Ready Capital Corp - Quarter Report: 2016 September (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

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

For the quarterly period ended September 30, 2016
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 x 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 x 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 x

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 8,836,902 shares of common stock, par value $0.0001 per share, outstanding as of October 24, 2016.

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ZAIS Financial Corp. and Subsidiaries

Condensed Consolidated Balance Sheets (Unaudited)

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

ZAIS Financial Corp. and Subsidiaries

Condensed Consolidated Statements of Operations (Unaudited)

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

ZAIS Financial Corp. and Subsidiaries

Condensed Consolidated Statements of Equity (Unaudited)

(Expressed in United States Dollars, except share data)

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

ZAIS Financial Corp. and Subsidiaries

Condensed Consolidated Statements of Cash Flows (unaudited)

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

ZAIS FINANCIAL CORP. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Formation and Organization

General 

ZAIS Financial Corp. (together with its subsidiaries, 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.

The Company invests in residential mortgage loans. GMFS, LLC (“GMFS”), a mortgage banking platform the Company acquired in October 2014, originates, sells and services residential mortgage loans and the Company may acquire 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 residential 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.

The Company is the sole general partner of, and conducts substantially all of its business through, ZAIS Financial Partners, L.P. (“Company Operating Partnership” or the “Operating Partnership”). 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. GMFS had 260 employees at September 30, 2016.

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 in its residential mortgage investments segment, and the origination, sale and servicing of residential mortgage loans in its residential mortgage banking segment. The Company's objective is to provide attractive risk-adjusted returns to its stockholders, primarily through quarterly dividend distributions and secondarily through capital appreciation.

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.

Plan of Merger with Sutherland Asset Management Corporation (“Sutherland”) 

On April 6, 2016, the Company, the Operating Partnership, ZAIS Merger Sub, LLC (“Merger Sub”), a wholly owned subsidiary of the Company, Sutherland and Sutherland Partners, L.P. (“Sutherland Operating Partnership”) entered into an agreement and plan of merger, as amended on May 9, 2016 and August 4, 2016 (the “Sutherland Merger Agreement”). Subject to the terms and conditions of the Sutherland Merger Agreement, (i) Sutherland will merge with and into Merger Sub (the “Sutherland Merger”), with Merger Sub surviving the Sutherland Merger and continuing as a wholly owned subsidiary of the Company and (ii) Sutherland Operating Partnership will merge with and into Company Operating Partnership (the “Partnership Merger” and together with the Sutherland Merger, the “Mergers”), with Company Operating Partnership surviving the Partnership Merger (for tax purposes the Sutherland Operating Partnership will be the surviving partnership). The transaction will be accounted for as a reverse merger.

On April 6, 2016, the Company, Company Operating Partnership, the Advisor, Sutherland and certain subsidiaries of the Company entered into a termination agreement (the “Termination Agreement”). Pursuant to the Termination Agreement, effective upon the closing of the Mergers, the existing advisory agreement between the Company, the Advisor, Company Operating Partnership and the Company’s subsidiaries would be terminated and the Company would pay the Advisor a termination fee in the amount of $8,000,000. In the event that the Sutherland Merger Agreement is terminated prior to the consummation of the Mergers, the Termination Agreement will automatically terminate and be of no further effect. Such amount will be recognized by the Company upon closing of the Mergers.

Additionally, on April 6, 2016, the Company, the Operating Partnership, certain subsidiaries of the Company, Sutherland, and Waterfall Asset Management, LLC (“Waterfall”) entered into a management agreement, as amended as of May 9, 2016 (the “Sutherland Management Agreement”), and the Company and Waterfall entered into a related Side-Letter Agreement (the “Side Letter Agreement”). Pursuant to the Sutherland Management Agreement and the Side Letter Agreement, effective upon the closing of the Mergers, the Company will retain Waterfall to provide investment advisory services to the Company on the terms and conditions set forth in the Sutherland Management Agreement. In exchange for services provided, the Company will pay Waterfall a management fee and the Operating Partnership will issue Waterfall a newly authorized special limited partnership unit entitling Waterfall to an incentive fee under the terms of the Sutherland Management Agreement. The Sutherland Management Agreement has an initial term of three years, after which it will renew automatically for additional one year terms. In the event that the Merger Agreement is terminated prior to the consummation of the Mergers, the Sutherland Management Agreement and the Side Letter Agreement will automatically terminate and be of no further effect.

On September 12, 2016 the Company and Sutherland announced the final exchange ratio in accordance with the terms of the Sutherland Merger Agreement. If the Mergers and the other transactions contemplated by the Sutherland Merger Agreement are completed, Sutherland’s common stockholders will receive 0.8356 newly issued shares of the combined company’s common stock for each share of Sutherland common stock held immediately prior to the effective time of the merger, and holders of operating partnership units of the Sutherland Operating Partnership will receive 0.8356 operating partnership units in the surviving partnership for each limited partnership interest held immediately prior to the effective time of the merger.

On September 27, 2016, the Company and Sutherland announced that they had each received the necessary stockholder approvals to complete the Mergers. At separate special meetings of the stockholders of the Company and Sutherland, the Company’s stockholders voted in favor of the proposal to issue shares to Sutherland stockholders in connection with the Mergers, and the Sutherland stockholders voted in favor of the proposal to approve the Merger of Sutherland with and into Merger Sub. Assuming all conditions to closing the Mergers have been satisfied, the Mergers are expected to close on or after October 31, 2016.

Additionally, on September 27, 2016, the Company commenced a tender offer to purchase up to 4,185,497 shares of the Company’s common stock, par value $0.0001, at a price of $15.37 per share (the “Tender Offer”). The tender offer price is equal to 95% of a further adjusted per share value, which is calculated by reducing the Company’s Adjusted Book Value by the Company’s pro-rata share of (i) the $8,000,000 contractual termination payment to the Advisor, (ii) $4,064,000 related to the remaining recorded value of intangible assets relating to GMFS, and (iii) $297,400 of expenses and reserves associated with certain litigation relating to the Mergers, with such price per share rounded to the nearest whole cent. The Company’s pro rata share of these amounts was determined by multiplying the sum of the items in (i)-(iii) above, by the quotient obtained by dividing the number of issued and outstanding shares of Company common stock (without regard for the effects of the Tender Offer), calculated on a fully diluted basis, by the sum of the number of issued and outstanding shares of Company common stock (without regard for the effects of the offer), plus the number of shares of Company common stock expected to be issued in the Sutherland Merger, both calculated on a fully diluted basis. The Tender Offer period will expire at 12:00 midnight, Eastern Time, at the end of October 25, 2016 (the “Tender Offer Expiration Date”).

The decision to enter the Sutherland Merger Agreement resulted from a strategic review of the Company which began during the fourth quarter of 2015. As a result of that review, in order to reduce market risk in its investment portfolio, prior to entering into the Sutherland Merger Agreement, the Company had begun the process of selling its seasoned, re-performing mortgage loans from its residential mortgage investments segment. The Sutherland Merger Agreement required the Company to complete the sale of its seasoned, re-performing mortgage loans as a condition to closing of the Mergers. The sale of the mortgage loans, which also included real estate owned (“REO”), was completed on May 26, 2016. These mortgage loan sales resulted in a reduction of the Company’s investment income (see Note 5 – Mortgage Loans Held for Investment, at Fair Value and Held for Sale Previously Held for Investment, at Fair Value – “Distressed and re-performing loans at the time of purchase”). Additionally, as part of the strategic review, the Company had made the decision to cease the purchase of newly originated residential mortgage loans as part of its mortgage conduit purchase program and is in the process of terminating contracts and surrendering governmental licenses relating to the Company’s mortgage conduit business. The Sutherland Merger Agreement requires the Company to complete this process of terminating contracts and surrendering governmental licenses.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying condensed 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 periods are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. GAAP as contained in the ASC have been condensed or omitted from the unaudited interim consolidated financial statements according to the SEC rules and regulations. The information and disclosures contained in the unaudited interim consolidated financial statements and notes should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2015.

The Company operates in two business segments: residential mortgage investments and residential mortgage banking.

The Company does not have any other “Other Comprehensive Income” items other than those reported in its condensed consolidated statements of operations.

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, the Operating Partnership, all of the wholly owned subsidiaries of the Operating Partnership, including its taxable REIT subsidiaries (“TRS Entities”), and a joint venture in which GMFS has a controlling financial interest. 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, held approximately 99.3% and 89.6% of the operating partnership units ("OP Units") in the Operating Partnership at September 30, 2016 and December 31, 2015, respectively. 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 interests in its consolidated subsidiaries) while the Company retains its controlling interest in the subsidiaries, 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 subsidiaries, with the offset to equity attributable to the Company.

Variable Interest Entities

In February 2015, the FASB issued Accounting Standards Update (“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 Company adopted ASU 2015-02 on January 1, 2016. The adoption of this standard did not have a material effect on the Company’s consolidated financial statements.

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 or 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 its investment in the securities 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 September 30, 2016 or December 31, 2015. 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.    

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. Cash and cash equivalents at September 30, 2016 includes U.S. Treasury bills (“Treasury Securities”) with a carrying amount of $69,993,637. The Company did not have any Treasury Securities at December 31, 2015.

Mortgage Loans Held for Sale Previously Held for Investment

Mortgage loans which the Company has decided it no longer intends to hold for the foreseeable future are reclassified from mortgage loans held for investment to mortgage loans held for sale previously held for investment.  These mortgage loans were reported at fair value when held for investment and held for sale.

The Company decided during the three months ended March 31, 2016 that it no longer intended to hold its seasoned, re-performing mortgage loan portfolio for the foreseeable future and, as such, reclassified mortgage loans with a fair value of $368,956,195 from held for investment to held for sale previously held for investment. These loans were sold on May 26, 2016. 

Other Investment Securities

The Company held Freddie Mac Structured Agency Credit Risk Notes (“FMRT Notes”) and Fannie Mae's Risk Transfer Notes (“FNRT Notes”) at September 30, 2016 and December 31, 2015, and during the three and nine months ended September 30, 2016 and September 30, 2015. (the FMRT Notes and the FNRT Notes are collectively referred to as 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.

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 gains 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 grants the Company relief under certain statutory provisions. Such an event could materially adversely affect the Company's net income under U.S. GAAP 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 separately made 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 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.

Recently Issued 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, 2017. The Company is currently evaluating the impact of adopting this new standard.

In March 2016, the FASB published ASU No. 2016-08 “Revenue from Contracts with Customers” (Topic 606). The amendments in this update are intended to improve the operability and understandability of the implementation guidance on principal versus agent considerations. The amendments in this update affect the guidance in ASU 2014-09 which is not yet effective. The effective date for this update is the same as for ASU 2015-14 “Revenue from Contracts with Customers (Topic 606) which defers the effective date of ASU 2014-09 by one year resulting in the effective date being fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company is currently evaluating the impact of adopting this new standard.

In April 2016, the FASB published ASU No. 2016-10 “Revenue from Contracts with Customers” (Topic 606). The amendments in this update are intended to clarify the following two aspects of Topic 606: identifying performance obligations and the licensing implementation guidance, while retaining the related principles for those areas. The amendments in this update affect the guidance in ASU 2014-09 which is not yet effective. The effective date for this update is the same as for ASU 2015-14 which defers the effective date of ASU 2014-09 by one year resulting in the effective date being fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. 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 January 2016, the FASB issued ASU 2016-01, “Financial Instruments─Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities” (“ASU 2016-01”). 'The amendments in ASU 2016-01, among other things: (i) requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; (ii) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (iii) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables) and (iii) eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. ASU 2016-01 is effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The new guidance permits early adoption of the own credit provision. The Company is currently evaluating the impact of adopting this new standard.

In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments” (“ASU 2016-15”). This Accounting Standards Update addresses the following eight specific cash flow issues: Debt prepayment or debt extinguishment costs; settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing; contingent consideration payments made after a business combination; proceeds from the settlement of insurance claims; proceeds from the settlement of corporate-owned life insurance policies (COLIs) (including bank-owned life insurance policies (BOLIs)); distributions received from equity method investees; beneficial interests in securitization transactions; and separately identifiable cash flows and application of the predominance principle. ASU 2016-15 is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early application is permitted, including adoption in an interim period. Adoption of ASU 2016-15 is not expected to have a material effect on the Company's consolidated financial statements.

3. Acquisition of GMFS

The following relates to the acquisition of GMFS in October 2014 pursuant to the terms of the agreement and plan of merger dated August 5, 2014 (the “GMFS Merger Agreement”):

Contingent Consideration

In addition to cash paid at closing for the acquisition of GMFS, two contingent $1 million deferred premium payments are payable in cash over two years, plus potential additional consideration based on future loan production and profits are payable over a four-year period if certain conditions are met (the “Production and Profitability Earn-Out”). The $2 million of deferred premium payments is contingent on GMFS remaining profitable and retaining certain key employees. The Production and Profitability Earn-Out are dependent on GMFS achieving certain profitability and loan production goals and is capped at $20 million. Up to 50% of the Production and Profitability Earn-Out may be paid in common stock of the Company, at the Company's option.

Contingent consideration represents the estimated present value of the deferred premiums and Production and Profitability Earn-Out. Contingent consideration was estimated at closing based on future production and 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 condensed consolidated statements of operations.

For the three and nine months ended September 30, 2016 and September 30, 2015, the Company recorded the following changes in the contingent consideration liability:

The increase in the estimated liability for the three and nine months ended September 30, 2016 and September 30, 2015 resulted from production and profitability that was above the projections at the time of acquisition and the impact of the passage of time. The change in the contingent consideration liability is included in operating expenses in the condensed consolidated statements of operations.

The Company has delayed the first year installment payment of the contingent consideration pursuant to the indemnification provisions in the GMFS Merger Agreement (see Note 22 – Commitment and Contingencies).

Goodwill

Goodwill, with a carrying amount of $14,183,537 at September 30, 2016 and December 31, 2015, represents the excess of the purchase price over the fair value of the net assets acquired and has been allocated to the Company’s residential mortgage banking segment.

The changes in the carrying amount of the goodwill during the nine months ended September 30, 2016 and September 30, 2015.

Goodwill is not amortized but is tested for impairment on the anniversary date of the acquisition or more frequently if events or changes in circumstances indicate that a potential impairment may have occurred. No impairment losses relating to goodwill were recorded for the three and nine months ended September 30, 2016 or September 30, 2015.

Intangible Assets

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

Amortization expense related to the intangible assets for the three and nine months ended September 30, 2016 and September 30, 2015 was as follows:

Such amounts are recorded as other expenses in the condensed consolidated statements of operations.

At September 30, 2016 and December 31, 2015, accumulated amortization is as follows:

Amortization expense related to the intangible assets for the period October 1, 2016 to December 31, 2016 and for the five years subsequent to December 31, 2016 will be as follows:

No impairment losses relating to intangible assets were recorded for the three and nine months ended September 30, 2016 or September 30, 2015.

4. Fair Value

Fair Value Measurement

The Company has elected the Fair Value Option for its mortgage loans held for investment, real estate securities, Other Investment Securities and the related derivative instruments. The Company’s current intentions are to generally hold these investments and related derivatives to generate interest income, however the Company has and may continue to sell certain of these investments as part of its overall investment strategy.

The Company has also elected the Fair Value Option for its mortgage loans held for sale and MSRs in its residential mortgage banking segments. The Company’s mortgage banking operations include originating and selling residential mortgage loans, some of which will be sold servicing retained.

The Company’s management believes that reporting these instruments at their fair value better represents the Company’s financial position than historical cost.

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 tables present the Company’s financial instruments that were accounted for at fair value on a recurring basis at September 30, 2016 and December 31, 2015 by level within the fair value hierarchy:

September 30, 2016

December 31, 2015

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:

Mortgage Loans Held for Investment and Held for Sale Previously Held for Investment, Real Estate Securities and Other Investment Securities

Derivative Instruments

MSRs

See Note 8 – "Mortgage Servicing Rights, at Fair Value" for additional information about the Company's MSRs.

Contingent Consideration

See Note 3 – "Acquisition of GMFS” for additional information about the Company's contingent consideration.

There were no financial assets or liabilities that were accounted for at fair value on a nonrecurring basis at September 30, 2016 or December 31, 2015. During the three and nine months ended September 30, 2016 and September 30, 2015, mortgage loans held for investment were transferred out of Level 3 when the properties were foreclosed and were classified as REO. There were no other transfers into or out of Level 1, Level 2 or Level 3 during the three or nine months ended September 30, 2016 or September 30, 2015.

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