P., the Company's consolidated operating partnership subsidiary (the "Operating Partnership").

The Company's charter authorizes the issuance of up to 500,000,000 shares of common stock with a par value of $0.0001 per share, and 50,000,000 shares of preferred stock, with a par value of $0.0001 per share. The Company's board of directors is authorized to amend its charter, without the approval of stockholders, to increase the aggregate number of authorized shares of capital stock or the number of shares of any class or series of capital stock or to classify and reclassify any unissued shares of its capital stock into other classes or series of stock that the Company has authority to issue.

2. Summary of Significant Accounting Policies

Basis of Quarterly Presentation

The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("U.S. GAAP") as contained within the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") and the rules and regulations of the U.S. Securities and Exchange Commission ("SEC") for interim financial reporting. In the opinion of management, all adjustments considered necessary for a fair statement of the Company's financial position, results of operations and cash flows have been included and are of a normal and recurring nature. The operating results presented for the interim period are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. Certain prior period amounts have been reclassified to conform to the current period's presentation.

The Company currently operates as one business segment.

Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may ultimately differ from those estimates.

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Principles of Consolidation

The consolidated financial statements include the accounts of the Company and all of the wholly owned subsidiaries of the Operating Partnership. The Company, which serves as the sole general partner of and conducts substantially all of its business through the Operating Partnership, holds approximately 89.6% of the operating partnership units ("OP units") in the Operating Partnership at September 30, 2014 and December 31, 2013. The Operating Partnership in turn holds directly or indirectly all of the equity interests in its subsidiaries. All intercompany balances have been eliminated in consolidation.

Changes in the Company's ownership interest (and transactions with non-controlling interest unit holders in the Operating Partnership) while the Company retains its controlling interest in its subsidiary, are accounted for as equity transactions. The carrying amount of the non-controlling interest is adjusted to reflect the change in its ownership interest in the subsidiary, with the offset to equity attributable to the Company.

Variable Interest Entities

A variable interest entity ("VIE") is an entity that lacks one or more of the characteristics of a voting interest entity. The Company evaluates each of its investments to determine whether it is a VIE based on: (1) the sufficiency of the entity's equity investment at risk to finance its activities without additional subordinated financial support provided by any parties, including the equity holders; (2) whether as a group the holders of the equity investment at risk have (a) the power, through voting rights or similar rights, to direct the activities of a legal entity that most significantly impacts the entity's economic performance, (b) the obligation to absorb the expected losses of the legal entity and (c) the right to receive the expected residual returns of the legal entity; and (3) whether the voting rights of these investors are proportional to their obligations to absorb the expected losses of the entity, their rights to receive the expected returns of their equity, or both, and whether substantially all of the entity's activities involve or are conducted on behalf of an investor that has disproportionately fewer voting rights. An investment that lacks one or more of the above three characteristics is considered to be a VIE. The Company reassesses its initial evaluation of an entity as a VIE upon the occurrence of certain reconsideration events.

A VIE is subject to consolidation if the equity investors either do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support, are unable to direct the entity's activities, or are not exposed to the entity's losses or entitled to its residual returns. VIEs are required to be consolidated by their primary beneficiary. The primary beneficiary of a VIE is determined to be the party that has both the power to direct the activities of a VIE that most significantly impact the VIE's economic performance and the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. This determination can sometimes involve complex and subjective analyses.

The Company has evaluated its real estate securities investments to determine if each represents a variable interest in a VIE. The Company monitors these investments and analyzes them for potential consolidation. The Company's real estate securities investments represent variable interests in VIEs. At September 30, 2014 and December 31, 2013, no VIEs required consolidation as the Company was not the primary beneficiary of any of these VIEs. At September 30, 2014 and December 31, 2013, the maximum exposure of the Company to VIEs is limited to the fair value of its investments in real estate securities as disclosed in the consolidated balance sheets.

Cash and Cash Equivalents

The Company considers highly liquid short-term interest bearing instruments with original maturities of three months or less and other instruments readily convertible into cash to be cash equivalents. The Company's deposits with financial institutions may exceed federally insurable limits of $250,000 per institution. The Company mitigates this risk by depositing funds with major financial institutions. At September 30, 2014, the Company's cash was held with two custodians.

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Restricted Cash

Restricted cash represents the Company's cash held by counterparties as collateral against the Company's derivatives and/or securities repurchase agreements. Cash held by counterparties as collateral is not available to the Company for general corporate purposes, but may be applied against amounts due to derivative or securities repurchase agreement counterparties or returned to the Company when the collateral requirements are exceeded or at the maturity of the derivatives or securities repurchase agreements.

Other Investment Securities

Other investment securities are comprised of investments in Fannie Mae's Risk Transfer Notes ("FMRT Notes") and Freddie Mac Structured Agency Credit Risk Notes ("FMSA Notes" and together with the FMRT Notes, the "Other Investment Securities"). The Other Investment Securities represent unsecured general obligations of Fannie Mae and Freddie Mac, respectively, and are structured to be subject to the performance of a certain pool of residential mortgage loans.

Mortgage Loans, Real Estate Securities and Other Investment Securities—Fair Value Election

U.S. GAAP permits entities to choose to measure certain eligible financial instruments at fair value. The Company has elected the fair value option for each of its mortgage loans, real estate securities and Other Investment Securities at the date of purchase. The fair value option election is irrevocable and requires the Company to measure these mortgage loans, real estate securities and Other Investment Securities at estimated fair value with the change in estimated fair value recognized in earnings. The Company has established a policy for these assets to separate interest income from the full change in fair value in the consolidated statements of operations. The interest income component is presented as interest income on mortgage loans, real estate securities and Other Investment Securities and the remainder of the change in fair value is presented separately as change in unrealized gain or loss in the Company's consolidated statements of operations.

Determination of Fair Value Measurement

The "Fair Value Measurements and Disclosures" Topic of the FASB ASC defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurements under U.S. GAAP. Specifically, this guidance defines fair value based on exit price, or the price that would be received upon the sale of an asset or the transfer of a liability in an orderly transaction between market participants at the measurement date.

Fair value under U.S. GAAP represents an exit price in the normal course of business, not a forced liquidation price. If the Company was forced to sell assets in a short period to meet liquidity needs, the prices it receives could be substantially less than their recorded fair values. Furthermore, the analysis of whether it is more likely than not that the Company will be required to sell securities in an unrealized loss position prior to an expected recovery in fair value (if any), the amount of such expected required sales, and the projected identification of which securities would be sold is also subject to significant judgment.

Any proposed changes to the valuation methodology will be reviewed by the Advisor to ensure changes are consistent with the applicable accounting guidance and approved as appropriate. The fair value methodology may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while the Company anticipates that the Advisor's valuation methods will be appropriate and consistent with other market participants, the use of different methodologies, or assumptions by other market participants, to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

The Company categorizes its financial instruments in accordance with U.S. GAAP, based on the priority of the inputs to the valuation, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.

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Financial assets and liabilities recorded in the consolidated balance sheets are categorized based on the inputs to the valuation techniques as follows:

The Company may use valuation techniques consistent with the market and income approaches to measure the fair value of its assets and liabilities. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. The income approach uses valuation techniques to convert future projected cash flows to a single discounted present value amount. When applying either approach, the Company maximizes the use of observable inputs and minimizes the use of unobservable inputs. The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires significant judgment and considers factors specific to the investment. The Company utilizes proprietary modeling analysis to support the independent third party broker quotes selected to determine the fair value of its real estate securities, Other Investment Securities and derivative instruments.

The following is a description of the valuation techniques used to measure fair value and the general classification of these instruments pursuant to the fair value hierarchy.

Mortgage Loans

The fair value of the Company's mortgage loans considers data such as loan origination information and additional updated borrower and loan servicing data, as available, forward interest rates, general economic conditions, home price index forecasts and valuations of the underlying properties. The variables considered most significant to the determination of the fair value of the Company's mortgage loans include market-implied discount rates, projections of default rates, delinquency rates, loss severity (considering mortgage insurance) and prepayment rates. The Company uses loan level data, macro-economic inputs and forward interest rates to generate loss adjusted cash flows and other information in determining the fair value of its mortgage loans. Because of the inherent uncertainty of such valuation, the fair values established for mortgage loans held by the Company may differ from the fair values that would have been established if a ready market existed for these mortgage loans. Accordingly, mortgage loans are classified as Level 3 in the fair value hierarchy.

At September 30, 2014, approximately 10.4% in unpaid principal balance of the Company's mortgage loans carries mortgage insurance.

Real Estate Securities and Other Investment Securities

The fair value of the Company's real estate securities and Other Investment Securities considers the underlying characteristics of each security including coupon, maturity date and collateral. The Company estimates the fair value of its RMBS and Other Investment Securities based upon a combination of observable prices in active markets, multiple indicative quotes from brokers and executable bids. In evaluating broker quotes the Company also considers additional observable market data points including recent observed trading activity for identical and similar securities, back-testing, broker challenges and other interactions with market participants, as well as yield levels generated by model-based valuation techniques. In the absence of observable quotes, the Company utilizes model-based valuation techniques that may contain unobservable valuation inputs.

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When available, the fair value of real estate securities is based on quoted prices in active markets. If quoted prices are not available, fair values are obtained from either broker quotes, observed traded levels or model-based valuation techniques using observable inputs such as benchmark yields or issuer spreads.

While the Company's non-Agency RMBS and Other Investment Securities are valued using the same process with similar inputs as the Agency RMBS as described below, a significant amount of inputs are unobservable due to relatively low levels of market activity. The fair value of these securities is typically based on broker quotes or the Company's model-based valuation. Accordingly, the Company's non-Agency RMBS and Other Investment Securities are classified as Level 3 in the fair value hierarchy. Model-based valuation consists primarily of discounted cash flow and yield analyses. Significant model inputs and assumptions include constant voluntary prepayment rates, constant default rates, delinquency rates, loss severity, market-implied discount rates, default rates, expected loss severity, weighted average life, collateral composition, borrower characteristics and prepayment rates, and may also include general economic conditions, including home price index forecasts, servicing data and other relevant information. Where possible, collateral-related assumptions are determined on an individual loan level basis.

The Company's Agency RMBS, if any, are valued using the market data described above, which includes inputs determined to be observable or whose significant fair value drivers are observable. Accordingly, Agency RMBS securities are classified as Level 2 in the fair value hierarchy.

Derivative Instruments

Interest Rate Swaption Agreements

An interest rate swaption agreement represents an option that gives the Company the right, but not the obligation, to enter into a previously agreed upon interest rate swap agreement 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 Company utilizes proprietary modeling analysis or industry standard third party analytics to support the counterparty valuations received for interest rate swaption agreements. These counterparty valuations are generally based on models with observable market inputs such as interest rates and contractual cash flows, and, as such, are classified as Level 2 on the fair value hierarchy. The Company's interest rate swaption agreements are governed by International Swap and Derivative Association trading agreements, which are separately negotiated agreements with dealer counterparties. At September 30, 2014, no credit valuation adjustment was made in determining the fair value of the derivative.

Interest Rate Swap Agreements

An interest rate swap is an agreement between the Company and a counterparty 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 Company utilizes proprietary modeling analysis or industry standard third party analytics to support the counterparty valuations received for interest rate swap agreements. These counterparty valuations are generally based on models with observable market inputs such as interest rates and contractual cash flows, and, as such, are classified as Level 2 on the fair value hierarchy. The Company's interest rate swap agreements are governed by International Swap and Derivative Association trading agreements, which are separately negotiated agreements with dealer counterparties. At September 30, 2014 and December 31, 2013, no credit valuation adjustment was made in determining the fair value of the derivative.

TBA Securities

A TBA security is a forward contract for the purchase of Agency RMBS at a predetermined price with a stated face amount, coupon and stated maturity at an agreed upon future date. The specific Agency RMBS delivered into the contract upon the settlement date, published each month by the Securities Industry and Financial Markets Association ("SIFMA"), are not known at the time of the transaction. The Company estimates the fair value of TBA securities based on independent third party closing levels. Accordingly, TBAs are classified as Level 2 in the fair value hierarchy.

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Interest Income Recognition and Impairment—Mortgage Loans

Pursuant to the Company's policy for separately presenting interest income on mortgage loans, the Company follows acceptable methods under U.S. GAAP for allocating a portion of the change in fair value of mortgage loans to interest income.

When the Company purchases mortgage loans that have shown evidence of credit deterioration since origination and management determines that it is probable the Company will not collect all contractual cash flows on those assets, the Company will apply the guidance that addresses accounting for differences between contractual cash flows and cash flows expected to be collected if those differences are attributable to, at least in part, credit quality.

Interest income is recognized on a level-yield basis over the life of the loan as long as cash flows can be reasonably estimated. The level-yield is determined by the excess of the Company's initial estimate of undiscounted expected principal, interest, and other cash flows (cash flows expected at acquisition to be collected) over the Company's initial investment in the mortgage loan (accretable yield). The amount of interest income to be recognized cannot result in a carrying amount that exceeds the payoff amount of the loan. The excess of contractual cash flows over cash flows expected to be collected (nonaccretable difference) will not be recognized as an adjustment of yield.

On a quarterly basis, the Company updates its estimate of the cash flows expected to be collected. For purposes of interest income recognition, any subsequent increases in cash flows expected to be collected are generally recognized as prospective yield adjustments (which establishes a new level yield) and any subsequent decreases in cash flows expected to be collected are recognized as an impairment to be recorded through change in unrealized gain or loss in the consolidated statements of operations.

Income recognition is suspended for a loan when cash flows cannot be reasonably estimated.

Interest Income Recognition and Impairment—Real Estate Securities and Other Investment Securities

Pursuant to the Company's policy for separately presenting interest income on real estate securities and Other Investment Securities, the Company follows acceptable methods under U.S. GAAP for allocating a portion of the change in fair value of real estate securities and Other Investment Securities to interest income.

Interest income on Agency RMBS, if any, is accrued based on the effective yield method on the outstanding principal balance and their contractual terms. Premiums and discounts associated with Agency RMBS at the time of purchase are amortized into interest income over the life of such securities using the effective yield method and adjusted for actual prepayments.

Interest income on the non-Agency RMBS and Other Investment Securities, which were purchased at a discount to par value and/or were rated below AA at the time of purchase, is recognized based on the effective yield method. The effective yield on these securities is based on the projected cash flows from each security, which are estimated based on the Company's observation of current information and events and include assumptions related to interest rates, prepayment rates and the timing and amount of credit losses. On a monthly basis, the Company reviews and, if appropriate, makes adjustments to its cash flow projections based on input and analysis received from external sources, internal models and its judgment about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. Changes in cash flows from those originally projected, or from those estimated at the last evaluation, may result in a prospective change in the yield/interest income recognized on such securities. Actual maturities of the securities are affected by the contractual lives of the associated mortgage collateral, periodic payments of principal, prepayments of principal and credit losses. Therefore, actual maturities of the securities are generally shorter than stated contractual maturities.

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Based on the projected cash flows from the Company's non-Agency RMBS purchased at a discount to par value, a portion of the purchase discount may be designated as credit protection against future credit losses and, therefore, not accreted into interest income. The amount designated as credit discount is determined, and may be adjusted over time, based on the actual performance of the security, its underlying collateral, actual and projected cash flow from such collateral, economic conditions and other factors. If the performance of a security with a credit discount is more favorable than forecasted, a portion of the amount designated as credit discount may be accreted into interest income prospectively.

RMBS and Other Investment Securities are evaluated for other-than-temporary impairment ("OTTI") each quarter. A security with a fair value that is less than amortized cost is considered impaired. Impairment of a security is considered to be other-than-temporary when: (i) the holder has the intent to sell the impaired security; (ii) it is more likely than not the holder will be required to sell the security; or (iii) the holder does not expect to recover the entire amortized cost of the security. When a security has been deemed to be other-than-temporarily impaired, the amount of OTTI is bifurcated into: (i) the amount related to expected credit losses; and (ii) the amount related to fair value adjustments in excess of expected credit losses. The portion of OTTI related to expected credit losses is recognized in the consolidated statements of operations as a realized loss on real estate securities and realized loss on Other Investment Securities. The remaining OTTI related to the valuation adjustment is recognized as a component of change in unrealized gain or loss in the consolidated statements of operations. Realized gains and losses on sale of real estate securities and Other Investment Securities are determined using the specific identification method. Real estate securities and Other Investment Securities transactions are recorded on the trade date.

Expense Recognition

Expenses are recognized when incurred. Expenses include, but are not limited to, loan servicing fees, advisory fees, professional fees for legal, accounting and consulting services, and general and administrative expenses such as insurance, custodial and miscellaneous fees.

Offering Costs

Offering costs are accounted for as a reduction of additional paid-in capital. Offering costs in connection with the Company's IPO were paid out of the proceeds of the IPO. Costs incurred to organize the Company were expensed as incurred. The Company's obligation to pay for organization and offering expenses directly related to the IPO was capped at $1.2 million and the Advisor paid for expenses incurred above the cap.

Loan Repurchase Facilities

The Company finances a portion of its distressed and re-performing mortgage loan portfolio through the use of repurchase agreements entered into under a master repurchase agreement with Citibank, N.A. ("Citi") in an aggregate principal amount of up to $325.0 million (the "Citi Loan Repurchase Facility"). In addition, on August 14, 2014, the Company entered into a master repurchase agreement with Credit Suisse First Boston Mortgage Capital LLC (“Credit Suisse”) to finance newly originated residential mortgage loans, in aggregate principal amount of up to $100 million, of which the entire $100 million is committed (the “Credit Suisse Loan Repurchase Facility” and together with the Citi Loan Repurchase Facility, the "Loan Repurchase Facilities"). Under the Loan Repurchase Facilities, the Company may sell, and later repurchase trust certificates representing interests in residential mortgage loans (the "Trust Certificates"). The borrowings under the Loan Repurchase Facilities are treated as collateralized financing transactions and are carried at their contractual amounts, including accrued interest, as specified in the respective agreement. The borrowings under the Loan Repurchase Facilities are recorded on the trade date at the contract amount.

The Company pledges cash and certain of its Trust Certificates as collateral under the Loan Repurchase Facilities. The amounts available to be borrowed are dependent upon the fair value of the Trust Certificates pledged as collateral, which fluctuates with changes in interest rates, type of underlying mortgage loans and liquidity conditions within the banking, mortgage finance and real estate industries. In response to declines in the fair value of pledged Trust Certificates, the lenders may require the Company to post additional collateral or pay down borrowings to re-establish agreed upon collateral requirements, referred to as margin calls. At September 30, 2014 and December 31, 2013, the Company has met all margin call requirements under the Citi Loan Repurchase Facility, and no borrowings were outstanding under the Credit Suisse Loan Repurchase Facility as of such dates.

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Securities Repurchase Agreements—Real Estate Securities and Other Investment Securities

The Company finances a portion of its RMBS portfolio and Other Investment Securities through the use of securities repurchase agreements entered into under master repurchase agreements with four financial institutions at September 30, 2014. Repurchase agreements are treated as collateralized financing transactions and are carried at their contractual amounts, including accrued interest, as specified in the respective agreements. Repurchase agreements are recorded on trade date at the contract amount.

The Company pledges cash and certain of its RMBS and Other Investment Securities as collateral under these securities repurchase agreements. The amounts available to be borrowed are dependent upon the fair value of the RMBS and Other Investment Securities pledged as collateral, which fluctuates with changes in interest rates, type of securities and liquidity conditions within the banking, mortgage finance and real estate industries. In response to declines in the fair value of pledged RMBS and Other Investment Securities, the lenders may require the Company to post additional collateral or pay down borrowings to re-establish agreed upon collateral requirements, referred to as margin calls. At September 30, 2014 and December 31, 2013, the Company has met all margin call requirements.

Derivatives and Hedging Activities

The Company accounts for its derivative financial instruments in accordance with derivative accounting guidance, which requires an entity to recognize all derivatives as either assets or liabilities in the consolidated balance sheets and to measure those instruments at fair value. The Company has not designated any of its derivative agreements as hedging instruments for accounting purposes. As a result, changes in the fair value of derivatives are recorded through current period earnings.

Interest Rate Swaption Agreements

The credit support annex provisions of the Company's interest rate swaption agreement allows the parties to mitigate their credit risk by requiring the party which is out of the money to post collateral. At September 30, 2014, all collateral provided under this agreement consisted of cash collateral.

Interest Rate Swap Agreements

The Company's interest rate swap agreements contain legally enforceable provisions that allow for netting or setting off of all individual interest rate swap receivables and payables with each respective counterparty and, therefore, the fair value of those interest rate swap agreements are netted. The credit support annex provisions of the Company's interest rate swap agreements allow the parties to mitigate their credit risk by requiring the party which is out of the money to post collateral. At September 30, 2014 and December 31, 2013, all collateral provided under these agreements consisted of cash collateral.

TBA Securities

The Company may, and has in the past, entered into TBA contracts as a means of acquiring exposure to Agency RMBS and may, from time to time, utilize TBA dollar roll transactions to finance Agency RMBS purchases. The Company may also enter into TBA contracts as a means of hedging against short-term changes in interest rates. The Company may choose, prior to settlement, to move the settlement of these securities to a later date by entering into an offsetting position (referred to as a "pair off"), settling the paired off positions against each other for cash, and simultaneously entering into a similar TBA contract for a later settlement date, which is commonly and collectively referred to as a "dollar roll" transaction. At September 30, 2014 and December 31, 2013, the Company did not have any TBA contracts outstanding.

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8% Exchangeable Senior Notes Due 2016

On November 25, 2013, the Operating Partnership issued $57.5 million aggregate principal amount of unsecured 8.00% Exchangeable Senior Notes due 2016 (the "Exchangeable Senior Notes"). The Exchangeable Senior Notes are carried at amortized cost. Interest expense on the Exchangeable Senior Notes is computed using the effective interest method. The conversion features of the Exchangeable Senior Notes are deemed to be an embedded derivative. Accordingly, the Company is required to bifurcate the embedded derivative related to the conversion features of the Exchangeable Senior Notes. The Company recognized the embedded derivative as a liability in its consolidated balance sheets at September 30, 2014 and December 31, 2013, measures it at its estimated fair value and recognizes changes in its estimated fair value in gain/(loss) on derivative instruments in the Company's consolidated statements of operations.

Net Income (Loss) Per Share

The Company's basic earnings per share ("EPS") is computed by dividing net income or loss attributable to common stockholders by the weighted average number of shares of common stock outstanding. Diluted EPS reflects the potential dilution that could occur if outstanding OP units and Exchangeable Senior Notes were converted to common stock, where such exercise or conversion would result in a lower EPS. The dilutive effect of OP units is computed assuming all units are converted to common stock. The dilutive effect of the Exchangeable Senior Notes is computed assuming shares converted are limited to 1,779,560 pursuant to New York Stock Exchange ("NYSE") restrictions. The 1,779,560 shares of common stock were included in the calculation of diluted EPS as such inclusion was dilutive for the nine months ended September 30, 2014.

Income Taxes

The Company has elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended (the "Code"), commencing with its taxable year ended December 31, 2011. The Company was organized and has operated and intends to continue to operate in a manner that will enable it to qualify to be taxed as a REIT. To qualify as a REIT, the Company must meet certain organizational and operational requirements, including a requirement to distribute at least 90% of the Company's annual REIT taxable income to its stockholders (which is computed without regard to the dividends paid deduction or net capital gain and which does not necessarily equal net income as calculated in accordance with U.S. GAAP). As a REIT, the Company will not be subject to federal income tax on its taxable income that it distributes to its stockholders. If the Company fails to qualify as a REIT in any taxable year, it will be subject to federal income tax on its taxable income at regular corporate income tax rates and generally will not be permitted to qualify for treatment as a REIT for federal income tax purposes for the four taxable years following the year during which qualification is lost unless the Internal Revenue Service grants the Company relief under certain statutory provisions. Such an event could materially adversely affect the Company's net income and net cash available for distribution to stockholders. However, the Company intends to continue to operate in a manner that will enable it to qualify for treatment as a REIT.

The Company evaluates uncertain income tax positions when applicable. Based upon its analysis of income tax positions, the Company concluded that it does not have any uncertain tax positions that meet the recognition or measurement criteria at either September 30, 2014 or December 31, 2013.

The Company has elected to treat three of its subsidiaries, ZFC Funding, Inc., ZFC Trust TRS I, LLC and ZFC Honeybee TRS, LLC as taxable REIT subsidiaries (the "TRS entities"). The Company may perform certain activities through these TRS entities that could adversely impact the Company's REIT qualification if performed other than through a TRS. Earnings from activities conducted through the TRS entities are subject to federal and state income taxes irrespective of the dividends-paid deduction available to REITs for federal income tax purposes. In addition, for the Company to continue to qualify to be taxed as a REIT, the Company's total investment in all TRS entities may not exceed 25% of the value of the total assets of the Company determined for federal income tax purposes.

For the three and nine months ended September 30, 2014, the Company had activity in the TRS entities which resulted in a deferred tax asset of $577,940, related to net operating losses and future deductible amounts for tax purposes. A full valuation allowance has been established with respect to taxes at the date of the consolidated balance sheet for the deferred tax asset. For the three and nine months ended September 30, 2013, the Company did not have any significant activity in the TRS entities which generated taxable income, therefore no provision for federal income taxes has been made in the accompanying consolidated financial statements.

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Recent Accounting Pronouncements

In January 2014, the FASB issued ASU 2014-04: Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure ("ASU 2014-04"), to reduce diversity in practice by clarifying when an in substance repossession or foreclosure has occurred and when a creditor should derecognize the associated loan receivable and recognize the real estate property. ASU 2014-04 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2014. Adoption of ASU 2014-04 is not expected to have a material effect on the Company's consolidated financial statements.

In June 2014, the FASB issued Accounting Standards Update No. 2014-11, Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures ("ASU 2014-11") which amends the accounting guidance for repo-to-maturity ("RTM") transactions and repurchase agreements executed as repurchase financings. Under this new accounting guidance, RTMs will be accounted for as secured borrowings rather than sales of an asset, and transfers of financial assets with a contemporaneous repurchase agreement will no longer be evaluated to determine whether they should be accounted for on a combined basis as forward contracts. The new guidance also prescribes additional disclosures particularly on the nature of collateral pledged in repurchase agreements accounted for as secured borrowings. ASU 2014-11 is effective for the first interim or annual reporting periods beginning after December 15, 2014. Adoption of ASU 2014-11 is not expected to have a material effect on the Company's consolidated financial statements.

In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements – Going Concern (Subtopic 205-04) Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”), which requires management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the Company’s ability to continue as a going concern within one year after the date the financial statements are issued. If conditions or events indicate it is probable that an entity will be unable to meet its obligations as they become due within one year after the financial statements are issued, the update requires additional disclosures. The update is effective for periods beginning after December 15, 2016 with early adoption permitted. Adoption of ASU 2014-15 is not expected to have a material effect on the Company’s consolidated financial statements.

3. Fair Value

Fair Value Measurement

Financial assets and liabilities recorded at fair value on a recurring basis are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

The following table sets forth the Company's financial instruments that were accounted for at fair value on a recurring basis at September 30, 2014, by level within the fair value hierarchy:

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The following table sets forth the Company's financial instruments that were accounted for at fair value on a recurring basis at December 31, 2013, by level within the fair value hierarchy:

The following table presents additional information about the Company's financial instruments which are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value:

There were no financial assets or liabilities that were accounted for at fair value on a nonrecurring basis at September 30, 2014 and December 31, 2013. There were no transfers into or out of Level 1, Level 2 or Level 3 during the three and nine months ended September 30, 2014.

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The following table presents quantitative information about the Company's mortgage loans which are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value:

Quantitative Information about Level 3 Fair Value Measurements

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The following table presents quantitative information about the Company's real estate securities which are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value:

Quantitative Information about Level 3 Fair Value Measurements

The following table presents quantitative information about the Company's Other Investment Securities which are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value:

Quantitative Information about Level 3 Fair Value Measurements

Real estate owned, which had a fair value of $166,427 at September 30, 2014, is valued using broker pricing opinions, adjusted for estimated time to liquidation.

The fair value measurements of these assets are sensitive to changes in assumptions regarding prepayment, probability of default, loss severity in the event of default, forecasts of home prices, and significant activity or developments in the real estate market. Significant changes in any of those inputs in isolation may result in significantly higher or lower fair value measurements. A change in the assumption used for forecasts of home price changes is accompanied by directionally opposite changes in the assumptions used for probability of default and loss severity. Significant increases (decreases) in any of these inputs in isolation would result in significantly lower (higher) fair value measurements.

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Fair Value Option

Changes in fair value for assets and liabilities for which the fair value option was elected are recognized in earnings as they occur. The fair value option may be elected on an instrument-by-instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.

The following table presents the difference between the fair value and the aggregate unpaid principal amount and/or notional balance of assets for which the fair value option was elected at September 30, 2014 and December 31, 2013:

(1)       Non-Agency RMBS includes an IO with a notional balance of $52.6 million and $64.3 million at September 30, 2014 and December 31, 2013, respectively.

Fair Value of Other Financial Instruments

In addition to the above disclosures regarding assets or liabilities which are recorded at fair value, U.S. GAAP requires disclosure about the fair value of all other financial instruments. Estimated fair value of financial instruments was determined by the Company using available market information and appropriate valuation methodologies. Considerable judgment is necessary to interpret market data and develop estimated fair values. The use of different market assumptions and/or estimation methodologies may have a material effect on estimated fair values.

The following table summarizes the estimated fair value for all other financial instruments at September 30, 2014 and December 31, 2013:

Cash includes cash on hand for which fair value equals carrying value (a Level 1 measurement). Restricted cash represents the Company's cash held by counterparties as collateral against the Company's derivatives, Loan Repurchase Facilities and securities repurchase agreements. Due to the short-term nature of the restrictions, fair value approximates carrying value (a Level 1 measurement). The fair value of securities repurchase agreements and of the Loan Repurchase Facilities is based on an expected present value technique using observable market interest rates. As such, the Company considers the estimated fair value to be a Level 2 measurement. This method discounts future estimated cash flows using rates the Company determined best reflect current market interest rates that would be offered for loans with similar characteristics and credit quality. The fair value of the Exchangeable Senior Notes is based on observable market prices (a Level 2 measurement).

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4. Mortgage Loans

During the Nine months ended September 30, 2014 and year ended December 31, 2013, the Company's acquisition of mortgage loans were as follows:

The following table sets forth certain information regarding the Company's mortgage loan portfolio at September 30, 2014:

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

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The following table presents the difference between the fair value and the aggregate unpaid principal balance of the Company's mortgage loan portfolio at September 30, 2014 and December 31, 2013:

At September 30, 2014 and December 31, 2013, the Company's mortgage loan portfolio consisted of mortgage loans on residential real estate located throughout the United States. The following is a summary of certain concentrations of credit risk in the mortgage loan portfolio at September 30, 2014 and December 31, 2013:

At September 30, 2014, the interest rates on the Company's mortgage loan portfolio ranged from 1.75% – 12.20% and the contractual maturities ranged from 1 – 46 years.

The following table presents the change in accretable yield for the nine months ended September 30, 2014:

5. Real Estate Securities and Other Investment Securities

The Company's non-Agency RMBS portfolio is not issued or guaranteed by Fannie Mae, Freddie Mac or any other U.S. Government agency or a federally chartered corporation and is therefore subject to additional credit risks.

The following table sets forth certain information regarding the Company's RMBS and Other Investment Securities at September 30, 2014: