Ready Capital Corp - Quarter Report: 2015 March (Form 10-Q)

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FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2015
Commission File Number: 001-35808

ZAIS FINANCIAL CORP.
(Exact Name of Registrant as Specified in its Charter)

Two Bridge Avenue, Suite 322, Red Bank, New Jersey 07701-1106
(Address of Principal Executive Offices, Including Zip Code)

(732) 978-7518
(Registrant's Telephone Number, Including Area Code)

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

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

The Company has 7,970,886 shares of common stock, par value $0.0001 per share, outstanding as of May 8, 2015.

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ZAIS FINANCIAL CORP.
FORM 10-Q
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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") is a Maryland corporation that originates, acquires, finances, sells, services and manages residential mortgage loans. GMFS, LLC ("GMFS"), a mortgage banking platform the Company acquired in October 2014, originates and sells mortgage loans and the Company acquires performing, re-performing and newly originated loans through other channels. 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”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”), or an agency of the U.S. Government, such as 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 and mortgage servicing rights ("MSRs"). The Company also has the discretion to invest in 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 as its target assets.

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'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 the authority to issue.

The Company is externally managed by ZAIS REIT Management, LLC (the "Advisor"), a subsidiary of ZAIS Group, LLC ("ZAIS"), and has no employees except for those employed by GMFS. 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 income is generated primarily by the net spread between the income it earns on its assets and the cost of its financing and hedging activities, and the origination, sale and servicing of residential mortgage loans by its mortgage banking operations. The Company's objective is to provide attractive risk-adjusted returns to its stockholders, primarily through quarterly distributions and secondarily through capital appreciation.

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 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. The information contained in the consolidated financial statements and notes included in the Annual Report on Form 10-K for the year ended December 31, 2014 should be referred to in connection with these unaudited interim consolidated financial statements. Professional fees, transaction costs, loan servicing fees and general and administrative expenses reported in the prior period have been reclassified to operating expenses and other expenses to conform to the current period's presentation. During the quarter the Company recorded an out of period adjustment, in the amount of $96,000, to Mortgage Banking activities, net, to reverse the reported unrealized gains relating to certain Mortgage loans held for sale, at fair value, that were previously sold. Management believes that previously issued financial statements are not materially misstated. The Company operates in the following two business segments: residential mortgage loan investments and residential mortgage banking.

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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.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and all of the wholly owned subsidiaries of the Operating Partnership. All intercompany balances have been eliminated in consolidation.

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 March 31, 2015 and December 31, 2014. The Operating Partnership in turn holds directly or indirectly all of the equity interests in its subsidiaries. Changes in the Company's ownership interest (and transactions with non-controlling interest unit holders in its consolidated subsidiaries) while the Company retains its controlling interest in the 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's mortgage loans held for sale are sold predominantly to Fannie Mae and Freddie Mac, which are government sponsored enterprises ("GSEs" or "Agencies"). The Company also issues Ginnie Mae securities by pooling eligible loans through a pool custodian and assigning rights to the loans to Ginnie Mae. Fannie Mae, Freddie Mac and Ginnie Mae provide credit enhancement of the loans through certain guarantee provisions. The Company also purchases RMBS from securitization trusts or similar vehicles. These securitizations involve VIEs as the trusts or similar vehicles, by design, have the characteristics of a VIE.

The Company has evaluated its interests in its real estate investment securities and its interests in the securitizations discussed in the preceding paragraph to determine if each represents a variable interest in a VIE. The Company monitors these investments and analyzes them for potential consolidation. The Company determined that it was not the primary beneficiary of the VIEs and therefore none of the VIEs were consolidated at March 31, 2015 and December 31, 2014. The maximum exposure of the Company to VIEs is limited to the fair value of its investments in real estate securities and MSRs as disclosed in the Company's consolidated balance sheets.

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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 March 31, 2015, a portion of the Company's operating cash was held with two custodians and two other financial institutions. The Company also maintains separate cash accounts for each of its warehouse lines of credit and repurchase agreements related to the GMFS origination platform pursuant to such agreements.

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

The Company held Freddie Mac Structured Agency Credit Risk Notes ("FMSA Notes") at and during the three months ended March 31, 2015 and at December 31, 2014. The Company held Fannie Mae's Risk Transfer Notes at and during the three months ended March 31, 2014 ("FMRT Notes" and together with the FMSA Notes, the "Other Investment Securities"). The Other Investment Securities represent unsecured general obligations of Fannie Mae and Freddie Mac and are structured to be subject to the performance of a certain pool of residential mortgage loans.

Mortgage Loans Held for Investment, Real Estate Securities, Other Investment Securities and MSRs — 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 some of its mortgage loans held for investment, and each of its real estate securities, Other Investment Securities and MSRs 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 its mortgage loans held for investment, real estate securities and Other Investment Securities 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 held for investment, mortgage loans held for sale, 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.

The Company follows the fair value measurement and disclosure guidance under U.S. GAAP, which establishes a hierarchical disclosure framework. This framework prioritizes and ranks the level of market price observability used in measuring investments at fair value. Market price observability is affected by a number of factors, including the type of investment, the characteristics specific to the investment and the state of the marketplace including the existence and transparency of transactions between market participants. Investments with readily available active quoted prices or for which fair value can be measured from actively quoted prices in an orderly market generally will have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value. In all cases, an instrument's level within the hierarchy is based upon the market pricing transparency of the instrument and does not necessarily correspond to the Company's perceived risk or liquidity of the instrument.

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The Company considers observable data to be market data which is readily available, regularly distributed or updated, reliable and verifiable, not proprietary, and provided by independent sources that are actively involved in the relevant market. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the determination of which category within the fair value hierarchy is appropriate for any given investment is based on the lowest level of input that is significant to the fair value measurement. 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.

Assets and liabilities that are measured and reported at fair value are classified and disclosed in one of the following categories:

Level 1 — Fair value is determined based on quoted prices for identical assets or liabilities in an active market. Assets and liabilities included in Level 1 include listed securities. As required in the fair value measurement and disclosure guidance under U.S. GAAP, the Company does not adjust the quoted price for these investments. The hierarchy gives highest priority to Level 1.

Level 2 — Fair value is determined based on inputs other than quoted prices that are observable for the asset or liability either directly or indirectly as of the reporting date. Assets and liabilities which are generally included in this category include corporate bonds and loans, less liquid and restricted equity securities and certain over-the-counter derivatives, including foreign exchange forward contracts whose values are based on the following:

Level 3 — Fair value is determined based on inputs that are unobservable for the investment and includes situations where there is little, if any, market activity for the asset or liability. The inputs into the determination of fair value require significant management judgment or estimation and the Company may use models or other valuation methodologies to arrive at fair value. Investments that are included in this category generally include distressed debt, less liquid corporate debt securities, non-investment grade residual interests in securitizations, collateralized debt obligations and certain derivative contracts. The hierarchy gives the lowest priority to Level 3.

ZAIS has established a valuation process that applies for all levels of investments in the valuation hierarchy to ensure that the valuation techniques are consistent and verifiable. The valuation process includes discussions between the valuation team, portfolio management team and the valuation committee (the “Valuation Committee”). The Valuation Committee consists of senior members of ZAIS and is co-chaired by the Chief Risk Officer and Chief Financial Officer of ZAIS. The Valuation Committee meets, not less frequently than semi-annually, to review the results of the valuation process and provides the ZAIS management committee with periodic reports. The Valuation Committee is responsible for oversight and review of the written valuation policies and procedures and ensuring that they are applied consistently.

The lack of an established, liquid secondary market for some of the Company’s holdings may have an adverse effect on the market value of those holdings and on the Company’s ability to dispose of them. Additionally, the public markets for the Company’s holdings may experience periods of volatility and periods of reduced liquidity and the Company’s holdings may be subject to certain other transfer restrictions that may further contribute to illiquidity. Such illiquidity may adversely affect the price and timing of liquidations of the Company’s holdings.

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

Mortgage Loans Held for Investment

The fair value of the Company's mortgage loans held for investment 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 held for investment include market-implied discount rates, projections of default rates, delinquency rates, loss severity (considering mortgage insurance) and prepayment rates. ZAIS 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 for investment by the Company may differ from the fair values that would have been established if a ready market existed for these mortgage loans held for investment. Accordingly, mortgage loans held for investment are classified as Level 3 in the fair value hierarchy. 

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At March 31, 2015 and December 31, 2014, approximately 9.6% and 10.3% in unpaid principal balance of the Company's mortgage loans carries mortgage insurance.

Mortgage Loans Held for Sale

The fair value of mortgage loans held for sale is determined, when possible, using quoted secondary-market prices. If no such quoted price exists, the fair value of a loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan. Accordingly, mortgage loans held for sale are classified as Level 2 in the fair value hierarchy.

Real Estate Securities and Other Investment Securities

ZAIS determines the fair value of the Company’s investments in RMBS generally using third party valuation services. ZAIS verifies that the quotes received from the valuation services are reflective of fair value as defined in U.S. GAAP, generally by comparing to trading activity for similar asset classes, pricing research provided by banks and brokers, the indicative broker quotes and results from ZAIS’ proprietary models.

If the values from the third party valuation services are insufficient or unavailable, fair value is determined using observable market data, indicative broker quotes or proprietary models that incorporate market based inputs but also include unobservable inputs. Some of the significant unobservable inputs used are constant prepayment rates, constant default rates, delinquency rates, security ratings, discount rates, credit spreads, and yields. The proprietary models convert future projected cash flows to a single discounted present value. ZAIS’ 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'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.

MSRs

The Company uses a third party vendor to estimate the fair value of MSRs. The third party vendor uses a discounted cash flow approach which consists of projecting servicing cash flows discounted at a rate that management believes market participants would use in their determinations of fair value. The key assumptions used in the estimation of the fair value of MSRs include prepayment speeds, discount rates, default rates, cost to service, contractual servicing fees, escrow earnings and ancillary income. MSRs are classified as Level 3 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 March 31, 2015 and December 31, 2014, no credit valuation adjustment was made in determining the fair value of the derivative. 

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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 predetermined dollar principal (notional amount). No principal (notional amount) is exchanged between the two parties at trade initiation date. Only interest payments are exchanged. ZAIS utilize 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 March 31, 2015 and December 31, 2014, no credit valuation adjustment was made in determining the fair value of the derivative. Changes in the value of the contract are reported in gain (loss) on derivative instruments related to investment portfolio in the consolidated statements of operations.

Loan Purchase Commitments ("LPCs")

LPCs are agreements with approved third-party residential loan originators to purchase residential loans at a future date. LPCs that qualify as derivatives are recorded at their estimated fair values in the Company's consolidated balance sheets. The fair value of the Company's LPCs are based on the prices the underlying loans can be purchased for in the secondary market, adjusted for an estimated pull through rate. Changes in fair value are reported in the statement of operations. LPCs are classified as Level 3 in the fair value hierarchy.

Interest Rate Lock Commitments ("IRLCs")

IRLCs are agreements under which the Company 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 GSE mortgage backed security ("MBS") prices, estimates of the fair value of the MSRs and the probability that the mortgage loan will fund within the terms of the IRLC, net of commission expense and broker fees. IRLCs are classified as Level 3 in the fair value hierarchy.

MBS Forward Sales Contracts and TBA Securities

MBS forward sales contracts and TBA securities are forward contracts for the purchase or sale of MBS at a predetermined price with a stated face amount, coupon and stated maturity at a agreed upon future date. The specific MBS 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 MBS forward sales contracts and TBA securities based on third party vendor prices and quoted MBS prices. MBS forward sales contracts and TBA securities are classified as Level 2 in the fair value hierarchy.

Mortgage Loans Held for Investment, at Cost

Mortgage loans held for investment related to the Company's mortgage banking activities includes loans which, due to various reasons, are unable to be sold to a third party. Such loans are performing loans which the Company carries at amortized cost, less a valuation allowance for estimated credit losses, if applicable.

Revenue Recognition

Mortgage Loans Held for Investment, at fair value

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 certain mortgage loans held for investment to interest income.

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When the Company purchases mortgage loans which are held for investment and which 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 loans, the Company applies 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 on newly originated mortgage loans which are purchased by the Company and held for investment, is accrued based on the effective yield method on the outstanding principal balance and their contractual terms. Premiums and discounts associated with these mortgage loans at the time of purchase are amortized into interest income over the life of such loan using the effective yield method and adjusted for actual prepayments.

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.

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. 

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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.

Mortgage Loans Held for Investment, at Cost and Mortgage Loans Held for Sale

Interest income on mortgage loans is accrued to income based upon the principal amount outstanding and contractual interest rates and is included in interest income on mortgage loans held for sale in the consolidated statements of operations. Income recognition is discontinued when loans become 90 days delinquent or when in management's opinion, the collectability of principal and income becomes doubtful and the mortgage loans held for sale or investment are put on nonaccrual status.

Mortgage Banking Activities

Gain on Sale of Mortgage Loans Held for Sale

Mortgage loans held for sale are considered sold when the Company surrenders control over the financial assets. Control is considered to have been surrendered when the transferred assets have been isolated from the Company, beyond the reach of the Company and its creditors; the purchaser obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets; and the Company does not maintain effective control over the transferred assets through an agreement that both entitles and obligates the Company to repurchase or redeem the transferred assets before their maturity or the ability to unilaterally cause the holder to return specific assets. Such transfers may involve securitizations, participation agreements or repurchase agreements. If the criteria above are not met, such transfers are accounted for as secured borrowings, in which the assets remain on the consolidated balance sheets, the proceeds from the transaction are recognized as a liability and no MSRs are recorded for the transferred loans.

Gains and losses from the sale of mortgages are recognized based upon the difference between the sales proceeds and carrying value of the related loans upon sale and is included in Mortgage banking activities, net in the consolidated statements of operations. The sales proceeds reflect the cash received and the initial fair value of the separately recognized MSRs less the fair value of the incurred liability for mortgage repurchases and indemnifications. 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 MBS forward sales contracts and IRLCs.

Loan Origination Fee Income

Loan origination fee income represents revenue earned from originating mortgage loans and is included in Mortgage banking activities, net in the Company's consolidated statements of operations. Loan origination fees and related direct loan origination costs are reflected in Mortgage banking activities, net when loans are sold and deferred and amortized over the life of the loan as an adjustment of yield.

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Loan Servicing Fee Income

Loan servicing fee income represents revenue earned for servicing loans for various investors and is included in the consolidated statements of operations. The servicing fees are based on a contractual percentage of the outstanding principal balance and recognized into revenue as the related mortgage payments are received. Loan servicing expenses are offset against loan servicing fee income as incurred.

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.

Servicing Advances

Servicing advances represent escrows and advances on behalf of borrowers and investors to cover delinquent balances for property taxes, insurance premiums and other out-of-pocket costs. Advances are made in accordance with the servicing agreements and are recoverable upon liquidation. The Company periodically reviews the advances for collectability and amounts are written off when they are deemed uncollectible. At March 31, 2015 and December 31, 2014, the Company had servicing advances of $1,875,628 and $1,987,073 million, respectively. Such amounts are included in other assets in the Company's consolidated balance sheets.

Repurchase Facilities

Loan Repurchase Facilities

The Company finances a portion of its mortgage loans held for investment, at fair value through the use of repurchase agreements entered into under master repurchase agreements with certain lenders (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 March 31, 2015 and December 31, 2014, the Company has met all margin call requirements related to any outstanding balances under its Loan Repurchase Facilities.

Securities Repurchase Agreements

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. The Company has master repurchase agreements with four financial institutions at March 31, 2015. 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 March 31, 2015 and December 31, 2014, the Company has met all margin call requirements under its securities repurchase agreements. 

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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.

Real Estate Owned

The Company records real estate owned ("REO") when it is considered to have received physical possession (resulting from an in substance repossession or foreclosure) of residential real estate property collateralizing mortgage loans. The Company is considered to have received physical possession of the property upon the occurrence of either (i) obtaining legal title to the residential real estate property upon completion of a foreclosure (the Company may obtain legal title to the residential real estate property even if the borrower has redemption rights that provide the borrower with a legal right for a period of time after a foreclosure to reclaim the real estate property by paying certain amounts specified by law) or (ii) the borrower conveying all interest in the residential real estate property to the Company to satisfy the loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. The deed in lieu of foreclosure or similar legal agreement is completed when agreed-upon terms and conditions have been satisfied by both the borrower and the creditor.

The Company records its REO at fair value, less costs to sell. All legal fees and direct costs relating to real estate owned are expensed as incurred. The excess of the Company's investment in the mortgage loan satisfied over the fair value of the foreclosed property (less cost to sell) is reported as a realized loss in the Company's statements of operations.

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 consolidated balance sheets. Such amounts reflect the unpaid principal balance of the loans. There were no actual repurchases of Ginnie Mae delinquent or defaulted mortgage loans during the three months ended March 31, 2015.

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 March 31, 2015 and December 31, 2014 and measured it at its estimated fair value and recognized changes in its estimated fair value in gain/(loss) on derivative instruments in the Company's consolidated statements of operations.

Liability for Loan Repurchases and Indemnifications

Loans sold to investors by the Company and which met investor and agency underwriting guidelines at the time of sale may be subject to repurchase or indemnification in the event of specific default by the borrower or subsequent discovery that underwriting standards were not met. The Company may, upon mutual agreement, agree to repurchase the loans or indemnify the investor against future losses on such loans. In such cases, the Company bears any subsequent credit loss on the loans. The Company has established a liability for potential losses related to these representations and warranties with a corresponding provision recorded for loan losses. The liability is included in accounts payable and other liabilities in the Company's consolidated balance sheets and the provision is included in mortgage banking activities, net in the Company's consolidated statements of operations. In assessing the adequacy of the liability, management evaluates various factors including actual losses on repurchases and indemnifications during the period, historical loss experience, known delinquent and other problem loans, and economic trends and conditions in the industry. Actual losses incurred are reflected as charge-offs against the reserve liability. 

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Because of the uncertainty in the various estimates underlying the loan indemnification reserve, there is a range of losses in excess of the recorded loan indemnification reserve that is reasonably possible. The estimate of the range of possible losses for representations and warranties does not represent a probable loss, and is based on current available information, significant judgment, and a number of assumptions that are subject to change.

Escrow and Fiduciary Funds

The Company maintains segregated bank accounts in trust for mortgagor escrow balances. The balances of these accounts were $23,282,733 million and $25,619,979 million at March 31, 2015 and December 31, 2014, respectively and are excluded from the Company's consolidated balance sheets.

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.

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 long as the Company qualifies as a REIT, the Company generally will not be subject to U.S. federal income taxes on its taxable income to the extent it annually distributes its net taxable income to stockholders and does not engage in prohibited transactions. The majority of States also recognize the Company's REIT status. 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 ("IRS") 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, it is assumed that the Company will retain its REIT status and will incur no REIT level taxation as it intends to comply with the REIT regulations and annual distribution requirements.

The Company has made separate joint elections with three of its subsidiaries, ZFC Funding Inc., ZFC Trust TRS I, LLC and ZFC Honeybee TRS, LLC, to treat such subsidiaries 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 entity. The Company's TRS entities file separate tax returns and are taxed as standalone U.S. C-Corporations irrespective of the dividends-paid deduction available to REITs for federal income tax purposes.

The Company assesses its tax positions for all open tax years and records tax benefits only if tax positions meet a more-likely-than-not threshold in accordance with U.S. GAAP for guidance on accounting for uncertainty in income taxes.

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Goodwill and Intangible Assets

The purchase price of GMFS was allocated to the assets acquired, including identifiable intangible assets (trade name, customer relationships, licenses and favorable leases), and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of purchase price over the fair value of the net assets acquired was recognized as goodwill. Goodwill is carried at cost, net of impairment charges, and reflected on the Company's consolidated balance sheets.

Goodwill is not amortized but is tested for impairment on October 31st of each calendar year, or more frequently if events or changes in circumstances indicate that a potential impairment may have occurred. The testing of goodwill for impairment is initially based on a qualitative assessment to determine if it is more likely than not that the fair value of a reporting unit is less than its carrying value including goodwill. If the facts indicate that it is more likely than not that that an impairment may exist, a two-step quantitative assessment is conducted to (a) calculate the fair value of the reporting unit and compare to its carrying value including goodwill and (b) if the carrying value of a reporting unit exceeds its fair value, goodwill is considered impaired with the impairment loss equal to the amount by which the carrying value of the goodwill exceeds the implied fair value of that goodwill. The impairment is recognized as an expense in the period in which the impairment occurs.

The Company does not amortize intangible assets with indefinite lives. The Company amortizes intangible assets with identified estimated useful lives on a straight-line basis over their estimated useful lives.

Contingent Consideration

Contingent consideration represent future payments of cash or equity interests to the former owners of GMFS which was acquired on October 31, 2014. The contingent consideration was initially recorded on the date of acquisition at fair value in the consolidated balance sheet and is subsequently remeasured each reporting period at fair value with the change in the fair value recorded in operating expenses in the consolidated statements of operations.

Recent Accounting Pronouncements

In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers" ("ASU 2014-09"). The objective of the guidance is to clarify the principles for recognizing revenue. ASU 2014-09 supersedes most current revenue recognition guidance, including industry-specific guidance, and also enhances disclosure requirements around revenue recognition and the related cash flows. The guidance is to be applied retrospectively to all prior periods presented or through a cumulative adjustment in the year of adoption, for interim and annual periods beginning after December 15, 2018. Early adoption is not permitted. The Company is currently evaluating the impact of adopting this new standard.

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.

In February 2015, the FASB issued ASU 2015-02, "Consolidation: Amendments to the Consolidation Analysis" ("ASU 2015-02"). ASU 2015-02 makes changes to both the variable interest model and the voting model. The guidance is effective for annual and interim periods beginning after December 15, 2015. Early adoption is permitted, including adoption in an interim period. The Company is currently evaluating the impact of adopting this new standard.

In April 2015 the FASB issued ASU 2015-03, "Interest - Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs" ("ASU 2015-03"). ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The guidance is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted for financial statements that have not been previously issued. Adoption of ASU 2015-03 is not expected to have a material effect on the Company's consolidated financial statements.

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3. GMFS Transaction

On August 5, 2014, the Company, in its capacity as guarantor, entered into an agreement and plan of merger (the "Merger Agreement") among ZFC Honeybee TRS, LLC, an indirect subsidiary of the Company, ZFC Honeybee Acquisitions, LLC ("Honeybee Acquisitions"), a wholly owned subsidiary of ZFC Honeybee TRS, LLC, GMFS, and Honeyrep, LLC, solely in its capacity as the security holder representative. GMFS is an origination platform that primarily originates and services agency and government guaranteed residential mortgage loans in the southern United States. On October 31, 2014, the Company completed its acquisition of GMFS. Honeybee Acquisitions was merged with and into GMFS (the "Merger"), with GMFS surviving the Merger as an indirect subsidiary of the Company.

The Merger Agreement contained customary representations and warranties by the parties, as well as customary covenants, including non-competition and non-solicitation covenants by GMFS's key managers and indemnification covenants by both parties, subject to stated thresholds and limitations.

While subject to a final reconciliation of October 31, 2014 values, the preliminary purchase price was approximately $62.8 million at closing which was comprised of (i) the estimated fair market value of GMFS's MSR portfolio, (ii) the estimated value of GMFS's net tangible assets at October 31, 2014 and (iii) a purchase price premium. In addition to cash paid at closing, two contingent $1 million deferred premium payments payable in cash over two years, plus potential additional consideration based on future loan production and profits will be payable over a four-year period if certain conditions are met. The $2 million of deferred premium payments is contingent on GMFS remaining profitable and retaining certain key employees. The additional contingent consideration is dependent on GMFS achieving certain profitability and loan production goals and is capped at $20 million. Up to 50% of the additional contingent consideration may be paid in common stock of the Company, at the Company's option. The Company funded the closing cash payment through a combination of available cash and the liquidation of a portion of its non-agency RMBS portfolio.

Contingent consideration represents the estimated present value of future earn-out payments as defined in the Merger Agreement. Contingent consideration was estimated based on future earnings projections of GMFS over the four year earn-out period and is re-measured to fair value at each reporting date until the contingency is resolved. The changes in fair value are recognized in earnings. The final consideration paid could be materially different from the estimate and the difference will be recorded through earnings in the consolidated statement of operations. For the three months ended March 31, 2015, the Company recorded an increase in contingent consideration of $523,425 due to the passage of time. Such amount is included in operating expenses in the consolidated statements of operations.

Under the acquisition method of accounting, the total purchase price allocated to the identifiable tangible and intangible assets acquired and the liabilities assumed is based on management's preliminary valuation of GMFS's tangible and intangible assets acquired by the Company and GMFS's liabilities assumed by the Company as of October 31, 2014, and a preliminary valuation of the net assets acquired is summarized as follows:

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Goodwill represents the excess of the purchase price over the fair value of the net assets acquired and liabilities assumed and is primarily made up of expected synergies and the assembled workforce of GMFS. This determination of goodwill is preliminary, and is subject to change when the valuation is complete. A preliminary determination of the goodwill is as follows:

Goodwill has been allocated to the Company's mortgage banking segment. Additionally, goodwill is expected to be deductible for tax purposes over a 15-year life.

The Company recorded a reduction in goodwill of $385,610 during the three months ended March 31, 2015 liability recorded by GMFS at the date of acquisition. The adjustment was recorded based on information obtained subsequent to the acquisition date that related to information that existed as of the acquisition date.

The preliminary valuation above is based upon information available to the Company at October 31, 2014, and is subject to change. The Company continues to review the underlying assumptions and valuation techniques utilized to calculate the fair value of goodwill and intangible assets acquired. Additional adjustments may be recorded during the allocation period specified by U.S. GAAP as additional information becomes available.

The following table presents information about the intangible assets acquired by the Company:

Amortization expense related to the intangible assets acquired was $197,085 for the three months ended March 31, 2015, and is recorded as other expenses in the consolidated statements of operations. Amortization expense related to the intangible assets for the period April 1, 2015 to December 31, 2015 and for the five years subsequent to December 31, 2015 is as follows:

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4. 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 March 31, 2015, by level within the fair value hierarchy:

The following table sets forth the Company's financial instruments that were accounted for at fair value on a recurring basis at December 31, 2014, by level within the fair value hierarchy:

The following tables present 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:

Mortgage Loans Held for Investment, RMBS and Other Investment Securities

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Derivative Instruments

MSR

There were no financial assets or liabilities that were accounted for at fair value on a nonrecurring basis at March 31, 2015 and December 31, 2014. During the three months ended March 31, 2015 and the year ended December 31, 2014, real estate owned was transferred out of Level 3. There were no other transfers into or out of Level 1, Level 2 or Level 3 during the three month period ended March 31, 2015 and year ended December 31, 2014.

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The following tables present quantitative information about the Company's mortgage loans held for investment, real estate securities and 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:

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

The following is a quantitative summary of key inputs used in the valuation of the Company's MSRs at March 31, 2015 and the effect on the estimated fair value from adverse changes in those assumptions (weighted averages are based upon unpaid principal balance):

Derivative Financial Instruments

The Company estimates the fair value of IRLCs based on quoted Agency MBS prices, its estimate of the fair value of the MSRs it expects to receive in the sale of the loans and the probability that the mortgage loan will be purchased as a percentage of the commitments it has made (the "pull-through rate"). The Company categorizes IRLCs as a "Level 3" financial statement item.

The significant unobservable inputs used in the fair value measurement of the Company's IRLCs are the pull-through rate and the MSR component of the Company's estimate of the value of the mortgage loans it has committed to purchase. Significant changes in the pull-through rate and the MSR component of the IRLCs, in isolation, may result in a significant change in fair value. The financial effects of changes in these assumptions are generally inversely correlated as increasing interest rates have a positive effect on the fair value of the MSR component of IRLC value, but increase the pull-through rate for loans that have decreased in fair value.

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The following is a quantitative summary of key unobservable inputs used in the valuation of IRLCs:

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.

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 March 31, 2015 and December 31, 2014: