Velocity Financial, Inc. - Quarter Report: 2020 June (Form 10-Q)

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

Emerging growth company

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

☒	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2020

☐	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______ to _____

Commission File Number: 001-39183

Velocity Financial, Inc.

(Exact Name of Registrant as Specified in its Charter)

Delaware	46-0659719
( State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
30699 Russell Ranch Road, Suite 295 Westlake Village, California	91362
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: (818) 532-3700

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

Trading

Symbol(s)

Name of each exchange on which registered

Common stock, par value $0.01 per share

VEL

The New York Stock Exchange

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 every Interactive Data File required to be submitted 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 such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

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

As of July 31, 2020, the registrant had 20,087,494 shares of common stock, $0.01par value per share, outstanding.

Table of Contents

		Page
PART I.	FINANCIAL INFORMATION
Item 1.	Consolidated Financial Statements (Unaudited)	1
	Consolidated Balance Sheets	1
	Consolidated Statements of Income	2
	Consolidated Statements of Changes in Stockholders’/ Members’ Equity	3
	Consolidated Statements of Cash Flows	4
	Notes to Unaudited Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	25
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	49
Item 4.	Controls and Procedures	49

PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	50
Item 1A.	Risk Factors	50
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	50
Item 3.	Defaults Upon Senior Securities	50
Item 4.	Mine Safety Disclosures	50
Item 5.	Other Information	50
Item 6.	Exhibits	51

SIGNATURES		53

PART I—FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements (Unaudited)

VELOCITY FINANCIAL, INC.

(FORMERLY KNOWN AS VELOCITY FINANCIAL, LLC AND SUBSIDIARIES)

CONSOLIDATED BALANCE SHEETS

($ in thousands, except par value amounts)

	June 30, 2020		December 31, 2019
ASSETS	(Unaudited)
Cash and cash equivalents	$	9,803	$	21,465
Restricted cash		6,735		6,087
Loans held for sale, net		212,344		214,467
Loans held for investment, net		1,861,819		1,863,360
Loans held for investment, at fair value		2,956		2,960
Total loans, net		2,077,119		2,080,787
Accrued interest receivables		17,793		13,295
Receivables due from servicers		36,028		49,659
Other receivables		4,609		4,778
Real estate owned, net		15,648		13,068
Property and equipment, net		4,718		4,680
Net deferred tax asset		5,556		8,280
Other assets		9,042		12,667
Total assets	$	2,187,051	$	2,214,766
LIABILITIES
Accounts payable and accrued expenses	$	55,938	$	56,146
Secured financing, net		74,571		145,599
Securitizations, net		1,599,719		1,438,629
Warehouse repurchase facilities, net		160,796		421,548
Total liabilities		1,891,024		2,061,922
Commitments and contingencies
MEZZANINE EQUITY
Series A Convertible preferred stock (45,000 shares designated, $0.01 par value; 45,000 shares issued and outstanding)		90,000		—
STOCKHOLDERS' / MEMBERS' EQUITY
Preferred stock ($0.01 par value, 25,000,000 shares authorized; 45,000 issued and outstanding as reflected in Mezzanine Equity)		—		—
Common stock ($0.01 par value, 100,000,000 shares authorized; 20,087,494 shares issued and outstanding at June 30, 2020, none issued and outstanding at December 31, 2019)		201		—
Additional paid-in capital		203,685		—
Retained earnings		2,141		—
Members’ equity (at December 31, 2019)		—		152,844
Total stockholders' / members’ equity		206,027		152,844
Total liabilities, mezzanine equity and stockholders' / members’ equity	$	2,187,051	$	2,214,766

See accompanying Notes to Consolidated Financial Statements.

VELOCITY FINANCIAL, INC.

(FORMERLY KNOWN AS VELOCITY FINANCIAL, LLC AND SUBSIDIARIES)

CONSOLIDATED STATEMENTS OF INCOME

($ in thousands, except per share amounts)

(Unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2020			2019			2020			2019
Interest income	$	39,755		$	36,884		$	84,391		$	73,028
Interest expense — portfolio related		21,189			20,324			44,036			39,387
Net interest income — portfolio related		18,566			16,560			40,355			33,641
Interest expense — corporate debt		1,894			3,353			8,237			6,706
Net interest income		16,672			13,207			32,118			26,935
Provision for loan losses		1,800			212			3,088			560
Net interest income after provision for loan losses		14,872			12,995			29,030			26,375
Other operating income
Gain on disposition of loans		155			863			2,772			2,858
Unrealized gain (loss) on fair value loans		(13	)		(25	)		32			(34	)
Other income (expense)		(1,481	)		(530	)		(2,524	)		(796	)
Total other operating (expense) income		(1,339	)		308			280			2,028
Operating expenses
Compensation and employee benefits		5,863			3,800			10,904			7,806
Rent and occupancy		448			399			903			736
Loan servicing		1,754			1,551			3,658			3,006
Professional fees		588			534			1,772			1,190
Real estate owned, net		408			561			1,542			862
Other operating expenses		1,847			1,479			4,180			3,223
Total operating expenses		10,908			8,324			22,959			16,823
Income before income taxes		2,625			4,979			6,351			11,580
Income tax expense		484			1,444			1,631			3,350
Net income	$	2,141		$	3,535		$	4,720		$	8,230
Less deemed dividends on preferred stock	$	48,955		NA			$	48,955		NA
Net loss allocated to common shareholders	$	(46,814	)	NA			$	(44,235	)	NA
Loss per common share
Basic	$	(2.33	)	NA			$	(2.20	)	NA
Diluted	$	(2.33	)	NA			$	(2.20	)	NA
Weighted average common share outstanding
Basic		20,087		NA				20,087		NA
Diluted		20,087		NA				20,087		NA

See accompanying Notes to Consolidated Financial Statements.

VELOCITY FINANCIAL, INC.

(FORMERLY KNOWN AS VELOCITY FINANCIAL, LLC AND SUBSIDIARIES)

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ / MEMBERS' EQUITY

($ in thousands)

(Unaudited)

				Common Stock
	Members’ Equity			Shares		Par Value		Additional Paid-in Capital			Retained Earnings			Total Stockholders' Equity
Balance – December 31, 2018	$	136,800			—	$	—	$	—		$	—		$	—
Liquidation preference return, Class C		(463	)		—		—		—			—			—
Net income		4,695			—		—		—			—			—
Balance – March 31, 2019	$	141,032			—		—		—			—			—
Liquidation preference return, Class C		(471	)		—		—		—			—			—
Net income		3,535			—		—		—			—			—
Balance – June 30, 2019	$	144,096			—	$	—	$	—		$	—		$	—

Balance – December 31, 2019	$	152,844			—	$	—	$	—		$	—		$	152,844
Cumulative effect of change in accounting principle(1)		—			—		—		—			(96	)		(96	)
Class A equity units conversion		(92,650	)		—		—		—			—			(92,650	)
Class D equity units conversion		(60,194	)		—		—		—			—			(60,194	)
Issuance of common stock		—			20,087,494		201		247,539			—			247,740
Stock-based compensation		—			—		—		207			—			207
Net income		—			—		—		—			2,579			2,579
Balance – March 31, 2020	$	—			20,087,494	$	201	$	247,746		$	2,483		$	250,430
Deemed dividends-convertible preferred stock		—			—		—		(46,472	)		(2,483	)		(48,955	)
Issuance of warrants		—			—		—		2,158			-			2,158
Stock-based compensation		—			—		—		253			-			253
Net income		—			—		—		—			2,141			2,141
Balance – June 30, 2020	$	—			20,087,494	$	201	$	203,685		$	2,141		$	206,027

(1)	Impact due to adoption of ASU 2016-13, "Measurement of Credit Losses on Financial Instruments", and related amendments on January 1, 2020.

See accompanying Notes to Consolidated Financial Statements.

VELOCITY FINANCIAL, INC.

(FORMERLY KNOWN AS VELOCITY FINANCIAL, LLC AND SUBSIDIARIES)

CONSOLIDATED STATEMENTS OF CASH FLOWS

($ in thousands)

	Six Months Ended June 30,
	2020			2019
	(Unaudited)
Cash flows from operating activities:
Net income	$	4,720		$	8,230
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		606			671
Amortization of right-of-use assets		609			569
Provision for loan losses		3,088			560
Origination of loans held for sale		(96,064	)		(120,373	)
Proceeds from sales of loans held for sale		80,858			121,456
Purchase of held for sale loans		(203	)		(6,362	)
Repayments on loans held for sale		18,843			4,270
Net accretion of discount on purchased loans and deferred loan origination costs		2,265			2,169
Provision for uncollectible borrower advances		174			24
Gain on disposition of loans		(2,772	)		(2,858	)
Amortization of debt issuance discount and costs		8,862			4,573
Loss on disposal of property and equipment		38			6
Change in valuation of real estate owned		1,216			377
Change in valuation of fair value loans		(32	)		34
Change in valuation of held for sale loans		961			(68	)
Gain on sale of real estate owned		(395	)		(156	)
Stock-based compensation		460			—
Net deferred tax benefit		2,765			(2,711	)
(Increase) decrease in operating assets and liabilities:
Accrued interest and other receivables		(4,440	)		4,985
Other assets		(975	)		(11,470	)
Accounts payable and accrued expenses		3,156			5,279
Net cash provided by operating activities		23,740			9,205
Cash flows from investing activities:
Purchase of loans held for investment		(3,571	)		(9,146	)
Origination of loans held for investment		(153,600	)		(296,132	)
Payoffs of loans held for investment and loans at fair value		163,998			178,344
Proceeds from sale of real estate owned		2,827			1,843
Capitalized real estate owned improvements		(347	)		(709	)
Change in advances		(2,554	)		(327	)
Change in impounds and deposits		(3,367	)		(1,633	)
Purchase of property and equipment		(682	)		(189	)
Net cash provided by (used in) investing activities		2,704			(127,949	)
Cash flows from financing activities:
Warehouse repurchase facilities advances		250,416			379,399
Warehouse repurchase facilities repayments		(511,664	)		(315,414	)
Repayment of secured financing		(75,000	)		—
Proceeds of securitizations, net		341,926			235,535
Repayment of securitizations		(179,968	)		(178,269	)
Debt issuance costs		(5,268	)		(3,537	)
Net proceeds from issuance of preferred stock		41,045			—
Proceeds from issuance of warrants		2,158			—
Issuance of common stock		100,800			—
IPO deal costs		(1,903	)		—
Net cash (used in) provided by financing activities		(37,458	)		117,714
Net decrease in cash, cash equivalents, and restricted cash		(11,014	)		(1,030	)
Cash, cash equivalents, and restricted cash at beginning of period		27,552			16,677
Cash, cash equivalents, and restricted cash at end of period	$	16,538		$	15,647
Supplemental cash flow information:
Cash paid during the period for interest	$	42,824		$	40,675
Cash paid during the period for income taxes		38			12,485
Noncash transactions from investing and financing activities:
Transfer of loans held for investment to real estate owned		5,380			8,337
Return paid-in-kind on Class C preferred units		—			934
Return paid-in-kind on Class D preferred units		—			6,757
Deferred IPO costs charged against additional paid-in capital		(4,000	)		—
Discount (premium) on issuance of securitizations		3,126			45

See accompanying Notes to Consolidated Financial Statements.

VELOCITY FINANCIAL, INC. AND SUBSIDIARIES

(FORMERLY KNOWN AS VELOCITY FINANCIAL, LLC AND SUBSIDIARIES)

Notes to Consolidated Financial Statements (Unaudited)

Note 1 — Organization and Description of Business

Velocity Financial, LLC (VF or the Company) was a Delaware limited liability company formed on July 9, 2012 for the purpose of acquiring all membership units in Velocity Commercial Capital, LLC (VCC). On January 16, 2020, Velocity Financial, LLC converted from a Delaware limited liability company to a Delaware corporation and changed its name to Velocity Financial, Inc. Upon completion of the conversion, Velocity Financial, LLC’s Class A equity units of 97,513,533 and Class D equity units of 60,193,989 were converted to 11,749,994 shares of Velocity Financial, Inc. common stock. On January 22, 2020, the Company completed its initial public offering of 7,250,000 shares of common stock at a price to the public of $13.00 per share. On January 28, 2020, the Company completed the sale of an additional 1,087,500 shares of its common stock, representing the full exercise of the underwriters’ option to purchase additional shares, at a public offering price of $13.00 per share. The Company’s stock trades on The New York Stock Exchange under the symbol “VEL”.

VCC, a California LLC formed on June 2, 2004, is a mortgage lender that originates and acquires small balance investor real estate loans, providing capital to the investor real estate loan market. The Company is licensed as a California Finance Lender and, as such, is required to maintain a minimum net worth of $250 thousand. The Company does not believe there is any potential risk of not being able to meet this regulatory requirement. The Company uses its equity capital and borrowed funds to originate and invest in investor real estate loans and seeks to generate income based on the difference between the yield on its investor real estate loan portfolio and the cost of its borrowings. The Company does not engage in any other significant line of business or offer any other products or services, nor does it originate or acquire investments outside of the United States of America.

The Company, through its wholly owned subsidiaries, is the sole beneficial owner of the Velocity Commercial Capital Loan Trusts, from the 2014-1 Trust through and including the 2020-2 Trust, all of which are New York common law trusts. The Trusts are bankruptcy remote, variable interest entities (VIE) formed for the purpose of providing secured borrowings to the Company and are consolidated with the accounts of the Company.

Note 2 — Basis of Presentation and Summary of Significant Accounting Policies

The consolidated financial statements of the Company have been prepared on the accrual basis of accounting and in accordance with United States Generally Accepted Accounting Principles (U.S. GAAP).

(a)	Partnership to Corporation Conversion

On January 16, 2020, Velocity Financial, LLC converted from a limited liability company to a corporation and changed its name to Velocity Financial, Inc. The Conversion was accounted for in accordance with ASC 805-50 –Business Combinations, as a transaction between entities under common control. All assets and liabilities of Velocity Financial, LLC were contributed to Velocity Financial, Inc. at their carrying value, and the results of operations are being presented as if the Conversion had occurred on January 1, 2020. Additionally, Class A and Class D’s partnership equity at December 31, 2019 were converted to stockholders’ equity and presented as such on the Consolidated Balance Sheets and the Consolidated Statement of Changes in Stockholders’ Equity effective January 1, 2020.

(b)	Use of 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, the disclosures of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of consolidated income and expenses during the reporting period.

(c)	Significant Accounting Policies

The Company’s significant accounting policies are described in Note 2 — Basis of Presentation and Summary of Significant Accounting Policies, of its audited consolidated financial statements included in its Annual Report on Form 10-K for the year ended December 31, 2019 as filed with the Securities and Exchange Commission ("Form 10-K").

There have been no significant changes to the Company’s significant accounting policies as described in its 2019 Annual Report other than the adoption of ASU 2016-13 Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments as described in Note 3 — Current Accounting Developments.

(d)	Principles of Consolidation

The principles of consolidation require management to determine and reassess the requirement to consolidate VIEs each reporting period, and therefore, the determination may change based on new facts and circumstances pertaining to each VIE. This could result in a material impact to the Company’s consolidated financial statements in subsequent reporting periods.

The Company consolidates the assets, liabilities, and remainder interests of the Trusts as management determined that VCC is the primary beneficiary of these entities. The Company’s ongoing asset management responsibilities provide the Company with the power to direct the activities that most significantly impact the VIE’s economic performance, and the remainder interests provide the Company with the right to receive benefits and the obligation to absorb losses, limited to its investment in the remainder interest of the Trusts.

The following table presents a summary of the assets and liabilities of the Trusts as of June 30, 2020 and December 31, 2019. Intercompany balances have been eliminated for purposes of this presentation (in thousands):

	June 30, 2020		December 31, 2019
Restricted cash	$	1,501	$	—
Loans held for investment, net		1,813,658		1,571,100
Accrued interest and other receivables		48,012		56,675
Real estate owned, net		8,440		6,091
Other assets		5		11
Total assets	$	1,871,616	$	1,633,877
Accounts payable and accrued expenses	$	29,888	$	21,265
Securities issued		1,599,719		1,438,629
Total liabilities	$	1,629,607	$	1,459,894

The consolidated financial statements as of June 30, 2020 and December 31, 2019 include only those assets, liabilities, and results of operations related to the business of the Company, its subsidiaries, and VIEs, and do not include any assets, liabilities, revenues, and expenses attributable to limited liability members’ individual activities. The liability of each member in an LLC was limited to the amounts reflected in their respective member accounts.

Note 3 — Current Accounting Developments

Accounting Standards Adopted in 2019

Effective January 1, 2020, the Company adopted ASU 2016-13 Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments using the open pool methodology for all financial assets measured at amortized cost, which as of the adoption date consisted of the Company’s held for investment loan portfolio, excluding loans held for investment measured at fair value.

ASU 2016-13 replaces the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (CECL) methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loan receivables held for investment. Under the CECL methodology, the allowance for credit losses is measured on a collective (pool) basis when similar risk characteristics exist. The Company has identified the following portfolio segments based on risk characteristics of the loans in its loan portfolio (pool):

•

Residential 1– 4 Unit – Purchase (loans to purchase 1– 4 unit residential rental properties);

•

Residential 1– 4 Unit – Refinance (refinance loans on 1– 4 unit residential rental properties);

•

Commercial – Purchase (loans to purchase traditional commercial properties) and

•

Commercial – Refinance (refinance loans on traditional commercial properties).

The Company determines the collectability of its loans by evaluating certain risk characteristics. The segmentation of its loan portfolio was determined based on analyses of the Company’s loan portfolio performance over the past seven years. Based on analyses of the loan portfolio’s historical performance, the Company concluded that loan purpose and product types are the most significant risk factors in determining its expectation of future loan losses. Loan purpose considers whether a borrower is acquiring the property or refinancing an existing property. The Company’s historical experience shows that refinance loans have higher loss rates than acquisitions. Product type includes residential 1-4 unit property and traditional commercial property. The Company’s historical experience shows that traditional commercial property loans have higher loss rates than residential 1-4 unit property.

To determine the loss rates used for the open pool methodology, the Company starts with its historical database of losses, segments the loans by loan purpose and product type, and then adjusts the loss rates based upon macroeconomic forecasts over a reasonable and supportable period. The reasonable and supportable period is meant to represent the period in which the Company believes the forecasted macroeconomic variables can be reasonably estimated.

In determining the January 1, 2020 CECL transition impact, the Company used a third-party model with a four-quarter reasonable and supportable forecast period followed by a four-quarter straight-line reversion period. Management determined that a four-quarter forecast period and four-quarter straight-line reversion period were appropriate for the January 1, 2020 initial CECL estimate because, as of the beginning of the year, the economy was strong, unemployment and interest rates were low, and GDP was expected to have a modest increase during 2020. Management concluded that using a 1-year forecast trending steadily back to the Company’s historical loss levels best fit the strong, stable economy at that time.

For the March 31, 2020 CECL estimate, the Company used a COVID-19 stress scenario with a six-quarter reasonable and supportable forecast period followed by a three-quarter straight-line reversion period. Management concluded that using a six-quarter forecast and a three-quarter straight-line reversion best coincided with management and analysts’ sentiments that the impact of the COVID crisis would linger into 2021, with expectation of a quick recovery. This forecast period and reversion to historical loss is subject to change as conditions in the market change and the Company’s ability to forecast economic events evolves.

For the June 30, 2020 CECL estimate, the Company used a COVID-19 stress scenario with a five-quarter reasonable and supportable forecast period followed by a four-quarter straight-line reversion period. Management concluded that the original six-quarter COVID-19 stress forecast was still appropriate and, therefore, used five remaining forecasted quarters as of June 30. Given the second wave of the COVID pandemic, management decided to extend its reversion period by a quarter and used a four-quarter reversion period as of June 30. This forecast period and reversion to historical loss is subject to change as conditions in the market change and the Company’s ability to forecast economic events evolves.

Loans 90 days or more delinquent, in bankruptcy, or in foreclosure, are evaluated individually for determination of allowance for credit losses. Loans individually evaluated are excluded from loans evaluated collectively by segment. The Company primarily relies on the value of the underlying real estate, coupled with low loan-to-value ratios, to satisfy the loan obligation, either through successful loss mitigation efforts or foreclosure and sale of the underlying real estate. Expected loan losses are based on the fair value of the collateral underlying the loans at the reporting date, adjusted for estimated selling costs as appropriate.

The allowance for credit losses is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on the loans. Loans are charged off against the allowance when the Company believes the uncollectibility of a loan balance is confirmed. Expected recoveries do not exceed the aggregate of amounts previously charged-off and expected to be charged-off.

The Company estimates the allowance using relevant available information, from internal and external sources, relating to historical performance, current conditions, and reasonable and supportable macroeconomic forecasts. Historical credit loss experience provides the basis for the estimation of expected credit losses. Adjustments to historical loss information are considered for differences in current loan-specific risk characteristics such as differences in underwriting standards, portfolio mix, delinquency levels, or term, as well as for changes in environmental conditions, such as unemployment rates, property values and changes in the competitive or regulatory environment.

The allowance for credit losses is maintained at a level deemed adequate by management to provide for expected losses in the portfolio at the balance sheet date. While management uses available information to estimate its required allowance for credit losses, future additions to the allowance for credit losses may be necessary based on changes in estimates resulting from economic and other conditions.

Interest income on loans held for investment is accrued on the unpaid principal balance (UPB) at their respective stated interest rates. Generally, loans are placed on nonaccrual status when they become 90 days past due. Loans are considered past due when contractually required principal or interest payments have not been made on the due dates. Management has concluded that ASC 310-20-35-18(a) on interest income recognition does not apply to the forbearances granted under the Company’s COVID-19 forbearance program. The Company will continue to accrue interest on the COVID-19 forbearance granted loans for all such loans that were less than 90 days past due at the forbearance grant date. The Company will continue to evaluate the COVID-19 forbearance-granted loans on an individual basis to determine if a reserve should be established on the collectability of the accrued interest and whether any loans should be placed on nonaccrual status at a future date.

The Company has made the accounting policy election not to measure an allowance for credit losses for accrued interest receivables. When a loan is placed on nonaccrual status, the accrued and unpaid interest is reversed as a reduction of interest income and accrued interest receivable. Accrued interest receivable is excluded from the amortized cost of loans and it is presented as accrued interest receivable in the Consolidated Balance Sheets.

The Company adopted ASU 2016-13, or ASU 326 using the modified-retrospective transition approach. Upon adoption, the Company recognized a cumulative effect adjustment to decrease retained earnings by $96,000, net of taxes. Results for reporting periods after January 1, 2020 are presented under ASC 326, while prior period amounts continue to be reported in accordance with previously applicable GAAP.

The following table illustrates the impact of ASC 326 on the Company’s allowance for credit losses (in thousands):

	January 1, 2020
	As Reported				Impact of
	Under		Pre-ASC 326		ASC 326
Allowance for credit losses	ASC 326		Adoption		Adoption
Commercial - Purchase	$	323	$	304	$	19
Commercial - Refinance		1,078		1,016		62
Residential 1-4 Unit - Purchase		157		148		9
Residential 1-4 Unit - Refinance		819		772		47
Total	$	2,377	$	2,240	$	137

Recent Regulatory and Legislative Developments

On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), which, among other things, allows the Company to (i) elect to suspend the requirements under GAAP for loan modifications related to COVID-19 that would otherwise be categorized as troubled debt restructurings (TDRs), and (ii) suspend any determination of a loan modified as a result of the effects of COVID-19 as being a TDR, including impairment for accounting purposes.

On March 22, 2020, the federal banking agencies issued an interagency statement to provide additional guidance to financial institutions who are working with borrowers affected by COVID-19. The agencies have confirmed with staff of the Financial Accounting Standards Board that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief, are not TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers considered current are those that are less than 30 days past due on their contractual payments at the time a modification program is implemented

In response to the COVID-19 pandemic, the Company has implemented a COVID-19 forbearance program allowing customers to primarily defer payments for up to 90 days. Deferrals under the CARES Act or interagency guidance are not considered troubled debt restructurings. Interest on loans in the COVID-19 forbearance program that were less than 90 days past due at forbearance grant date will continue to accrue.

Note 4 — Cash, Cash Equivalents, and Restricted Cash

The Company is required to hold cash for potential future advances due to certain borrowers. The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported within the Company’s consolidated statement of financial condition that sum to the total of the same such amounts shown in the consolidated statements of cash flows for the six months ended June 30, 2020 and 2019 (in thousands):

	Six Months Ended June 30,
	2020		2019
Cash and cash equivalents	$	9,803	$	14,105
Restricted cash		6,735		1,542
Total cash, cash equivalents, and restricted cash shown in the statement of cash flows	$	16,538	$	15,647

Note 5 — Loans Held for Sale, Net

The following table summarizes loans held for sale as of June 30, 2020 and December 31, 2019 (in thousands):

	June 30, 2020			December 31, 2019
Unpaid principal balance	$	214,382		$	216,054
Valuation adjustments		(1,307	)		(396	)
Deferred loan origination costs		(731	)		(1,191	)
Ending balance	$	212,344		$	214,467

As of June 30, 2020, $41.0 million of loans held for sale have participated in the COVID-19 forbearance program. Accrued interest on these loans was $1.7 million as of June 30, 2020.

Note 6 — Loans Held for Investment and Loans Held for Investment at Fair Value

The following tables summarize loans held for investment as of June 30, 2020 and December 31, 2019 (in thousands):

	June 30, 2020									December 31, 2019
	Loans held for investment, net			Loans held for investment, at fair value			Total loans held for investment			Total loans held for investment
Unpaid principal balance	$	1,841,238		$	3,369		$	1,844,607		$	1,843,290
Valuation adjustments on FVO loans		—			(413	)		(413	)		(444	)
Deferred loan origination costs		25,801			—			25,801			25,714
		1,867,039			2,956			1,869,995			1,868,560
Allowance for loan losses		(5,220	)		—			(5,220	)		(2,240	)
Total loans held for investment and loans held for investment at fair value, net	$	1,861,819		$	2,956		$	1,864,775		$	1,866,320

As of June 30, 2020, $293.7 million of loans held for investment have participated in the COVID-19 forbearance program. Accrued interest on these loans was $11.6 million as of June 30, 2020.

As of June 30, 2020 and December 31, 2019, the gross unpaid principal balance of loans held for investment pledged as collateral for the Company’s warehouse facility agreements, and securitizations issued were as follows (in thousands):

	June 30, 2020		December 31, 2019
Citibank warehouse repurchase agreement	$	148,272	$	108,504
Barclays warehouse repurchase agreement		120,498		175,689
Pacific Western Bank agreement		—		3,331
Total pledged loans	$	268,770	$	287,524

2014-1 Trust		26,124		29,559
2015-1 Trust		59,168		64,876
2016-1 Trust		82,693		97,727
2016-2 Trust		56,517		68,961
2017-1 Trust		95,491		116,670
2017-2 Trust		157,558		173,390
2018-1 Trust		129,111		141,567
2018-2 Trust		239,362		260,278
2019-1 Trust		218,681		229,151
2019-2 Trust		193,185		210,312
2019-3 Trust		146,479		157,119
2020-1 Trust		256,683		—
2020-2 Trust		128,207
Total	$	1,789,259	$	1,549,610

(a)	Nonaccrual Loans

The following tables present the amortized cost basis, or recorded investment, of the Company’s loans held for investment that were nonperforming and on nonaccrual status as of June 30, 2020 and December 31, 2019, and accruing loans that were 90 days or more past due as of June 30, 2020 under the Company’s COVID-19 payment deferral programs. There were no loans accruing interest that were greater than 90 days past due as of December 31, 2019.

	June 30, 2020
	Nonaccrual With				Loans 90+ DPD
	No Allowance		Total		Still Accruing
	for Loan Loss		Nonaccrual		COVID-19 Program
	(In thousands)
Commercial - Purchase	$	19,269	$	20,615	$	18,798
Commercial - Refinance		109,897		113,350		54,323
Residential 1-4 Unit - Purchase		21,760		22,017		14,603
Residential 1-4 Unit - Refinance		109,005		114,790		36,264
Total	$	259,931	$	270,772	$	123,988

Troubled Debt Restructuring included in nonaccrual loans:	$	—	$	175	$	—

	December 31, 2019
	($ in thousands)
Nonaccrual loans:
Recorded investment	$	125,819
Percentage of the originated loans held for investment		6.7	%
Impaired loans:
Unpaid principal balance	$	124,050
Recorded investment		125,998
Recorded investment of impaired loans requiring a specific allowance		12,286
Specific allowance		913
Specific allowance as a percentage of recorded investment of impaired loans requiring a specific allowance		7.4	%
Recorded investment of impaired loans not requiring a specific allowance	$	113,712
Percentage of recorded investment of impaired loans not requiring a specific allowance		90.2	%
TDRs included in impaired loans:
Recorded investment of TDRs	$	179
Recorded investment of TDRs with a specific allowance		179
Specific allowance		25
Recorded investment of TDRs without a specific allowance		—

The Company has made the accounting policy election not to measure an allowance for credit losses for accrued interest receivables. The Company has also made the accounting policy election to write off accrued interest receivables by reversing interest income when loans are placed on nonaccrual status, or 90 days or more past due, other than the COVID-19 forbearance-granted loans. The Company will continue to evaluate the COVID-19 forbearance-granted loans on an individual basis to determine if a reserve should be established on the collectability of the accrued interest and whether any loans should be placed on nonaccrual status at a future date. The following table presents the amortized cost basis in the loans held for investment as of June 30, 2020 and 2019, and the amount of accrued interest receivables written off by reversing interest income by portfolio segment for the six months ended June 30, 2020 and 2019 (in thousands):

	June 30, 2020				June 30, 2019
	Amortized Cost		Interest Reversal		Amortized Cost		Interest Reversal
Commercial - Purchase	$	303,373	$	425	$	255,802	$	119
Commercial - Refinance		711,397		2,633	$	647,838		558
Residential 1-4 Unit - Purchase		245,579		404	$	237,445		154
Residential 1-4 Unit - Refinance		606,432		2,255	$	544,663		499
Total	$	1,866,781	$	5,717	$	1,685,748	$	1,330

For the six months ended June 30, 2020 and 2019, there was no accrued interest income recognized on nonaccrual loans, cash basis interest income recognized on nonaccrual loans was $6.7 million and $5.4 million, respectively, and the average recorded investment of individually evaluated loans, computed using month-end balances, was $180.2 million and $105.2 million, respectively. There were no commitments to lend additional funds to debtors whose loans have been modified as of June 30, 2020 and December 31, 2019.

(b)	Allowance for Credit Losses

The following tables present the activity in the allowance for credit losses for the three and six months ended June 30, 2020 and 2019 (in thousands):

	Three Months Ended June 30,
	2020													2019
					Residential			Residential
	Commercial		Commercial		1-4 Unit			1-4 Unit
	Purchase		Refinance		Purchase			Refinance			Total			Total
Allowance for credit losses:
Beginning balance	$	352	$	1,594	$	250		$	1,300		$	3,496		$	1,916
Provision for loan losses		172		1,093		211			324			1,800			212
Charge-offs		—		—		(58	)		(18	)		(76	)		(32	)
Ending balance	$	524	$	2,687	$	403		$	1,606		$	5,220		$	2,096

	Six Months Ended June 30,
	2020														2019
						Residential			Residential
	Commercial			Commercial		1-4 Unit			1-4 Unit
	Purchase			Refinance		Purchase			Refinance			Total			Total
Allowance for credit losses:
Beginning balance, prior to adoption of ASC 326	$	304		$	1,016	$	148		$	772		$	2,240		$	1,680
Impact of adopting ASC 326		19			62		9			47			137			—
Provision for loan losses		280			1,609		382			817			3,088			560
Charge-offs		(79	)		—		(136	)		(30	)		(245	)		(144	)
Ending balance	$	524		$	2,687	$	403		$	1,606		$	5,220		$	2,096

Allowance related to:
Loans individually evaluated	$	181		$	592	$	96		$	404		$	1,273		$	803
Loans collectively evaluated		342			2,095		307			1,203			3,947			1,293
Amortized cost related to:
Loans individually evaluated	$	20,615		$	113,350	$	22,017		$	114,790		$	270,772		$	99,905
Loans collectively evaluated		282,759			598,046		223,561			491,643			1,596,009			1,585,843

(c)	Credit Quality Indicator

A credit quality indicator is a statistic used by the Company to monitor and assess the credit quality of loans held for investment, excluding loans held for investment at fair value. The Company monitors its charge-off rate in relation to its nonperforming loans as its credit quality indicator. Nonperforming loans are loans that are 90 or more days past due, in bankruptcy, in foreclosure, or not accruing interest. For the three months ended June 30, 2020, the annualized charge-off rate was 0.1%of average nonperforming loans. The charged-off rate was 0.52% for the year ended December 31, 2019.

Other credit quality indicators include aging status and accrual status. The following table presents the aging status of the amortized cost basis in the loans held for investment portfolio as of June 30, 2020, which includes $293.7 million loans in the Company’s COVID-19 forbearance program, and as of December 31, 2019 (in thousands):

	30–59 days		60–89 days		90+days		Total				Total
June 30, 2020	past due		past due		past due⁽¹⁾		past due		Current		loans
Loans individually evaluated
Commercial - Purchase	$	256	$	2,346	$	18,013	$	20,615	$	—	$	20,615
Commercial - Refinance		6,349		3,957		102,869		113,175		175		113,350
Residential 1-4 Unit - Purchase		—		193		21,824		22,017		—		22,017
Residential 1-4 Unit - Refinance		2,122		3,741		108,927		114,790		—		114,790
Total loans individually evaluated	$	8,727	$	10,237	$	251,633	$	270,597	$	175	$	270,772
Loans collectively evaluated
Commercial - Purchase	$	20,880	$	21,454	$	18,798	$	61,132	$	221,626	$	282,758
Commercial - Refinance		42,512		57,863		54,323		154,698		443,349		598,047
Residential 1-4 Unit - Purchase		16,377		17,571		14,603.0		48,551		175,011		223,562
Residential 1-4 Unit - Refinance		43,251		51,319		36,264.0		130,834		360,808		491,642
Total loans collectively evaluated	$	123,020	$	148,207	$	123,988	$	395,215	$	1,200,794	$	1,596,009
Ending balance	$	131,747	$	158,444	$	375,621	$	665,812	$	1,200,969	$	1,866,781

December 31, 2019:
Impaired loans	$	6,195	$	7,696	$	111,928	$	125,819	$	179	$	125,998
Nonimpaired loans		119,465		41,138		—		160,603		1,578,984		1,739,587
Ending balance	$	125,660	$	48,834	$	111,928	$	286,422	$	1,579,163	$	1,865,585

(1)

Includes loans in bankruptcy and foreclosure less than 90 days past due

The following table presents the aging of the amortized cost basis of loans held for investment in the Company's COVID-19 forbearance program as of June 30, 2020 (in thousands):

	30–59 days		60–89 days		90+days		Total				Total
June 30, 2020	past due		past due		past due⁽¹⁾		past due		Current		loans
Loans individually evaluated
Commercial - Purchase	$	—	$	607	$	493	$	1,100	$	—	$	1,100
Commercial - Refinance		2,143		2,659		5,938		10,740		—		10,740
Residential 1-4 Unit - Purchase		—		—		—		—		—		—
Residential 1-4 Unit - Refinance		—		677		6,935		7,612		—		7,612
Total loans individually evaluated	$	2,143	$	3,943	$	13,366	$	19,452	$	—	$	19,452
Loans collectively evaluated
Commercial - Purchase	$	6,397	$	18,220	$	18,798	$	43,415	$	1,357	$	44,772
Commercial - Refinance		14,932		39,382		54,323		108,637		5,128		113,765
Residential 1-4 Unit - Purchase		4,447		12,957		14,603.0		32,007		504		32,511
Residential 1-4 Unit - Refinance		11,607		30,649		36,264.0		78,520		4,718		83,238
Total loans collectively evaluated	$	37,383	$	101,208	$	123,988	$	262,579	$	11,707	$	274,286
Ending balance	$	39,526	$	105,151	$	137,354	$	282,031	$	11,707	$	293,738

(1)

Includes loans in bankruptcy and foreclosure less than 90 days past due

In addition to the aging status, the Company also evaluates credit quality by accrual status. The following table presents the amortized cost in loans held for investment, excluding loans held for investment at fair value, based on accrual status and by loan origination year.

	Term Loans Amortized Cost Basis by Origination Year
June 30, 2020:	2020		2019		2018		2017		2016		Pre-2016		Total
Commercial - Purchase
Payment performance
Performing	$	34,584	$	108,737	$	69,533	$	43,403	$	12,436	$	14,065	$	282,758
Nonperforming		1,248		2,311		7,556		5,455		1,638		2,407		20,615
Total Commercial - Purchase	$	35,832	$	111,048	$	77,089	$	48,858	$	14,074	$	16,472	$	303,373

Commercial - Refinance
Payment performance
Performing	$	47,092	$	189,377	$	162,485	$	97,438	$	41,402	$	60,253	$	598,047
Nonperforming		4,329		24,968		36,661		26,465		8,234		12,693		113,350
Total Commercial - Refinance	$	51,421	$	214,345	$	199,146	$	123,903	$	49,636	$	72,946	$	711,397

Residential 1-4 Unit - Purchase
Payment performance
Performing	$	17,197	$	79,654	$	52,571	$	33,293	$	9,076	$	31,771	$	223,562
Nonperforming		—		6,057		6,715		4,355		1,348		3,542		22,017
Total Residential 1-4 Unit - Purchase	$	17,197	$	85,711	$	59,286	$	37,648	$	10,424	$	35,313	$	245,579

Residential 1-4 Unit - Refinance
Payment performance
Performing	$	45,449	$	194,144	$	106,217	$	73,069	$	28,540	$	44,223	$	491,642
Nonperforming		3,206		35,013		37,479		16,467		7,400		15,225		114,790
Total Residential 1-4 Unit - Purchase	$	48,655	$	229,157	$	143,696	$	89,536	$	35,940	$	59,448	$	606,432

Total Portfolio	$	153,105	$	640,261	$	479,217	$	299,945	$	110,074	$	184,179	$	1,866,781

Note 7 — Securitizations, Net

From May 2011 through June 2020, the Company completed fourteen securitizations of $3.1 billion of loans, issuing $2.9 billion of securities to third parties through fourteen respective Trusts. The Company is the sole beneficial interest holder of the Trusts, which are variable interest entities included in the consolidated financial statements. The transactions are accounted for as secured borrowings under U.S. GAAP. The securities are subject to redemption by the Company when the stated principal balance is less than a certain percentage, ranging from 5%–30% of the original stated principal balance of loans at issuance. As a result, the actual maturity dates of the securities issued could be earlier than their respective stated maturity dates, ranging from September 2044 through June 2050.

The following table summarizes the outstanding balance, net of discounts and deals costs, of the securities and the effective interest rate for the six months ended June 30, 2020 and 2019 (dollars in thousands):

	Six Months Ended June 30,
	2020			2019
Securitizations:
Securitizations, net	$	1,599,719		$	1,261,456
Interest expense		37,104			33,553
Average outstanding balance		1,565,754			1,277,009
Effective interest rate (1)		4.74	%		5.25	%

(1)	Represents annualized interest expense divided by average gross outstanding balance and includes average rate (4.19%) and debt issue cost amortization (0.55%) and average rate (4.65%) and debt issue cost amortization (0.60%) for the six months ended June 30, 2020 and 2019, respectively.

Note 8 — Other Debt

The secured financing and warehouse facilities were utilized to finance the origination and purchase of commercial real estate mortgage loans. Warehouse facilities are designated to fund mortgage loans that are purchased and originated within specified underwriting guidelines. These lines of credit fund less than 100% of the principal balance of the mortgage loans originated and purchased, requiring the use of working capital to fund the remaining portion.

(a)	Secured Financing, Net (Corporate Debt)

On August 29, 2019, the Company entered into a five-year $153.0 million corporate debt agreement with Owl Rock Capital Corporation, the “2019 Term Loan”. The 2019 Term Loan under this agreement bears interest at a rate equal to one-month LIBOR (with a LIBOR floor that is generally 1.0%) plus 7.50% and matures in August 2024.

As of June 30, 2020 and December 31, 2019, the balance of the 2019 Term Loan was $78.0 million and $153.0 million, respectively. In January 2020, the Company used a portion of its IPO proceeds to pay down $75.0 million in principal amount of the 2019 Term Loan. The balance in the consolidated Statements of Financial Condition is net of debt issuance costs of $3.4 million and $7.4 million, respectively. The 2019 Term Loan is secured by substantially all assets of the Company not otherwise pledged under a securitization or warehouse facility and contains certain reporting and financial covenants. Should the Company fail to adhere to those covenants or otherwise default under the notes, the lenders have the right to demand immediate repayment that may require the Company to sell the collateral at less than the carrying amounts. As of June 30, 2020 and December 31, 2019, the Company was in compliance with these covenants.

(b)	Warehouse Repurchase and Revolving Loan Facilities, Net

The Barclays Repurchase Agreement was originally entered into on May 29, 2015 by and between VCC and Barclays Bank PLC and matured on August 3, 2020. The agreement was a short-term borrowing facility, collateralized by a pool of loans, with an initial maximum capacity of $300.0 million, and borne interest at one-month LIBOR plus a margin that ranges from 3.000% to 3.125%. All borrower payments on loans financed under the warehouse repurchase facility were first used to pay interest on the facility. For the six months ended June 30, 2020 and 2019, the effective interest rates were 4.81% and 5.90%, respectively.

The Citibank Repurchase Agreement was originally entered into on May 17, 2013 by and between VCC and Citibank, N.A. and has a current maturity date of September 30, 2020. The Agreement is a short-term borrowing facility, collateralized by a pool of performing loans, with a maximum capacity of $200.0 million, and bears interest at one-month LIBOR plus 3.25%. All borrower payments on loans financed under the warehouse repurchase facility are first used to pay interest on the facility. For the six months ended June 30, 2020 and 2019, the effective interest rates were 4.29% and 5.78%, respectively.

On September 12, 2018, the Company entered into a three-year secured revolving loan facility agreement with Pacific Western Bank. During the borrowing period, the Company can take loan advances from time to time subject to availability. Each loan advance bears interest at the lesser of the one-month LIBOR Rate plus 3.5% per annum and the maximum rate, which is the highest lawful and non-usurious rate of interest applicable to the loan. The maximum loan amount under this facility is $50 million. This facility was paid down to zero as of June 30, 2020.

On December 26, 2019, the Company entered into a $3.0 million loan agreement with Hershiser Capital Finance, the “HCF loan”. The HCF loan is secured by five real properties acquired by the Company through foreclosure or by deed-in lieu of foreclosure. The HCF loan bears a fixed interest rate of 9.5%, and matures the earlier of (i) January 1, 2021, and (ii) the date on which the unpaid principal balance of this loan becomes due and payable by acceleration or otherwise pursuant to the loan documents or the exercise by the lender of any right or remedy under any loan document. The maturity date of the HCF loan is subject to extension up to July 1, 2021.

Certain of the Company’s loans are pledged as security under the warehouse repurchase facilities and the revolving loan facility, which contain covenants. Should the Company fail to adhere to those covenants or otherwise default under the facilities, the lenders have the right to terminate the facilities and demand immediate repayment that may require the Company to sell the collateral at less than the carrying amounts. As of June 30, 2020 and December 31, 2019, the Company was in compliance with these covenants.

The following table summarizes the maximum borrowing capacity and current gross balances outstanding for the Company’s warehouse facilities and loan agreements as of June 30, 2020 and December 31, 2019 (in thousands):

	June 30, 2020				December 31, 2019
	Period end balance⁽¹⁾		Maximum borrowing capacity		Period end balance⁽¹⁾		Maximum borrowing capacity
Barclays repurchase agreement	$	71,522	$	300,000	$	226,212	$	250,000
Citibank repurchase agreement		87,098		200,000		190,977		200,000
Pacific Western credit agreement		—		50,000		2,499		50,000
Hershiser Capital Finance loan agreement		2,820		3,000		3,000		3,000

(1)	Warehouse repurchase facilities amounts in the consolidated balance sheets are net of debt issuance costs amounting to $0.6 million and $1.1 million as of June 30, 2020 and December 31, 2019, respectively.

The following table provides an overview of the activity and effective interest rate for the six months ended June 30, 2020 and 2019 (dollars in thousands):

	Six Months Ended June 30,
	2020			2019
Warehouse repurchase facilities:
Average outstanding balance	$	295,013		$	197,721
Highest outstanding balance at any month-end		439,547			280,710
Effective interest rate (1)		4.70	%		5.90	%

(1)	Represents annualized interest expense divided by average gross outstanding balance and includes average rate (4.29%) and debt issue cost amortization (.41%) and average rate (5.46%) and debt issue cost amortization (0.44%) for the six months ended June 30, 2020 and 2019, respectively.

The following table provides a summary of interest expense that includes debt issuance cost amortization, interest, amortization of discount, and deal cost amortization for the six months ended June 30, 2020 and 2019 (in thousands):

	Six Months Ended June 30,
	2020			2019
Warehouse repurchase facilities	$	6,932		$	5,834
Securitizations		37,104			33,553
Interest expense — portfolio related		44,036			39,387
Interest expense — corporate debt		8,237	(1)		6,706
Total interest expense	$	52,273		$	46,093

(1)

Included in the $8.2 million of interest expense – corporate debt for the six months ended June 30, 2020 was the one-time debt issuance costs write-off of $3.5 million and prepayment penalties of $0.3 million associated with the repayment of $75.0 million in outstanding principal amount in January 2020.

Note 9 — Commitments and Contingencies

(a)	Repurchase Liability

When the Company sells loans, it is required to make normal and customary representations and warranties about the loans to the purchaser. The loan sale agreements generally require the Company to repurchase loans if the Company breaches a representation or warranty given to the loan purchaser. In addition, the Company may be required to repurchase loans as a result of borrower fraud or if a payment default occurs on a loan shortly after its sale.

The Company records a repurchase liability relating to representations and warranties and early payment defaults. The method used to estimate the liability for repurchase is a function of the representations and warranties given and considers a combination of factors, including, but not limited to, estimated future defaults and loan repurchase rates and the potential severity of loss in the event of defaults. The Company establishes a liability at the time loans are sold and continually updates the estimated repurchase liability. The level of the repurchase liability for representations and warranties and early payment default requires considerable management judgment. As of June 30, 2020 and December 31, 2019, the balance of repurchase liability was $76 thousand, and it is included in accounts payable and accrued expenses in the consolidated balance sheets.

(b)	Legal Proceedings

The Company is a party to various legal proceedings in the normal course of business. The Company, after consultation with legal counsel, believes the disposition of all pending litigation will not have a material effect on the Company’s consolidated financial condition or results of operations.

Note 10 — Members’ Equity

Prior to the conversion of Velocity Financial, LLC into a corporation, the Company had the authority to issue four types of membership units, Class A, Class B, Class C, and Class D units. The Class A units represented ownership interests in VF. Class B units were profit interest units, which represented a right to share, with the Class A units, in the distribution of profits earned by the Company. The Class C and Class D units were preferred units, which had the right to convert to Class A units.

The Company repurchased all outstanding Class C preferred units for an aggregate purchase price equal to the Class C liquidation preference of approximately $27.7 million on August 29, 2019. All Class A and Class D units were converted to common stock upon the conversion of the Company into a corporation on January 16, 2020. All Class B units were converted at zero value upon the conversion of the Company into a corporation on January 16, 2020. Prior to the Company’s IPO, the outstanding Class A, Class B and Class D units and equity balance were as follows as of December 31, 2019 ($ in thousands):

	December 31, 2019
Class A units issued and outstanding		97,514
Class A equity balance	$	92,650
Class B units issued and outstanding		16,072
Class B equity balance	$	—
Class D units issued and outstanding		60,194
Class D equity balance	$	60,194

Note 11 — Stock-Based Compensation

The Company’s 2020 Omnibus Incentive Plan, or the 2020 Plan, authorized grants of stock‑based compensation instruments to purchase or issue up to 1,520,000 shares of Company common stock. In connection with its IPO in January 2020, the Company granted stock options to non-employee directors and certain employees, including named executive officers to purchase approximately 782,500 shares of common stock with an exercise price per share equal to the initial public offering price of $13.00.

Stock options vest ratably over a service period of three years from the date of the grant. Compensation expense related to stock options is based on the fair value of the underlying stock on the award date and is recognized over the vesting period using the straight‑line method. For the six months ended June 30, 2020, 10,000 shares of stock options were forfeited, and the Company recognized $0.5 million compensation expense related to the outstanding stock options granted to employees. Such amount is included in “Compensation and employee benefits” on the Consolidated Statement of Income. The amount of unrecognized compensation expense related to unvested stock options totaled $2.6 million as of June 30, 2020. As of June 30, 2020, unvested stock options outstanding were 772,500 shares at an exercise price per share of $13.00.

Note 12 — Earnings (Loss) Per Share

The two-class method is used in the calculation of basic and diluted earnings per share. Under the two-class method, earnings available to common shareholders for the period are allocated between common shareholders and participating securities according to dividends declared (or accumulated) and participation rights in undistributed earnings. Basic earnings per share is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if stock options or other contracts to issue common stock were exercised or converted into common stock and resulted in the issuance of common stock that shared in earnings.

The following table presents the basic and diluted loss per share calculations for the three and six months ended June 30, 2020:

	Three Months Ended			Six Months Ended
	June 30, 2020			June 30, 2020
	(In thousands, except share and per share data)
Basic EPS:
Net income	$	2,141		$	4,720
Less deemed dividends on preferred stock		48,955			48,955
Net loss allocated to common stock	$	(46,814	)	$	(44,235	)
Less earnings allocated to participating securities		—			—
Net loss allocated to common stock	$	(46,814	)	$	(44,235	)
Weighted average common shares outstanding		20,087			20,087
Basic loss per common share	$	(2.33	)	$	(2.20	)
Diluted EPS:
Net loss allocated to common shareholders	$	(46,814	)	$	(44,235	)
Weighted average common shares outstanding		20,087			20,087
Add dilutive effects for assumed conversion of Series A preferred stock		—			—
Add dilutive effects for warrants		—			—
Add dilutive effects for stock options		—			—
Weighted average diluted common shares outstanding		20,087			20,087
Diluted loss per common share	$	(2.33	)	$	(2.20	)

Earnings per common share is not applicable to periods prior to the Company's IPO on January 17, 2020.

The following table sets forth the number of shares excluded from the computation of diluted loss per share, as their inclusion would have been anti-dilutive:

	Three Months Ended		Six Months Ended
	June 30, 2020		June 30, 2020
Shares underlying Series A Convertible Preferred Stock		11,688,312		11,688,312
Shares underlying warrants		3,013,125		3,013,125
Stock options		772,500		772,500
Share equivalents excluded from EPS		15,473,937		15,473,937

Note 13 — Convertible Preferred Stock

On April 7, 2020, the Company issued and sold in a private placement 45,000 newly issued shares of Series A Convertible Preferred Stock, par value $0.01 per share (the “Preferred”), at a price per share of $1,000, plus warrants (the “Warrants”) to purchase an aggregate of 3,013,125 shares of the Company’s common stock to funds affiliated with Snow Phipps and a fund affiliated with Pacific Investment Management Company LLC (TOBI). Snow Phipps and TOBI are considered affiliates and, therefore, are related parties to the Company. This offering resulted in net proceeds to the Company of $43.2 million. In connection with these transactions, the Company entered into a securities purchase agreement with Snow Phipps and TOBI granting TOBI the right to nominate an additional director to the Company’s board of directors for so long as TOBI and its permitted transferees meet certain ownership thresholds.

The Preferred ranks senior to the Company’s common stock with respect to the payment of dividends and distribution of assets upon liquidation, dissolution and winding up. It is entitled to receive any dividends or distributions paid in respect of the common stock on an as-converted basis and has no stated maturity and will remain outstanding indefinitely unless converted into common stock or repurchased by the Company. Holders of the Preferred will be entitled to vote, together with the holders of common stock, on an as-converted basis, subject to limitations of the rules of the New York Stock Exchange, on all matters submitted to a vote of the holders of common stock, and as a separate class as required by law. The holders of the Preferred will also have the right to elect two directors to the board of directors of the Company if the Company defaults under its obligation to repurchase the Preferred.

The Preferred has a liquidation preference equal to the greater of (i) $2,000 per share from April 7, 2020 through October 7, 2022, which amount increases ratably to $3,000 per share from October 8, 2022 through November 28, 2024 and to $3,000 per share from and after November 28, 2024 and (ii) the amount such holder would have received if the Preferred had converted into common stock immediately prior to such liquidation.

Following shareholder approval at the Special Meeting of Shareholders held on August 13, 2020, the Preferred is convertible at the option of the holder into the number of shares of common stock equal to then applicable conversion rate plus cash in lieu of fractional shares, if any. The initial conversion price is $3.85 per share of common stock and is subject to customary antidilution adjustments. In addition, the Company has the right to cause the Preferred to convert beginning October 7, 2021 if the Company’s common stock meets certain weighted average price targets.

Beginning on October 7, 2022, if permitted by the terms of the Company’s material indebtedness, and in no event later than November 28, 2024, holders of the Preferred have the option to cause the Company to repurchase all or a portion of such holder’s shares of Preferred, for an amount in cash equal to such share’s liquidation preference. If the Company defaults on its repurchase obligation, the holders of the Preferred have the right (until the repurchase price has been paid in full, in cash, or such the Preferred has been converted) to force a sale of the Company and the holders of the Preferred will have the right to elect two directors of the Company’s Board until such default is cured. The Company is also required to redeem the Preferred upon a change of control (as defined in the certificate of designation governing the Preferred).

The Warrants are exercisable at the warrantholder’s option at any time and from time to time, in whole or in part, until April 7, 2025 at an exercise price of $2.96 per share of common stock, with respect to 2,008,750 of the Warrants, and at an exercise price of $4.94 per share of common stock, with respect to 1,004,375 of the Warrants. The exercise price and the number of shares of common stock issuable upon exercise of the Warrants are subject to customary antidilution adjustments and certain issuances of common stock (or securities convertible into or exercisable for common stock) at a price (or having a conversion or exercise price) that is less than the then current exercise price. The Company is not required to affect an exercise of Warrants, if after giving effect to the issuance of common stock upon exercise of such Warrants such warrantholder together with its affiliates would beneficially own 49% or more of the Company’s outstanding common stock.

The Company determined that none of the features embedded in the Preferred were required to be accounted for separately as a derivative.

The Preferred is recorded as mezzanine equity (temporary equity) on the consolidated balance sheets because it is not mandatorily redeemable, but does contain a redemption feature at the option of the preferred stock holders that is considered not solely within the Company’s control. Because the Preferred becomes redeemable at any time after 2.5 years from the Closing Date of April 7, 2020, the Company has elected to recognize the changes in the maximum redemption value immediately as they occur and adjust the carrying value of the Preferred to equal the maximum redemption value at the end of each reporting period which is viewed as the redemption date for the Preferred. At June 30, 2020, the Company recognized the Preferred maximum redemption value of $90.0 million, which is the maximum redemption value on the earliest redemption date based on a redemption value of $2,000 per share and 45,000 shares of Preferred. The recording of the Preferred maximum redemption value was treated as a deemed dividend and resulted in a $49.0 million charge to Shareholders’ Equity.

Note 14 — Fair Value Measurements

(a)	Fair Value Determination

ASC Topic 820, “Fair Value Measurement,” defines fair value, establishes a framework for measuring fair value including a three-level valuation hierarchy, and requires disclosures about fair value measurements. Fair value is defined as the exchange price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date reflecting assumptions that a market participant would use when pricing an asset or liability. The hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows:

•

Level 1 - Valuation is based on quoted prices for identical instruments traded in active markets.

•

Level 2 - Valuation is based on quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable and can be corroborated by market data.

•

Level 3 - Valuation is based on significant unobservable inputs for determining the fair value of assets or liabilities. These significant unobservable inputs reflect assumptions that market participants may use in pricing the assets or liabilities.

Given the nature of some of the Company’s assets and liabilities, clearly determinable market-based valuation inputs are often not available; therefore, these assets and liabilities are valued using internal estimates. As subjectivity exists with respect to the valuation estimates used, the fair values disclosed may not equal prices that can ultimately be realized if the assets are sold or the liabilities are settled with third parties.

Below is a description of the valuation methods for the assets and liabilities recorded at fair value on either a recurring or nonrecurring basis and for estimating fair value of financial instruments not recorded at fair value for disclosure purposes. While management believes the valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the measurement date.

(b)	Cash and Cash Equivalents and Restricted Cash

Cash and restricted cash are recorded at historical cost. The carrying amount is a reasonable estimate of fair value as these instruments have short-term maturities and interest rates that approximate market, a Level 1 measurement.

(c)	Loans Held for Investment

Loans held for investment are recorded at their outstanding principal balance, net of purchase discounts, deferred loan origination fees/costs, and allowance for credit losses.

The Company determined the fair value estimate of loans held for investment using a cash flow model incorporating the latest securitization execution prices as a proxy, a Level 3 measurement. The significant unobservable inputs used in the fair value measurement of the Company’s mortgage loans held for investment are interest rates, prepayment speeds, loss severity, and default rates. Significant changes in any of those inputs could result in a significant change to the loans’ fair value measurement.

(d)	Collateral Dependent or Loans Individually Evaluated

Nonaccrual loans held for investment are evaluated individually and are recorded at fair value on a nonrecurring basis. To the extent a loan is collateral dependent, the Company determines the allowance for credit losses based on the estimated fair value of the underlying collateral. The fair value of each loan’s collateral is generally based on appraisals or broker price opinions obtained, less estimated costs to sell, a Level 3 measurement.

(e)	Loans Held for Sale

Loans held for sale are carried at the lower of cost or fair value, with fair value adjustments recorded on a nonrecurring basis. The Company uses a discounted cash flow model to estimate the fair value of loans held for sale, a Level 3 measurement.

(f)	Interest-Only Strips

The Company retains an interest-only strip on certain sales of held for sale loans. The interest-only strips are classified as trading securities under FASB ASC Topic 320, Investments-Debt Securities. The interest-only strips are measured based on their estimated fair values using a discounted cash flow model, a Level 3 measurement. Changes in fair value are reflected in income as they occur.

(g)	Loans Held for Investment, at Fair Value

The Company has elected to account for certain purchased distressed loans held for investment, at fair value (the FVO Loans) using FASB ASC Topic 825, Financial Instruments (ASC 825). The FVO loans are measured based on their estimated fair values. Management identified all of these loans to be accounted for at estimated fair value at the instrument level. Changes in fair value are reflected in income as they occur.

The Company uses a modified discounted cash flow model to estimate the fair value at instrument level, a Level 3 measurement. The significant unobservable inputs used in the fair value measurement of the Company’s mortgage loans held for investment, at fair value are discount rate, property values, prepayment speeds, loss severity, and default rates. Significant changes in any of those inputs in isolation could result in a significant change to the loans’ fair value measurement.

(h)	Real Estate Owned, Net (REO)

Real estate owned, net is initially recorded at the property’s estimated fair value, based on appraisals or broker price opinions obtained, less estimated costs to sell, at the acquisition date, a Level 3 measurement. From time to time, nonrecurring fair value adjustments are made to real estate owned, net based on the current updated appraised value of the property, or management’s judgment and estimation of value based on recent market trends or negotiated sales prices with potential buyers.

(i)	Secured Financing, Net (Corporate Debt)

The Company determined the fair values estimate of the secured financing using the estimated cash flows discounted at an appropriate market rate, a Level 3 measurement.

(j)	Warehouse Repurchase Facilities, Net

Warehouse repurchase facilities are recorded at historical cost. The carrying amount is a reasonable estimate of fair value as these instruments have short-term maturities of one-year or less and interest rates that approximate market plus a spread, a Level 2 measurement.

(k)	Securitizations, Net

The fair value estimate of securities issued is determined by using estimated cash flows discounted at an appropriate market rate, a Level 3 measurement.

(l)	Accrued Interest Receivable and Accrued Interest Payable

The carrying amounts of accrued interest receivable and accrued interest payable approximate fair value due to the short-term nature of these instruments, a Level 1 measurement.

The Company does not have any off-balance sheet financial instruments.

(m)	Fair Value Disclosures

The following tables present information on assets measured and recorded at fair value as of June 30, 2020 and December 31, 2019, by level, in the fair value hierarchy (in thousands):

	Fair value measurements using						Total at
June 30, 2020	Level 1		Level 2		Level 3		fair value
Recurring fair value measurements:
Loans held for investment, at fair value	$	—	$	—	$	2,956	$	2,956
Interest-only strips		—		—		845		845
Total recurring fair value measurements		—		—		3,801		3,801
Nonrecurring fair value measurements:
Loans held for sale, net		—		—		212,344		212,344
Real estate owned, net		—		—		15,648		15,648
Individually evaluated loans requiring specific allowance, net		—		—		269,499		269,499
Total nonrecurring fair value measurements		—		—		497,491		497,491
Total assets	$	—	$	—	$	501,292	$	501,292

	Fair value measurements using						Total at
December 31, 2019	Level 1		Level 2		Level 3		fair value
Recurring fair value measurements:
Loans held for investment, at fair value	$	—	$	—	$	2,960	$	2,960
Interest-only strips		—		—		894		894
Total recurring fair value measurements		—		—		3,854		3,854
Nonrecurring fair value measurements:
Loans held for sale, net		—		—		214,467		214,467
Real estate owned, net		—		—		13,068		13,068
Impaired loans requiring specific allowance, net		—		—		11,373		11,373
Total nonrecurring fair value measurements		—		—		238,908		238,908
Total assets	$	—	$	—	$	242,762	$	242,762

The following table presents gains and losses recognized on assets measured on a nonrecurring basis for the three and six months ended June 30, 2020 and 2019 (in thousands):

	Three Months Ended June 30,						Six Months Ended June 30,
Gain (loss) on assets measured on a nonrecurring basis	2020			2019			2020			2019
Loans held for sale, net	$	(921	)	$	(20	)	$	(961	)	$	69
Real estate held for sale, net		(648	)		(363	)		(1,216	)		(377	)
Individually evaluated loans requiring specific allowance, net		(431	)		(66	)		(360	)		(167	)
Total net loss	$	(2,000	)	$	(449	)	$	(2,537	)	$	(475	)

The following tables present the primary valuation techniques and unobservable inputs related to Level 3 assets as of June 30, 2020 and December 31, 2019 (dollars in thousands):

	June 30, 2020
Asset category	Fair value		Primary valuation technique	Unobservable input	Range	Weighted average
Individually evaluated loans requiring allowance, net	$	269,499	Market comparables	Selling costs	8.0%	8.0%
Real estate owned, net		15,648	Market comparables	Selling costs	8.0%	8.0%
Loans held for investment, at fair value		2,956	Discounted cash flow	Discount rate	10.5%	10.5%
				Collateral value (% of UPB)	8.0% to 97.0%	88.0%
				Timing of resolution/payoff (months)	5 to 212		60.0
				Prepayment rate	15.0%	15.0%
				Default rate	1.0%	1.0%
				Loss severity rate	10.0%	10.0%
Loans held for sale		212,344	Discounted cash flow	Discount rate	12.0% to 15.0%	14.5%
				Timing of resolution/payoff (months)	0 to 13		7.6

Interest-only strips		845	Discounted cash flow	Discount rate	15.0%	15.0%
				Timing of resolution/payoff (months)	0 to 13.0		2.4

	December 31, 2019
Asset category	Fair value		Primary valuation technique	Unobservable input	Range	Weighted average
Collateral dependent impaired loans requiring specific allowance, net	$	11,373	Market comparables	Selling costs	8.0%	8.0%
Real estate owned, net		13,068	Market comparables	Selling costs	8.0%	8.0%
Loans held for investment, at fair value		2,960	Discounted cash flow	Discount rate	10.5%	10.5%
				Collateral value (% of UPB)	18.0% to 94.0%	87.0%
				Timing of resolution/payoff (months)	5 to 218		65.0
				Prepayment rate	15.0%	15.0%
				Default rate	1.0%	1.0%
				Loss severity rate	10.0%	10.0%
Loans held for sale		214,467	Discounted cash flow	Discount rate	12.0% to 15.0%	14.7%
				Timing of resolution/payoff (months)	0 to 12		7.0

Interest-only strips		894	Discounted cash flow	Discount rate	15.0%	15.0%
				Timing of resolution/payoff (months)	0 to 7.0		2.1

The following is a rollforward of loans that are measured at estimated fair value on a recurring basis for the periods indicated (in thousands):

	Three Months Ended June 30,						Six Months Ended June 30,
	2020			2019			2020			2019
Beginning balance	$	2,987		$	2,971		$	2,960		$	3,463
Loans liquidated		—			45			—			(421	)
Principal paydowns		(18	)		(17	)		(36	)		(34	)
Total unrealized gain (loss) included in net income		(13	)		(25	)		32			(34	)
Ending balance	$	2,956		$	2,974		$	2,956		$	2,974

The following is a rollforward of interest-only strips that are measured at estimated fair value on a recurring basis for the periods indicated (in thousands):

	Three Months Ended June 30,						Six Months Ended June 30,
	2020			2019			2020			2019
Beginning balance	$	1,534		$	1,609		$	894		$	812
Interest-only strip additions		—			330			1,820			1,634
Interest-only strip write-offs		(689	)		(661	)		(1,869	)		(1,131	)
Total unrealized loss included in net income		—			(85	)		—			(122	)
Ending balance	$	845		$	1,193		$	845		$	1,193

The Company estimates the fair value of certain financial instruments on a quarterly basis. These instruments are recorded at fair value through the use of a valuation allowance only if they are individually evaluated. As described above, these adjustments to fair value usually result from the application of lower of cost or fair value accounting or write-downs of individual assets. As of June 30, 2020 and December 31, 2019, the only financial assets measured at fair value were certain individually evaluated loans held for investment, loans held for sale, interest-only strips, REO and FVO loans, which were measured using unobservable inputs, including appraisals and broker price opinions on the values of the underlying collateral. Individually evaluated loans requiring an allowance were carried at approximately $9.6 million and $11.4 million as of June 30, 2020 and December 31, 2019, net of specific allowance for credit losses of approximately $1.3 million and $0.9 million, respectively.

A financial instrument is cash, evidence of an ownership interest in an entity, or a contract that creates a contractual obligation or right to deliver or receive cash or another financial instrument from a second entity on potentially favorable terms. The methods and assumptions used in estimating the fair values of the Company’s financial instruments are described above.

The following tables present carrying amounts and estimated fair values of certain financial instruments as of the dates indicated (in thousands):

	June 30, 2020
	Carrying								Estimated
Asset category	Value		Level 1		Level 2		Level 3		Fair Value
Assets:
Cash	$	9,803	$	9,803	$	—	$	—	$	9,803
Restricted cash		6,735		6,735		—		—		6,735
Loans held for sale, net		212,344		—		—		212,344		212,344
Loans held for investment, net		1,861,819		—		—		1,767,635		1,767,635
Loans held for investment, at fair value		2,956		—		—		2,956		2,956
Accrued interest receivables		17,793		17,793		—		—		17,793
Interest-only strips		845		—		—		845		845

Liabilities:
Secured financing, net	$	74,571	$	—	$	—	$	75,010	$	75,010
Warehouse repurchase facilities, net		160,796		—		160,796		—		160,796
Securitizations, net		1,599,719		—		—		1,617,114		1,617,114
Accrued interest payable		7,777		7,777		—		—		7,777

	December 31, 2019
	Carrying								Estimated
Asset category	Value		Level 1		Level 2		Level 3		Fair Value
Assets:
Cash	$	21,465	$	21,465	$	—	$	—	$	21,465
Restricted cash		6,087		6,087		—		—		6,087
Loans held for sale, net		214,467		—		—		222,260		222,260
Loans held for investment, net		1,863,360		—		—		1,913,481		1,913,481
Loans held for investment, at fair value		2,960		—		—		2,960		2,960
Accrued interest receivable		13,295		13,295		—		—		13,295
Real estate owned, net		13,068		—		—		13,068		13,068
Interest-only strips	894			—		—	894		894

Liabilities:
Secured financing, net	$	145,599	$	—	$	—	$	153,000	$	153,000
Warehouse repurchase facilities, net		421,548		—		421,548		—		421,548
Securitizations, net		1,438,629		—		—		1,486,990		1,486,990
Accrued interest payable		7,190		7,190		—		—		7,190

Note 15 — Subsequent Events

The Company completed the securitization of $276.0 million of investor real estate loans through VCC 2020-MC1 on July 10, 2020. The securitization is accounted for as secured borrowings. The VCC 2020-MC1 Trust (“2020-MC1”) is a debt for tax structure and is collateralized primarily with the Company’s short-term loans and traditional loans. On July 1, 2020, management elected to transfer its entire portfolio of short-term loans from HFS to HFI based on a change in intent from selling the short-term loans to holding them to maturity as collateral for the 2020-MC1 securitization.

On July 9, 2020, a class action complaint was filed in the United States District Court for the Central District of California, naming the Company, certain of its directors, officers and shareholders and others alleging violations of securities laws, including making false and misleading statements and omissions in the Company's offering materials for the Company's January 2020 initial public offering of its common stock. The complaints seek unspecified damages and an award of costs and expenses, including attorneys’ fees. We cannot predict the length of time that this action will be ongoing or the liability, if any, which may arise.

The Barclays Repurchase Agreement between VCC and Barclays Bank PLC matured and terminated on August 3, 2020. The Citibank Repurchase Agreement between VCC and Citibank, N.A. was extended to September 30, 2020.

The Company has evaluated events that have occurred subsequent to June 30, 2020 through the issuance of the accompanying consolidated financial statements and has concluded there are no other subsequent events that would require recognition or disclosure in the accompanying consolidated financial statements.

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

The following discussion should be read in conjunction with the information included in our Annual Report on Form 10-K for the year ended December 31, 2019, the risk factors contained in our Form 10-Q for the quarter ended March 31, 2020 as well as the unaudited financial statements included elsewhere in this Quarterly Report on Form 10-Q (the “Quarterly Report”).

In addition, the statements and assumptions in this Quarterly Report that are not statements of historical fact are forward-looking statements within the meaning of federal securities laws. In particular, statements about our plans, strategies and prospects as well as estimates of industry growth for the next quarter and beyond are forward-looking statements. For important information regarding these forward-looking statements, please see the discussion below under the caption “Cautionary Note on Forward-Looking Statements.”

References to “the Company,” “Velocity,” “we,” “us” and “our” refer to Velocity Financial, Inc. and include all of its consolidated subsidiaries, unless otherwise indicated or the context requires otherwise.

Business

We are a vertically integrated real estate finance company founded in 2004. We primarily originate and manage investor loans secured by 1-4 unit residential rental and small commercial properties, which we refer to collectively as investor real estate loans. We originate loans nationwide across our extensive network of independent mortgage brokers which we have built and refined over the 15 years since our inception. Our objective is to be the preferred and one of the most recognized brands in our core market, particularly within our network of mortgage brokers.

We operate in a large and highly fragmented market with substantial demand for financing and limited supply of institutional financing alternatives. We have developed the highly-specialized skill set required to effectively compete in this market, which we believe has afforded us a durable business model. We offer competitive pricing to our borrowers by pursuing low-cost financing strategies and by driving front- end process efficiencies through customized technology designed to control the cost of originating a loan. Furthermore, by originating loans through our efficient and scalable network of approved mortgage brokers, we are able to maintain a wide geographical presence and nimble operating infrastructure capable of reacting quickly to changing market environments.

Our primary source of revenue is interest income earned on our loan portfolio. Our typical loan is secured by a first lien on the underlying property with a personal guarantee and, based on all loans in our portfolio as of June 30, 2020, has an average balance of approximately $327,000. As of June 30, 2020, our loan portfolio, including both loans held for investment and loans held for sale, totaled $2.1 billion of UPB on properties in 45 states and the District of Columbia. The total portfolio had a weighted average loan-to-value ratio, or LTV at origination, of 65.8%, and was concentrated in 1-4 unit residential rental loans, which we refer to as investor 1-4 loans, representing 51.3% of the UPB. For the three months ended June 30, 2020, the annualized yield on our total portfolio was 7.59%.

We fund our portfolio primarily through a combination of committed and uncommitted secured warehouse repurchase facilities, securitizations, corporate debt and equity. The securitization market is our primary source of long-term financing. We have successfully executed fourteen securitizations, resulting in a total of over $2.9 billion in gross debt proceeds from May 2011 through June 2020.

One of our core profitably measurements is our portfolio related net interest margin, which measures the difference between interest income earned on our loan portfolio and interest expense paid on our portfolio-related debt, relative to the amount of loans outstanding over the period. Our portfolio-related debt consists of our warehouse repurchase facilities and securitizations and excludes our corporate debt. For the three months ended June 30, 2020, our annualized portfolio related net interest margin was 3.54%. We generate profits to the extent that our portfolio related net interest income exceeds our interest expense on corporate debt, provision for loan losses and operating expenses. For the three months ended June 30, 2020, we generated pre-tax income and net income of $2.6 million and $2.1 million, respectively.

In January 2020, we completed the initial public offering of our common stock, par value $0.01 per share (our “common stock”). We received net proceeds received from the sale of our common stock in the IPO of $100.7 million, a portion of which we used to repay $75.0 million of principal on our existing corporate debt.

On April 7, 2020, we issued and sold 45,000 shares of our newly designated Series A Convertible Preferred Stock, par value $0.01 per share (the “Preferred Stock”), in a private placement to affiliates of Snow Phipps and TOBI (the “Purchasers”), our two largest common stockholders, at a price per share of Preferred Stock of $1,000. In addition, as part of that private placement, we issued and sold to the Purchasers warrants (the “Warrants”) to purchase an aggregate of 3,013,125 shares of our common stock. This private placement offering resulted in gross proceeds to us of $45.0 million. We used the proceeds from this private placement to pay down our existing warehouse repurchase facilities and for general corporate purposes

Items Affecting Comparability of Results

Due to a number of factors, our historical financial results may not be comparable, either from period to period, or to our financial results in future periods. We have summarized the key factors affecting the comparability of our financial results below.

In 2014, we entered into a five-year, $100.0 million corporate debt agreement with the owners of our Class C preferred units, pursuant to which we issued at par senior secured notes, the 2014 Senior Secured Notes, that was due on December 16, 2019. The 2014 Senior Secured Notes bore interest, at our election, at either 10% annually paid in cash or 11% annually paid in kind.

In August 2019, we entered into a five-year $153.0 million corporate debt agreement with Owl Rock Capital Corporation (“2019 Term Loan”). The 2019 Term Loan under this agreement bears interest at a rate equal to one-month LIBOR plus 7.50% and mature in August 2024. A portion of the net proceeds from the 2019 Term Loan was used to redeem all of the outstanding 2014 Senior Secured Notes in August 2019. Another portion of the net proceeds from the 2019 Term Loan, together with cash on hand, was used to repurchase our outstanding Class C preferred units.

In January 2020, we used $75.7 million of the net proceeds from our IPO to lower our interest expense through the repayment of $75.0 million outstanding principal amount on the 2019 Term Loan.

In late March 2020, we temporarily suspended our loan originations and purchases due to the business and economic uncertainties caused by the COVID-19 outbreak. In addition, effective May 1, 2020, we furloughed a significant number of our employees, mostly within our loan origination function. As of June 30, 2020, loan originations remained suspended and our employee furlough remained on-going.

On April 7, 2020, we issued and sold Preferred Stock and Warrants resulting in gross proceeds to us of $45.0 million.

Recent Developments

Strategies to Address Uncertainties Caused by COVID-19

The COVID-19 outbreak has caused significant disruption in business activity and the financial markets both globally and in the United States. As a result of the spread of COVID-19, economic uncertainties have arisen which have negatively impacted our financial condition, results of operations and cash flows. The further extent of the impact of COVID-19 on our operational and financial performance will depend on certain developments, including the duration and spread of the outbreak and impact on our customers, employees and vendors, all of which is uncertain at this time and cannot be predicted.

We have executed a number of business initiatives as a result of the effects of the COVID-19 pandemic, including the following:

•

As mentioned, we temporarily suspended our loan originations and loan purchases and furloughed a significant number of our employees, mostly within our loan origination function. During the quarter ended June 30, 2020, we did not originate any loans and did not purchase any loans.

•

We issued and sold Preferred Stock and Warrants resulting in gross proceeds to us of $45.0 million. We used the proceeds from this private placement to pay down our existing warehouse repurchase facilities and for general corporate purposes.

•

We have implemented a COVID-19 forbearance program designed to help small investors retain their properties and minimize our portfolio losses.

•

On July 10, 2020, we securitized $276.0 million of short-term and traditional investor real estate loans and issued $179.4 million of notes and certificates. We used the proceeds from this securitization to fully pay off our existing warehouse lines.

•

We are exploring new financing alternatives for future use when we determine to resume originating and purchasing loans.

Critical Accounting Policies and Use of Estimates

The preparation of financial statements in accordance with U.S. GAAP requires certain judgments and assumptions, based on information available at the time of preparation of the consolidated financial statements, in determining accounting estimates used in preparation of the consolidated financial statements. The following discussion addresses the accounting policies that we believe apply to us based on the nature of our operations. Our most critical accounting policies involve decisions and assessments that could affect our reported assets and liabilities, as well as our reported revenues and expenses. We believe that all of the decisions and assessments used to prepare our financial statements are based upon reasonable assumptions given the information available at that time. We believe the following are critical accounting policies that require the most significant judgments and estimates used in the preparation of the consolidated financial statements. The summary below should be read in conjunction with the disclosure of our accounting policies and use of estimates in Note 2 to the consolidated financial statements.

Allowance for Credit Losses

Effective January 1, 2020, we adopted ASU 2016-13 Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments using the open pool methodology for all financial assets measured at amortized cost, which as of the adoption date consisted entirely of our held for investment loan portfolio.

ASU 2016-13 replaces the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (CECL) methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loan receivables held for investment. Under the CECL methodology, the allowance for credit losses is measured on a collective (pool) basis when similar risk characteristics exist. We identified the following portfolio segments based on risk characteristics of the loans in its loan portfolio (pool):

•

Residential 1– 4 Unit – Purchase (loans to purchase 1– 4 unit residential rental properties);

•

Residential 1– 4 Unit – Refinance (refinance loans on 1– 4 unit residential rental properties);

•

Commercial – Purchase (loans to purchase traditional commercial properties) and

•

Commercial – Refinance (refinance loans on traditional commercial properties).

We determined the collectability of our loans by evaluating certain risk characteristics. The segmentation of its loan portfolio was determined based on analyses of our loan portfolio performance over the past seven years. Based on analyses of the loan portfolio’s historical performance, we concluded that loan purpose and product types are the most significant risk factors in determining its expectation of future loan losses. Loan purpose considers whether a borrower is acquiring the property or refinancing an existing property. Our historical experience shows that refinance loans have higher loss rates than acquisitions. Product type includes residential 1-4 unit property and traditional commercial property. Our historical experience shows that traditional commercial property loans have higher loss rates than residential 1-4 unit property.

To determine the loss rates used for the open pool methodology, we start with our historical database of losses, segment the loans by loan purpose and product type, and then adjust the loss rates based upon macroeconomic forecasts over a reasonable and supportable period. The reasonable and supportable period is meant to represent the period in which we believe the forecasted macroeconomic variables can be reasonably estimated.

In determining the January 1, 2020 CECL transition impact, we used a third-party model with a four-quarter reasonable and supportable forecast period followed by a four-quarter straight-line reversion period. Management determined that a four-quarter forecast period and four-quarter straight-line reversion period were appropriate for the January 1, 2020 initial CECL estimate because, as of the beginning of the year, the economy was strong, unemployment and interest rates were low, and GDP was expected to have a modest increase during 2020. Management concluded that using a 1-year forecast trending steadily back to our historical loss levels best fit the strong, stable economy at that time.

For the June 30, 2020 CECL estimate, we used a COVID-19 stress scenario with a five-quarter reasonable and supportable forecast period followed by a four-quarter straight-line reversion period. Management concluded that the original six-quarter COVID-19 stress forecast was still appropriate and, therefore, used five remaining forecasted quarters as of June 30. Given the second wave of the COVID-19 pandemic, management decided to extend its reversion period by a quarter and used a four-quarter reversion period as of June 30. This forecast period and reversion to historical loss is subject to change as conditions in the market change and our ability to forecast economic events evolves.

Loans 90 days or more delinquent, in bankruptcy, or in foreclosure, are evaluated individually. Loans individually evaluated are excluded from loans evaluated collectively by segment. When loans are individually evaluated, we primarily rely on the value of the underlying real estate, coupled with low loan-to-value ratios, to satisfy the loan obligation, either through successful loss mitigation efforts or foreclosure and sale of the underlying real estate. Expected loan losses are based on the fair value of the collateral underlying the loans at the reporting date, adjusted for estimated selling costs as appropriate.

The allowance for credit losses is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on the loans. Loans are charged off against the allowance when we believe the uncollectibility of a loan balance is confirmed. Expected recoveries do not exceed the aggregate of amounts previously charged-off and expected to be charged-off.

We estimate the allowance using relevant available information, from internal and external sources, relating to historical performance, current conditions, and reasonable and supportable macroeconomic forecasts. Historical credit loss experience provides the basis for the estimation of expected credit losses. Adjustments to historical loss information are considered for differences in current loan-specific risk characteristics such as differences in underwriting standards, portfolio mix, delinquency levels, or term, as well as for changes in environmental conditions, such as unemployment rates, property values and changes in the competitive or regulatory environment.

Interest income on loans held for investment is accrued on the unpaid principal balance (UPB) at their respective stated interest rates. Generally, loans are placed on nonaccrual status when they become 90 days past due. Loans are considered past due when contractually required principal or interest payments have not been made on the due dates. Management has concluded that ASC 310-20-35-18(a) on interest income recognition does not apply to the forbearances granted under our forbearance program. We will continue to accrue interest on the COVID-19 forbearance granted loans for all such loans that were less than 90 days past due at the forbearance grant date. We will continue to evaluate the COVID-19 forbearance-granted loans on an individual basis to determine if a reserve should be established on the collectability of the accrued interest and whether any loans should be placed on nonaccrual status at a future date.

We made the accounting policy election not to measure an allowance for credit losses for accrued interest receivables. When a loan is placed on nonaccrual status, the accrued and unpaid interest is reversed as a reduction of interest income and accrued interest receivable. Accrued interest receivable is excluded from the amortized cost of loans and it is presented as accrued interest receivable in the Consolidated Balance Sheets.

Deferred Income Tax Assets and Liabilities

Our deferred income tax assets and liabilities arise from differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We determine whether a deferred tax asset is realizable based on facts and circumstances, including our current and projected future tax position, the historical level of our taxable income, and estimates of our future taxable income. In most cases, the realization of deferred tax assets is based on our future profitability. If we were to experience either reduced profitability or operating losses in a future period, the realization of our deferred tax assets may no longer be considered more likely than not and, accordingly, we could be required to record a valuation allowance on our deferred tax assets by charging earnings.

How We Assess Our Business Performance

Net income is the primary metric by which we assess our business performance. Accordingly, we closely monitor the primary drivers of net income which consist of the following:

Net Interest Income

Net interest income is the largest contributor to our net income and is monitored on both an absolute basis and relative to provisions for loan losses and operating expenses. We generate net interest income to the extent that the rate at which we lend in our portfolio exceeds the cost of financing our portfolio, which we primarily achieve through long-term securitizations. Accordingly, we closely monitor the financing markets and maintain consistent dialogue with investors and financial institutions as we evaluate our financing sources and cost of funds.

To evaluate net interest income, we measure and monitor: (1) the yields on our loans, (2) the costs of our funding sources, (3) our net interest spread and (4) our net interest margin. Net interest spread measures the difference between the rates earned on our loans and the rates paid on our funding sources. Net interest margin measures the difference between our annualized interest income and annualized interest expense, or net interest income, as a percentage of average loans outstanding over the specified time period.

Periodic changes in net interest income are primarily driven by: (1) origination volume and changes in average outstanding loan balances and (2) interest rates and changes in interest earned on our portfolio or paid on our debt. Historically, origination volume and portfolio size have been the largest contributors to the growth in our net interest income. We measure net interest income before and after interest expense related to our corporate debt and before and after our provisions for loan losses.

Credit Losses

We strive to minimize actual credit losses through our rigorous screening and underwriting process and life of loan portfolio management and special servicing practices. We closely monitor the credit performance of our loan portfolio, including delinquency rates and expected and actual credit losses, as a key factor in assessing our overall business performance.

Operating Expenses

We incur operating expenses from compensation and benefits related to our employee base, rent and other occupancy costs associated with our leased facilities, our third-party primary loan servicing vendors, professional fees to the extent we utilize third-party legal, consulting and advisory firms, and costs associated with the resolution and disposition of real estate owned, among other items. We monitor and strive to prudently manage operating expenses and to balance current period profitability with investment in the continued development of our platform. Because volume and portfolio size determine the magnitude of the impact of each of the above factors on our earnings, we also closely monitor origination volume along with all key terms of new loan originations, such as interest rates, loan-to-value ratios, estimated credit losses and expected duration.

Factors Affecting Our Results of Operations

We believe there are a number of factors that impact our business, including those discussed below and in the risk factors disclosed in our Form 10-K for the year ended December 31, 2019 and Form 10-Q for the quarter ended March 31, 2020.

Our results of operations depend on, among other things, the level of our net interest income, the credit performance of our loan portfolio and the efficiency of our operating platform. These measures are affected by a number of factors, including the demand for investor real estate loans, the competitiveness of the market for originating or acquiring investor real estate loans, the cost of financing our portfolio, the availability of funding sources and the underlying performance of the collateral supporting our loans. While we have been successful at managing these elements in the past, there are certain circumstances beyond our control, including the current disruption caused by the COVID-19 pandemic, macroeconomic conditions and market fundamentals, which can affect each of these factors and potentially impact our business performance.

Origination Volume

Portfolio related net interest income is the largest contributor to our net income. We have grown our portfolio related net interest income by $2.0 million or 12.1% from $16.6 million for the quarter ended June 30, 2019 to $18.6 million for the quarter ended June 30, 2020. The growth in net interest income is largely attributable to our growth in loan originations until mid-March 2020, at which time we suspended originations due to the COVID-19 lockdown.

Our future performance will be impacted to the extent that we continue to suspend loan originations as we rely on new loans to offset maturities and prepayments in our existing portfolio. Loan originations remain suspended as of June 30, 2020. We are exploring new financing alternatives for future use when we determine to resume originating and purchasing loans.

Competition

The investor real estate loan market is highly competitive which could affect our profitability and growth. We believe we compete favorably through diversified borrower access driven by our extensive network of mortgage brokers and by emphasizing a high level of real estate and financial expertise, customer service, and flexibility in structuring transactions, as well as by attracting and retaining experienced managerial and marketing personnel. However, some of our competitors may be better positioned to market their services and financing programs because of their ability to offer more favorable rates and terms and other services.

Availability and Cost of Funding

Our primary funding sources have historically included cash from operations, warehouse repurchase facilities, term securitizations, corporate debt and equity. We believe we have an established brand in the term securitization market and that this market will continue to support our portfolio growth with long-term financing. Changes in macroeconomic conditions can adversely impact our ability to issue securitizations and, thereby, limit our options for long-term financing. In consideration of this potential risk, we have entered into a credit facility for longer-term financing that will provide us with capital resources to fund loan growth in the event we are not able to issue securitizations.

Loan Performance

We underwrite and structure our loans to minimize potential losses. We believe our fully amortizing loan structures and avoidance of large balloon payments, coupled with meaningful borrower equity in properties, limit the probability of losses and that our proven in-house asset management capability allows us to minimize potential losses in situations where there is insufficient equity in the property. Our income is highly dependent upon borrowers making their payments and resolving delinquent loans as favorably as possible. Macroeconomic conditions can, however, impact credit trends in our core market and have an adverse impact on financial results.

Macroeconomic Conditions

The investor real estate loan market may be impacted by a wide range of macroeconomic factors such as interest rates, residential and commercial real estate prices, home ownership and unemployment rates, and availability of credit, among others. We believe our prudent underwriting, conservative loan structures and interest rate protections, and proven in-house asset management capability leave us well positioned to manage changing macroeconomic conditions.

Portfolio and Asset Quality

Key Portfolio Statistics

	June 30, 2020				December 31, 2019			June 30, 2019
	($ in thousands)
Total loans	$	2,058,990			$	2,059,344		$	1,748,782
Loan count		6,294				6,373			5,503
Average loan balance	$	327			$	323		$	318
Weighted average loan-to-value		65.8	%			65.8	%		64.9	%
Weighted average coupon		8.60	%			8.69	%		8.66	%
Nonperforming loans (UPB)	$	329,132		(A)	$	141,607		$	112,073
Nonperforming loans (% of total)		15.99	%	(A)		6.88	%		6.41	%

(A)	Reflects the UPB of loans 90 days or more past due or placed on nonaccrual status. Includes $13.3 million of COVID-19 forbearance-granted loans 90 days or more past due as of June 30, 2020.

Total Loans. Total loans reflects the aggregate UPB at the end of the period. It excludes deferred origination costs, acquisition discounts, fair value adjustments and allowance for credit losses.

Loan Count. Loan count reflects the number of loans at the end of the period. It includes all loans with an outstanding principal balance.

Average Loan Balance. Average loan balance reflects the average UPB at the end of the period (i.e., total loans divided by loan count).

Weighted Average Loan-to-Value. Loan-to-value, or LTV, reflects the ratio of the original loan amount to the appraised value of the underlying property at the time of origination. In instances where the LTV at origination is not available for an acquired loan, the LTV reflects our best estimate of value at the time of acquisition. Weighted average LTV is calculated for the population of loans outstanding at the end of each specified period using the original loan amounts and appraised LTVs at the time of origination of each loan. LTV is a key statistic because requiring the borrower to invest more equity in the collateral minimizes our exposure for future credit losses.

Nonperforming Loans. Loans that are 90 or more days past due, in bankruptcy, in foreclosure, or not accruing interest are considered nonperforming loans. The dollar amount of nonperforming loans presented in the table above reflects the UPB of all loans that meet this definition. In the last 7 years, over 90% of our resolved nonperforming loans have either paid current or fully paid off, resulting in a complete recapture of all contractual principal and interest and, in many cases, additional default interest and prepayment fees.

Originations and Acquisitions

The following table presents new loan originations and acquisitions and includes average loan size, weighted average coupon and weighted average loan-to-value for the periods indicated:

($ in thousands)	Loan Count		Loan Balance		Average Loan Size		Weighted Average Coupon			Weighted Average LTV
Three Months Ended June 30, 2020:
Loan originations — held for investment		—		—		—		(—	)%		(—	)%
Loan originations — held for sale		—		—		—		(—	)%		(—	)%
Total loan originations		—	$	—	$	—		(—	)%		(—	)%
Loan acquisitions — held for investment		—		—		—		(—	)%		(—	)%
Total loans originated and acquired		—	$	—	$	—		(—	)%		(—	)%
Three Months Ended March 31, 2020:
Loan originations — held for investment		431	$	151,412	$	351		8.28	%		67.2	%
Loan originations — held for sale		316		96,223		305		9.75	%		68.2	%
Total loan originations		747	$	247,635	$	332		8.84	%		67.6	%
Loan acquisitions — held for investment		3		3,467		1,156		6.50	%		73.6	%
Total loans originated and acquired		750	$	251,102	$	335		8.81	%		67.7	%
Three Months Ended June 30, 2019:
Loan originations — held for investment		421		146,182		347		8.61	%		66.7	%
Loan originations — held for sale		235		67,204		286		10.14	%		67.1	%
Total loan originations		656		213,386		325		9.09	%		66.8	%
Loan acquisitions — held for investment		28		5,343		191		7.32	%		67.5	%
Total loans originated and acquired		684		218,729		320		9.05	%		66.8	%

We have temporarily suspended our loan originations since late March 2020 due to the dislocation caused by COVID-19.

Loans Held for Investment and Loans Held for Investment at Fair Value

Our total portfolio of loans held for investment consists of both loans held for investment at amortized cost, which are presented in the consolidated financial statements as loans held for investment, net, and loans held for investment at fair value, which are presented in the financial statements as loans held for investment at fair value. The following tables show the various components of loans held for investment as of the dates indicated:

(in thousands)	June 30, 2020			December 31, 2019			June 30, 2019
Unpaid principal balance	$	1,844,607		$	1,843,290		$	1,665,926
Valuation adjustments on FVO loans		(413	)		(444	)		(469	)
Deferred loan origination costs		25,801			25,714			23,345
Total loans held for investment, gross		1,869,995			1,868,560			1,688,802
Allowance for credit losses		(5,220	)		(2,240	)		(2,096	)
Loans held for investment, net	$	1,864,775		$	1,866,320		$	1,686,706

The following table illustrates the contractual maturities for our loans held for investment in aggregate UPB and as a percentage of our total held for investment loan portfolio as of June 30, 2020:

	June 30, 2020
($ in thousands)	UPB		%
Loans due in less than one year	$	2,158		0.1	%
Loans due in one to five years		2,655		0.1	%
Loans due in more than five years		1,839,794		99.8	%
Total loans held for investment	$	1,844,607		100.0	%

Allowance for Credit Losses

Although our charge-off rate remains low at 10bps for the three months ended June 30, 2020, we have increased our allowance for losses as a result of the uncertainty caused by the COVID pandemic. Our allowance for credit losses increased by $3.1 million to $5.2 million as of June 30, 2020, compared to $2.1 million as of June 30, 2019. The adoption of CECL effective January 1, 2020 contributed $137,000 to the increase in allowance for credit losses. $2.4 million of the $3.1 million increase in allowance for credit losses was attributed to the impact on macroeconomic forecasts as a result of COVID-19 coronavirus outbreak. The remaining increase in allowance for credit losses was attributed to the increase in our loan portfolio from June 30, 2019 to June 30, 2020. We strive to minimize actual credit losses through our rigorous screening and underwriting process, life of loan portfolio management and special servicing practices. Additionally, we believe borrower equity of 25% to 40% provides significant protection against credit losses.

To estimate the allowance for credit losses in our loans held for investment portfolio, we follow a detailed internal process, considering a number of different factors including, but not limited to, our ongoing analyses of loans, historical loss rates, relevant environmental factors, relevant market research, trends in delinquencies, effects and changes in credit concentrations, and ongoing evaluation of fair values.

The following table illustrates the activity in our allowance for credit losses over the periods indicated:

	Three Months Ended June 30,						Six Months Ended June 30,
	2020			2019			2020			2019
Allowance for credit losses:
Beginning balance, prior to adoption of ASC 326	$	3,496		$	1,916		$	2,240		$	1,680
Impact of adopting ASC 326		-			—			137			—
Provision for loan losses		1,800			212			3,088			559
Charge-offs		(76	)		(32	)		(245	)		(143	)
Ending balance	$	5,220		$	2,096		$	5,220		$	2,096
Total loans held for investment (UPB), excluding FVO (1)	$	1,841,238		$	1,662,483		$	1,841,238		$	1,662,483
% of allowance for credit losses / loans held for investment, excluding FVO		0.28	%		0.13	%		0.28	%		0.13	%

(1)

Reflects the UPB of loans held for investment excluding loans held for investment at fair value (FVO). Loans held for investment, net on the consolidated balance sheets is net of allowance for credit losses of $5.2 million, and net deferred loan origination fees/costs of $25.8 million as of June 30, 2020.

Credit Quality – Loans Held for Investment and Loans Held for Investment at Fair Value

The following table provides delinquency information on our loans held for investment and loans held for investment at fair value by UPB as of the dates indicated:

	June 30, 2020 (A)				COVID-19 Forbearance		March 31, 2020				June 30, 2019
Performing/Accruing:
Current	$	1,186,267	64.3	%	$	11,545	$	1,571,822	82.6	%	$	1,438,002	86.3	%
30-59 days past due		121,320	6.6			36,889		126,740	6.7			99,925	6.0
60-89 days past due		145,976	7.9			99,774		52,868	2.8			27,519	1.7
90+ days past due		122,195	6.6			122,195		—	—			—	—
Nonperforming/Nonaccrual:
<90 days past due		18,657	1.0			5,957		11,600	0.6			7,456	0.4
90+ days past due		136,577	7.4			12,397		42,529	2.2			12,533	0.8
Bankruptcy		8,668	0.5			—		9,463	0.5			8,259	0.5
In foreclosure		104,947	5.7			770		87,544	4.6			72,232	4.3
Total nonperforming loans		268,849	14.6			19,124		151,136	7.9			100,480	6.0
Total loans held for investment	$	1,844,607	100.0	%	$	289,527	$	1,902,566	100.0	%	$	1,665,926	100.0	%

(A)	Balance includes the UPB of loans held for investment in our COVID-19 forbearance program.

Other than loans in the COVID-19 forbearance program, loans that are 90+ days past due, in bankruptcy, in foreclosure, or not accruing interest are considered nonperforming loans. Nonperforming loans were $268.8 million or 14.6% of our held for investment loan portfolio as of June 30, 2020, compared to $151.1 million, or 7.9% as of March 31, 2020, and $100.5 million, or 6.0% of the held for investment loan portfolio as of June 30, 2019. The increase in total nonperforming loans as of June 30, 2020 was primarily attributed to the COVID-19 pandemic. We believe the significant equity cushion at origination and the active management of loans will continue to minimize credit losses on the resolution of defaulted loans and disposition of REO properties.

Historically, most loans that become nonperforming resolve prior to converting to REO. This is due to low LTVs at origination and our active management of the portfolio. The following table summarizes the resolution activities of loans originated by us that became nonperforming prior to the beginning of the periods indicated. Of the $151.0 million nonperforming loans as of March 31, 2020, we resolved $26.3 million, or 17.4% during the quarter ended June 30, 2020. During the quarter ended June 30, 2019, we resolved $17.7 million, or 17.6% of the $100.4 million nonperforming loans as of March 31, 2019. We realized net gains of $0.5 million and $0.3 million on these resolutions during the quarter ended June 30, 2020 and 2019, respectively. This is largely the result of collecting default interest and prepayment penalties in excess of the contractual interest due and collected.

	Three Months Ended June 30, 2020								Three Months Ended June 30, 2019
($ in thousands)	UPB		% of Nonperforming UPB			Gain / (Loss)			UPB		% of Nonperforming UPB			Gain / (Loss)
Nonperforming UPB, beginning of period	$	151,137							$	100,399
Resolved — paid in full		6,658		4.4	%	$	336			5,789		5.8	%	$	173
Resolved — paid current		19,635		13.0	%		208			11,923		11.9	%		151
Total resolutions	$	26,293		17.4	%	$	544		$	17,712		17.6	%	$	324
Recovery rate on resolved nonperforming UPB							102.1	%							101.8	%

Our actual losses incurred have been small as a percentage of nonperforming loans held for investment. The table below shows our actual loan losses for the periods indicated.

	Three Months Ended				Three Months Ended				Year Ended
($ in thousands)	June 30, 2020				March 31, 2020				December 31, 2019
Average nonperforming loans for the period (1)		289,940				144,883				111,427
Charge-offs		76				169				579
Charge-offs / Average nonperforming loans for the period (1)		0.10	%	(2)		0.47	%	(2)		0.52	%

(1)	Reflects the monthly average of nonperforming loans held for investment during the period.

(2)	Annualized

Concentrations – Loans Held for Investment

As of June 30, 2020, our held for investment loan portfolio was concentrated in investor 1-4 loans, representing 45.6% of the UPB. Mixed used properties represented 14.1% of the UPB and multifamily properties represented 10.5% of the UPB. No other property type represented more than 10.0% of our held for investment loan portfolio. By geography, the principal balance of our loans held for investment were concentrated 23.8% in New York, 22.3% in California, 12.2% in Florida, and 8.1% in New Jersey.

Property Type	June 30, 2020
($ in thousands)	Loan Count		UPB		% of Total UPB
Investor 1-4		3,179	$	841,076		45.6	%
Mixed use		687		259,675		14.1
Multifamily		463		193,206		10.5
Retail		413		177,608		9.6
Office		282		114,710		6.2
Warehouse		207		118,205		6.4
Other(1)		378		140,127		7.6
Total loans held for investment		5,609	$	1,844,607		100	%

(1)	All other properties individually comprise less than 5.0% of the total unpaid principal balance.

Geography (State)	June 30, 2020
($ in thousands)	Loan Count		UPB		% of Total UPB
New York	929		$	438,268		23.8	%
California	901			411,550		22.3
Florida	793			224,940		12.2
New Jersey	596			149,965		8.1
Other(1)		2,390		619,884		33.6
Total loans held for investment		5,609	$	1,844,607		100	%

(1)	All other states individually comprise less than 5.0% of the total unpaid principal balance.

Loans Held for Sale

We started originating short-term, interest-only loans in March 2017, which we have historically aggregated and sold at a premium to par to institutional investors. In July, we securitized these loans and transferred them to loans held for investment. As of June 30, 2020, our portfolio of loans held for sale, which were carried at the lower of cost or estimated fair value consisted of 685 loans with an aggregate UPB of $214.4 million, and carried a weighted average original loan term of 19.0 months, a weighted average coupon of 9.9%, and a weighted average LTV at origination of 68.5%.

The following tables show the various components of loans held for sale as of the dates indicated:

($ in thousands)	June 30, 2020			December 31, 2019
UPB	$	214,382		$	216,054
Valuation adjustments		(1,307	)		(396	)
Deferred loan origination fees, net		(731	)		(1,191	)
Total loans held for sale, net	$	212,344		$	214,467

Concentrations – Loans Held for Sale

As of June 30, 2020, our held for sale loan portfolio was entirely concentrated in investor 1-4 loans, representing 100.0% of the UPB. By geography, the principal balance of our loans held for sale were concentrated 31.3% in California, 10.0% in New York, 8.9% in Florida, 7.9% in Texas, 6.2% in New Jersey, and 5.6% in Georgia.

Geography (State)	June 30, 2020
($ in thousands)	Loan Count		UPB		% of Total UPB
California		83	$	67,164		31.3	%
New York		53		21,458		10.0
Florida		75		19,161		8.9
Texas		59		16,994		7.9
New Jersey		57		13,328		6.2
Georgia		53		12,044		5.6
Massachusetts		21		7,386		3.5
Other(1)		284		56,848		26.5
Total loans held for sale		685	$	214,382		100	%

(1)	All other states individually comprise less than 5.0% of the total UPB.

Real Estate Owned (REO)

REO includes real estate we acquire through foreclosure or by deed-in-lieu of foreclosure. REO assets are initially recorded at fair value, less estimated costs to sell, on the date of foreclosure. Adjustments that reduce the carrying value of the loan to the fair value of the real estate at the time of foreclosure are recognized as charge-offs in the allowance for credit losses. Positive adjustments at the time of foreclosure are recognized in other operating income. After foreclosure, we periodically obtain new valuations and any subsequent changes to fair value, less estimated costs to sell, are reflected as valuation adjustments.

As of June 30, 2020, our REO included 28 properties with an estimated fair value of $15.6 million compared to 24 properties with an estimated fair value of $13.1 million as of December 31, 2019.

Key Performance Metrics

	Three Months Ended
($ in thousands)	June 30, 2020 (1)			March 31, 2020 (1)			June 30, 2019 (1)
Average loans	$	2,095,307		$	2,083,783		$	1,693,566
Portfolio yield		7.59	%		8.57	%		8.71	%
Average debt — portfolio related		1,831,867			1,889,668			1,504,764
Average debt — total company		1,909,867			1,984,136			1,632,357
Cost of funds — portfolio related		4.63	%		4.84	%		5.40	%
Cost of funds — total company (2)		4.83	%		5.88	%		5.80	%
Net interest margin — portfolio related		3.54	%		4.18	%		3.91	%
Net interest margin — total company (2)		3.18	%		2.97	%		3.12	%
Charge-offs		0.00	%		0.01	%		0.00	%
Pre-tax return on equity (2)		4.94	%		6.62	%		13.07	%
Return on equity (2)		4.03	%		4.58	%		9.28	%

(1)

Percentages are annualized.

(2)

Excluding the one-time debt issuance costs write-off of $3.5 million and prepayment penalties of $0.3 million associated with the $75.0 million repayment of our corporate debt in January 2020, Key Performance Metrics for the three months ended March 31, 2020 are as follows: Cost of funds — total company 5.12%; Net interest margin — total company 3.69%; Pre-tax return on equity 13.32%; and Return on equity 9.22%.

Average Loans

Average loans reflects the daily average of total outstanding loans, including both loans held for investment and loans held for sale, as measured by UPB, over the specified time period.

Portfolio Yield

Portfolio yield is an annualized measure of the total interest income earned on our loan portfolio as a percentage of average loans over the given period. Interest income includes interest earned on performing loans, cash interest received on nonperforming loans, default interest and prepayment fees. The decrease in our portfolio yield over the periods shown was driven by additional loans placed on non-accrual status.

Average Debt — Portfolio Related and Total Company

Portfolio-related debt consists of borrowings related directly to financing our loan portfolio, which includes our warehouse repurchase facilities and securitizations. Total company debt consists of portfolio- related debt and corporate debt. The measures presented here reflect the monthly average of all portfolio- related and total company debt, as measured by outstanding principal balance, over the specified time period.

Cost of Funds — Portfolio Related and Total Company

Our portfolio related cost of funds improved to 4.63% for the three months ended June 30, 2020 from 4.84% for the three months ended March 31, 2020, and from 5.4% for the three months ended June 30, 2019. The decrease in portfolio related cost of funds was the result of lower spreads paid to investors in our more recent securitizations.

Portfolio related cost of funds is an annualized measure of the interest expense incurred on our portfolio-related debt as a percentage of average portfolio-related debt outstanding over the given period. Total company cost of funds is an annualized measure of the interest expense incurred on our portfolio-related debt and corporate debt outstanding over the given period. Interest expense includes the amortization of expenses incurred in connection with our portfolio related financing activities and corporate debt. Through the issuance of long-term securitizations, we have been able to fix a significant portion of our borrowing costs over time. The strong credit performance on our securitizations has allowed us to issue debt at attractive rates.

Net Interest Margin — Portfolio Related and Total Company

Our total company net interest margin increased from 2.97% for the three months ended March 31, 2020 to 3.18% for the three months ended June 30, 2020 as a result of the $75.0 million repayment of our corporate debt in January 2020.

Portfolio related net interest margin measures the difference between the interest income earned on our loan portfolio and the interest expense paid on our portfolio-related debt as a percentage of average loans over the specified time period. Total company net interest margin measures the difference between the interest income earned on our loan portfolio and the interest expense paid on our portfolio-related debt and corporate debt as a percentage of average loans over the specified time period. Over the periods shown, our portfolio related net interest margin increased from June 2019 to March 2020 mainly as a result of a reduction in our portfolio-related debt cost due to the lower cost of our most recent securitizations. In addition to achieving lower spreads in our more recent securitizations, we have also been able to utilize more favorable structures that will result in a lower and more stable cost of funds over the life of the securities. Our portfolio related net interest margin decreased from March 2020 to June 2020 mainly as a result of increased nonperforming loans due to the COVID-19 pandemic and, to a lesser extent, the seasoning of our loan portfolio.

The following tables show the average outstanding balance of our loan portfolio and portfolio-related debt, together with interest income and the corresponding yield earned on our portfolio, and interest expense and the corresponding rate paid on our portfolio-related debt for the periods indicated:

	Three Months Ended
	June 30, 2020							March 30, 2020								June 30, 2019
			Interest		Average					Interest		Average						Interest		Average
	Average		Income /		Yield /			Average		Income /		Yield /				Average		Income /		Yield /
($ in thousands)	Balance		Expense		Rate (1)			Balance		Expense		Rate (1)				Balance		Expense		Rate (1)
Loan portfolio:
Loans held for sale	$	220,047						$	202,474							$	60,940
Loans held for investment		1,875,260							1,881,309								1,632,626
Total loans	$	2,095,307	$	39,755		7.59	%	$	2,083,783	$	44,637		8.57	%		$	1,693,566	$	36,884		8.71	%

Debt:
Warehouse and repurchase facilities	$	242,676		2,632		4.34	%	$	347,350	$	4,301		4.95	%		$	179,193	$	2,692		6.01	%
Securitizations		1,589,191		18,557		4.67	%		1,542,318		18,547		4.81	%			1,325,571		17,632		5.32	%
Total debt - portfolio related		1,831,867		21,189		4.63	%		1,889,668		22,848		4.84	%			1,504,764		20,324		5.40	%
Corporate debt		78,000		1,894		9.71	%		94,468		6,342		26.85	%	(4)		127,594		3,353		10.51	%
Total debt	$	1,909,867	$	23,083		4.83	%	$	1,984,136	$	29,190		5.88	%		$	1,632,357	$	23,677		5.80	%

Net interest spread - portfolio related (2)						2.96	%						3.73	%							3.31	%
Net interest margin - portfolio related						3.54	%						4.18	%							3.91	%

Net interest spread - total company (3)						2.75	%						2.68	%	(4)						2.91	%
Net interest margin - total company						3.18	%						2.97	%	(4)						3.12	%

(1)	Annualized.

(2)	Net interest spread — portfolio related is the difference between the rate earned on our loan portfolio and the interest rates paid on our portfolio-related debt.

(3)	Net interest spread — total company is the difference between the rate earned on our loan portfolio and the interest rates paid on our total debt.

(4)

Excluding the one-time debt issuance costs write-off of $3.5 million and prepayment penalties of $0.3 million associated with the $75.0 million repayment of our corporate debt in January 2020, the Corporate debt average rate would have been 10.88%; Net interest spread — total company would have been 3.44%; and Net interest margin — total company would have been 3.69% for the three months ended March 31, 2020.

Charge-Offs

Our charge-off rate for the three months ended June 30, 2020 and March 31, 2020 remained low at 0.1% and 0.47%, respectively. The charge-offs rate reflects charge-offs as a percentage of average nonperforming loans held for investment. We do not record charge-offs on our loans held for sale which are carried at the lower of cost or estimated fair value.

Pre-Tax Return on Equity and Return on Equity

Pre-tax return on equity and return on equity reflect income before income taxes and net income, respectively, as a percentage of the monthly average of stockholders/members’ equity over the specified time period.

	Three Months Ended
($ in thousands)	June 30, 2020			March 31, 2020 (2)			June 30, 2019
Income before income taxes (A)	$	2,625		$	3,727		$	4,979
Net income (B)		2,141			2,579			3,535

Monthly average balance:
Stockholders' / Members' equity (C)		212,407			225,125			152,394

Pre-tax return on equity (A / C) (1)		4.9	%		6.6	%		13.1	%

Return on equity (B / C) (1)		4.0	%		4.6	%		9.3	%

(1)	Annualized.

(2)

Excluding the one-time debt issuance costs write-off of $3.5 million and prepayment penalties of $0.3 million associated with the $75.0 million repayment of our corporate debt in January 2020, Income before income taxes would have been $7.5 million; Net income would have been $5.2 million; Pre-tax return on equity would have been 13.3%; and Return on equity would have been 9.2% for the three months ended March 31, 2020.

Components of Results of Operations

Interest Income

We accrue interest on the UPB of our loans in accordance with the individual terms and conditions of each loan, discontinuing interest and reversing previously accrued interest once a loan becomes 90 days or more past due (nonaccrual status). When a loan is placed on nonaccrual status, the accrued and unpaid interest is reversed as a reduction to interest income and accrued interest receivable. Interest income is subsequently recognized only to the extent that cash payments are received or when the loan has returned to accrual status. Payments received on nonaccrual loans are first applied to interest due, then principal. Interest accrual resumes once a borrower has made all principal and interest payments due, bringing the loan back to current status.

In response to the COVID-19 pandemic, we implemented a COVID-19 forbearance program allowing customers to primarily defer payments for up to 90 days. We will continue to accrue interest on loans in the COVID-19 forbearance program that were less than 90 days past due at forbearance grant date. We will continue to evaluate the COVID-19 forbearance-granted loans on an individual basis to determine if a reserve should be established on the collectability of the accrued interest and whether any loans should be placed on nonaccrual status at a future date.

Interest income on loans held for investment is comprised of interest income on loans and prepayment fees less the amortization of deferred net costs related to the origination of loans. Interest income on loans held for sale is comprised of interest income earned on loans prior to their sale. The net fees and costs associated with loans held for sale are deferred as part of the carrying value of the loan and recognized as a gain or loss on the sale of the loan.

Interest Expense — Portfolio Related

Portfolio related interest expense is incurred on the debt we incur to fund our loan origination and portfolio activities and consists of our warehouse repurchase facilities and securitizations. Portfolio related interest expense also includes the amortization of expenses incurred as a result of issuing the debt, which are amortized using the level yield method. Key drivers of interest expense include the debt amounts outstanding, interest rates, and the mix of our securitizations and warehouse liabilities.

Net Interest Income — Portfolio Related

Portfolio related net interest income represents the difference between interest income and portfolio related interest expense.

Interest Expense — Corporate Debt

Interest expense on corporate debt primarily consists of interest expense paid with respect to the 2014 Senior Secured Notes and the 2019 Term Loan, as reflected on our consolidated statement of financial condition, and the related amortization of deferred debt issuance costs.

Net Interest Income

Net interest income represents the difference between portfolio related net interest income and interest expense on corporate debt.

Provision for Loan Losses

Provision for loan losses consists of amounts charged to income during the period to maintain an estimated allowance for credit losses, or ACL, to provide for credit losses inherent in our existing portfolio of loans held for investment (excluding those loans which we have elected to carry at fair value). The ACL consists of an allowance on loans that are assessed or evaluated individually, and an allowance for loans evaluated collectively by segment. Loans 90 days or more delinquent, in bankruptcy, or in foreclosure, are evaluated individually, and these loans are excluded from loans evaluated collectively by segment.

Other Operating Income

Gain on Disposition of Loans. When we sell a loan held for sale, we record a gain or loss that reflects the difference between the proceeds received for the sale of the loans and their respective carrying values. The gain or loss that we ultimately realize on the sale of our loans held for sale is primarily determined by the terms of the originated loans, current market interest rates and the sales price of the loans. In addition, when we transfer a loan to REO, we record the REO at its fair value at the time of the transfer. The difference between the fair value of the real estate and the carrying value of the loan is recorded as a gain or loss. Lastly, when our acquired loans, which were purchased at a discount, pay off, we record a gain related the write-off of the remaining purchase discount.

Unrealized Gain/(Loss) on Fair Value Loans. We have elected to account for certain purchased distressed loans at fair value using FASB ASC Topic 825, Financial Instruments (ASC 825). We regularly estimate the fair value of these loans as discussed more fully in the notes to our consolidated financial statements. Changes in fair value subsequent to initial recognition of fair value loans are reported as unrealized gain/(loss) on fair value loans, a component of other operating income within the consolidated statements of operations.

Other Income. Other income includes the following:

Unrealized Gains/(Losses) on Retained Interest Only Securities. As part of the proceeds received for the sale of our held for sale loans, we may receive an interest only security. Changes in fair value subsequent to initial recognition are reported as unrealized gains/(losses) on interest-only securities.

Fee Income. In certain situations, we collect fee income by originating loans and realizing miscellaneous fees.

Operating Expenses

Compensation and Employee Benefits. Costs related to employee compensation, commissions and related employee benefits, such as health, retirement, and payroll taxes.

Rent and Occupancy. Costs related to occupying our locations, including rent, maintenance and property taxes.

Loan Servicing. Costs related to our third-party servicers.

Professional Fees. Costs related to professional services, such as external audits, legal fees, tax, compliance and outside consultants.

Real Estate Owned, Net. Costs related to our real estate owned, net, including gains/(losses) on disposition of REO, maintenance of REO properties, and taxes and insurance.

Other Operating Expenses. Other operating expenses consist of general and administrative costs such as, travel and entertainment, marketing, data processing, insurance and office equipment.

Provision for Income Taxes

The provision for income taxes consists of the current and deferred U.S. federal and state income taxes we expect to pay, currently and in future years, with respect to the net income for the year. The amount of the provision is derived by adjusting our reported net income with various permanent differences. The tax- adjusted net income amount is then multiplied by the applicable federal and state income tax rates to arrive at the provision for income taxes.

Consolidated Results of Operations

The following table summarizes our consolidated results of operations for the periods indicated:

	Three Months Ended					Six Months Ended
($ in thousands)	June 30, 2020			June 30, 2019		June 30, 2020		June 30, 2019
Interest income	$	39,755		$	36,884	$	84,391	$	73,028
Interest expense - portfolio related		21,189			20,324		44,036		39,387
Net interest income - portfolio related		18,566			16,560		40,355		33,641
Interest expense - corporate debt		1,894			3,353		8,237		6,706
Net interest income		16,672			13,207		32,118		26,935
Provision for loan losses		1,800			212		3,088		560
Net interest income after provision for loan losses		14,872			12,995		29,030		26,375
Other operating income		(1,339	)		308		280		2,028
Total operating expenses		10,908			8,324		22,959		16,823
Income before income taxes		2,625			4,979		6,351		11,580
Income tax expense		484			1,444		1,631		3,350
Net income	$	2,141		$	3,535	$	4,720	$	8,230

Net Interest Income — Portfolio Related

	Three Months Ended						Six Months Ended
($ in thousands)	June 30, 2020		June 30, 2019		$ Change		June 30, 2020		June 30, 2019		$ Change
Interest income	$	39,755	$	36,884	$	2,871	$	84,391	$	73,028	$	11,363
Interest expense - portfolio related		21,189		20,324		865		44,036		39,387		4,649
Net interest income - portfolio related	$	18,566	$	16,560	$	2,006	$	40,355	$	33,641	$	6,714

Portfolio related net interest income is the largest contributor to our net income. We have grown our portfolio related net interest income by $2.0 million from $16.6 million for the three months ended June 30, 2019 to $18.6 million for the three months ended June 30, 2020; and from $33.6 million for the six months ended June 30, 2019 to $40.4 million six months ended June 30, 2020. The growth was due to the increase in originations in the last six months of 2019 and the first quarter of 2020, prior to the COVID-19 crisis. The pandemic caused a temporary suspension in originations starting in late March and has continued through the second quarter of 2020.

Interest Income. Interest income increased by $2.9 million to $39.8 million for the three months ended June 30, 2020, compared to $36.9 million for the three months ended June 30, 2019. The increase is primarily attributable to an increase in average loans, which increased $401.7 million from $1.7 billion for the three months ended June 30, 2019 to $2.1 billion for the three months ended June 30, 2020. The average yield over those same periods decreased from 8.71% to 7.59% mainly due to the increase in nonperforming loans due to COVID-19.

The following tables distinguish between the change in interest income attributable to change in volume and the change in interest income attributable to change in rate for the three months ended June 30, 2020 and March 31, 2020, and the three and six months ended June 30, 2020 and 2019, respectively. The effect of changes in volume is determined by multiplying the change in average loan balance by the previous period’s average yield. The effect of rate changes is calculated by multiplying the change in average yield by the current period’s average loan balance.

	Three Months Ended June 30, 2020 and March 31, 2020
($ in thousands)	Average Loans		Interest Income			Average Yield (1)
Three months ended June 30, 2020	$	2,095,307	$	39,755			7.59	%
Three months ended March 31, 2020		2,083,783		44,637			8.57	%
Volume variance		11,524		247
Rate variance				(5,129	)		(0.98	)%
Total interest income variance			$	(4,882	)
(1) Annualized.

	Three Months Ended June 30, 2020 and 2019
($ in thousands)	Average Loans		Interest Income			Average Yield (1)
Three months ended June 30, 2020	$	2,095,307	$	39,755			7.59	%
Three months ended June 30, 2019		1,693,566		36,884			8.71	%
Volume variance		401,741		8,749
Rate variance				(5,878	)		(1.12	)%
Total interest income variance			$	2,871
(1) Annualized.

	Six Months Ended June 30, 2020 and 2019
($ in thousands)	Average Loans		Interest Income			Average Yield (1)
Six months ended June 30, 2020	$	2,089,545	$	84,391			8.08	%
Six months ended June 30, 2019		1,659,782		73,028			8.80	%
Volume variance		429,763		18,909
Rate variance				(7,546	)		(0.72	)%
Total interest income variance			$	11,363
(1) Annualized.

Interest Expense — Portfolio Related. Portfolio related interest expense decreased by 0.21% to 4.63% for the three months ended June 30, 2020 from 4.84% for the three months ended March 31, 2020, and decreased by 0.78% from 5.4% for the three months ended June 30, 2019 as a result of recent lower costs securitizations. Portfolio related interest expense consists of interest incurred on our warehouse facilities and securitizations. The $1.7 million decrease from $22.8 million for the three months ended March 31, 2020 to $21.2 million for the three months ended June 30, 2020 was primarily due to the decrease in cost of funds and the decrease in warehouse repurchase facilities balance. The $0.9 million increase from $20.3 million for the three months ended June 30, 2019 to $21.2 million for the three months ended June 30, 2020 was primarily attributable to the increase in securitizations financing increased loan volume, offset by the decrease in cost of funds which decreased to 4.63% for the three months ended June 30, 2020 from 5.40% for the three months ended June 30, 2019. The decrease in cost of funds was primarily due to the addition of lower-cost pro-rata securitizations and the paydown of older higher-cost sequential securitizations.

The following tables present information regarding the portfolio related interest expense and distinguishes between the dollar amount of change in interest expense attributable to changes in the average outstanding debt balance (volume) versus changes in cost of funds (rate) for the three months ended June 30, 2020 and March 31, 2020, and the three and six months ended June 30, 2020 and 2019, respectively.

	Three Months Ended June 30, 2020 and March 31, 2020
($ in thousands)	Average Debt (1)			Interest Expense			Cost of Funds (2)
Three months ended June 30, 2020	$	1,831,867		$	21,189			4.63	%
Three months ended March 31, 2020		1,889,668			22,848			4.84	%
Volume variance		(57,801	)		(699	)
Rate variance					(960	)		(0.21	)%
Total interest income variance				$	(1,659	)
(1) Includes securitizations and warehouse repurchase agreements.
(2) Annualized.

	Three Months Ended June 30, 2020 and 2019
($ in thousands)	Average Debt (1)		Interest Expense			Cost of Funds (2)
Three months ended June 30, 2020	$	1,831,867	$	21,189			4.63	%
Three months ended June 30, 2019		1,504,764		20,324			5.40	%
Volume variance		327,103		4,418
Rate variance				(3,553	)		(0.78	)%
Total interest income variance			$	865
(1) Includes securitizations and warehouse repurchase agreements.
(2) Annualized.

	Six Months Ended June 30, 2020 and 2019
($ in thousands)	Average Debt (1)		Interest Expense			Cost of Funds (2)
Six months ended June 30, 2020	$	1,860,767	$	44,036			4.73	%
Six months ended June 30, 2019		1,474,730		39,387			5.34	%
Volume variance		386,037		10,310
Rate variance				(5,661	)		(0.61	)%
Total interest income variance			$	4,649
(1) Includes securitizations and warehouse repurchase agreements.
(2) Annualized.

Net Interest Income After Provision for Loan Losses

	Three Months Ended							Six Months Ended
($ in thousands)	June 30, 2020		June 30, 2019		$ Change			June 30, 2020		June 30, 2019		$ Change
Net interest income - portfolio related	$	18,566	$	16,560	$	2,006		$	40,355	$	33,641	$	6,714
Interest expense - corporate debt		1,894		3,353		(1,459	)		8,237		6,706		1,531
Net interest income		16,672		13,207		3,465			32,118		26,935		5,183
Provision for loan losses		1,800		212		1,588			3,088		560		2,528
Net interest income after provision for loan losses	$	14,872	$	12,995	$	1,877		$	29,030	$	26,375	$	2,655

Interest Expense — Corporate Debt. Corporate debt interest expense decreased by $1.5 million from $3.4 million for the three months ended June 30, 2019 to $1.9 million for the three months ended June 30, 2020 primarily due to the outstanding balance being lower by $49.6 million. Corporate debt interest expense increased by $1.5 million in the six months ended June 30, 2020 compared to the six months ended June 30, 2019, due to the one-time amortization of $3.5 million debt issuance costs and $0.3 million prepayment fees paid in January 2020 as a result of a $75 million debt principal paydown with IPO proceeds.

Provision for Loan Losses. Our provision for loan losses increased by $1.6 million from $0.2 million for the three months ended June 30, 2019 to $1.8 million for the three months ended June 30, 2020. The increase was due to additional reserves in response to the increased severity of the COVID-19 pandemic, which has caused significant disruption in business activity and the financial markets both globally and in the United States. We have increased our provision for loan losses in response to the expected impact of the pandemic on the economy. The provision for loan losses increased by $2.5 million from $0.6 million for the six months ended June 30, 2019 to $3.1 million for the six months ended June 30, 2020, mainly attributable to adverse business conditions caused by the COVID-19 pandemic.

Other Operating Income

The table below presents the various components of other operating income for the three and six months ended June 30, 2020 and 2019, respectively. The $1.6 million decrease from income of $0.3 million for the three months ended June 30, 2019 to expense of $1.3 million for the three months ended June 30, 2020 was driven by higher amortization expense from retained interest only strips and lower gain on sale because we chose not to sell HFS loans. The $1.7 million decrease from $2.0 million for the six months ended June 30, 2019 to $0.3 million for the six months ended June 30, 2020 is primarily higher amortization of interest-only strips.

	Three Months Ended									Six Months Ended
($ in thousands)	June 30, 2020			June 30, 2019			$ Change			June 30, 2020			June 30, 2019			$ Change
Gain on disposition of loans	$	155		$	863		$	(708	)	$	2,772		$	2,858		$	(86	)
Unrealized gain on fair value loans		(13	)		(25	)		12			32			(34	)		66
Other (expense) income		(1,481	)		(530	)		(951	)		(2,524	)		(796	)		(1,728	)
Total other operating income	$	(1,339	)	$	308		$	(1,647	)	$	280		$	2,028		$	(1,748	)

Operating Expenses

Total operating expenses increased by $2.6 million to $10.9 million for the three months ended June 30, 2020 from $8.3 million for three months ended June 30, 2019. For six months ended June 30, 2020, total operating expenses increased by $6.1 million compared to the same period in 2019. The increases are primarily attributable to direct loan origination costs included in the Compensation and Servicing lines in the table below that were deferred in 2019 in accordance with U.S. GAAP and amortized over the lives of new loan originations but were expensed in 2020 due to the suspension of loan production.

	Three Months Ended							Six Months Ended
($ in thousands)	June 30, 2020		June 30, 2019		$ Change			June 30, 2020		June 30, 2019		$ Change
Compensation and employee benefits	$	5,863	$	3,800	$	2,063		$	10,904	$	7,806	$	3,098
Rent and occupancy		448		399		49			903		736		167
Loan servicing		1,754		1,551		203			3,658		3,006		652
Professional fees		588		534		54			1,772		1,190		582
Real estate owned, net		408		561		(153	)		1,542		862		680
Other operating expenses		1,847		1,479		368			4,180		3,223		957
Total operating expenses	$	10,908	$	8,324	$	2,584		$	22,959	$	16,823	$	6,136

Compensation and Employee Benefits. Compensation and employee benefits increased from $3.8 million for the three months ended June 30, 2019 to $5.8 million for the three months ended June 30, 2020; and increased from $7.8 million for the six months ended June 30, 2019 to $10.9 million for the six months ended June 30, 2020 primarily due to the recognition of all compensation expenses, as opposed to in prior periods, we deferred some direct origination expenses associated with new originations.

Rent and Occupancy. Rent and occupancy expenses slightly increased for the three months ended June 30, 2020 compared to the three months ended June 30, 2019. The $0.2 million increase to $0.9 million for the six months ended June 30, 2020 compared to the same period in 2019 is due to an increase in office space.

Loan Servicing. Loan servicing expenses increased from $1.6 million for the three months ended June 30, 2019 to $1.8 million for the three months ended June 30, 2020. The increase from $3.0 million for the six months ended June 30, 2019 to $3.7 million for the six months ended June 30, 2020 is due to the increase in our loan portfolio.

Professional Fees. Professional fees increased from $0.5 million for the three months ended June 30, 2019 to $0.6 million for the three months ended June 30, 2020; and increased from $1.2 million for the six months ended June 30, 2019 to $1.8 million for the six months ended June 30, 2020, mainly due to our growth and increased costs as a public company.

Net Expenses of Real Estate Owned. Net expenses of real estate owned decreased from $0.6 million for the three months ended June 30, 2019 to $0.4 million for the three months ended June 30, 2020 due to an increase in rental income and gain on sale of REO, as well as a decrease in REO expenses. Net real estate costs increased from $0.9 million for the six months ended June 30, 2019 to $1.5 million for the six months ended June 30, 2020 mainly due to higher valuation adjustments, partly offset by higher gain on sale and rental income.

Other Operating Expenses. Other operating expenses increased from $1.5 million for the three months ended June 30, 2019 to $1.8 million for the three months ended June 30, 2020; and increased from $3.2 million for the six months ended June 30, 2019 to $4.2 million for the six months ended June 30, 2020, primarily due to the increase in directors’ and officers’ insurance expenses related to becoming a publicly traded company, as well as SEC filing fees.

Income Tax Expense. Income tax expense was $0.5 million and $1.4 million for the three months ended June 30, 2020 and 2019, and $1.6 million and $3.4 million for the six months ended June 30, 2020 and 2019, respectively. Our consolidated effective tax rate as a percentage of pre-tax income was 18.4% and 29.0% for the three months ended June 30, 2020 and 2019, and 25.7% and 28.9% for the six months ended June 30, 2020 and 2019, respectively. The effective tax rate for the three and six months ended June 30, 2020 were lower compared to the same periods in 2019 due to a FIN 48 reserve in 2019 which increased the effective tax rate.

Liquidity and Capital Resources

Sources and Uses of Liquidity

We fund our lending activities primarily through borrowings under our warehouse facilities, securitizations, members’ equity and other corporate-level debt, equity and debt securities, and net cash provided by operating activities to manage our business. We use cash to originate and acquire investor real estate loans, repay principal and interest on our borrowings, fund our operations and meet other general business needs.

As a result of the spread of the COVID-19, economic uncertainties have arisen which have negatively impacted our financial condition, results of operations and cash flows. We have executed a number of business initiatives to strengthen our liquidity and capital resources position in light of the impact of COVID-19, including the following:

•

On April 6, 2020, we entered into amendments to our warehouse repurchase agreements and issued and sold $45.0 million in gross proceeds of Preferred Stock and Warrants.

•

We successfully issued two securitizations in June and July, that resulted in approximately $273.0 million in proceeds that were used to fully pay off our existing warehouse lines. As of July 31, 2020, all of our loans are securitized with long-term financing.

Cash and Cash Equivalents

We had cash of $9.8 million and $14.1 million as of June 30, 2020 and 2019, respectively. The following table summarizes the net cash provided by (used in) operating activities, investing activities and financing activities as of the periods indicated:

	Six Months Ended
($ in thousands)	June 30, 2020			June 30, 2019
Cash provided by (used in):
Operating activities	$	23,740		$	9,205
Investing activities		2,704			(127,949	)
Financing activities		(37,458	)		117,714
Net change in cash, cash equivalents, and restricted cash	$	(11,014	)	$	(1,030	)

Cash flows from operating activities primarily includes net income adjusted for (1) cash used for origination of held for sale loans and the related cash proceeds from the sales of such loans, (2) non-cash items including depreciation, provision for loan loss, discount accretion, and valuation changes, and (3) changes in the balances of operating assets and liabilities.

For the six months ended June 30, 2020, our net cash provided from operating activities consisted mainly of $80.9 million in cash proceeds from sales of held for sale loans and $18.8 million in cash received from repayments on held for sale loans, partially offset by $96.1 million in cash used to originate held for sale loans.

For the six months ended June 30, 2020, our net cash provided by investing activities consisted mainly of $153.6 million in cash used to originate held for investment loans, offset by $164.0 million in cash received in payments on held for investment loans.

For the six months ended June 30, 2020, our net cash used in financing activities consisted mainly of $250.4 million and $341.9 million in cash from borrowings from our warehouse repurchase facilities and securitizations issued, respectively; proceeds from IPO of $100.8 million; and net proceeds from issuance of preferred stock of $41.0 million. This cash generated was partially offset by payments we made of $511.7 million and $180.0 million on our warehouse repurchase facilities and securitizations issued, respectively.

During the six months ended June 30, 2020, we used approximately $11.0 million of net cash and cash equivalents from operations, investing and financing activities. During six months ended June 30, 2019, we used approximately $1.0 million of net cash and cash equivalents from operations, investing and financing activities.

Warehouse Facilities

As of June 30, 2020, we had two warehouse repurchase agreements to finance loans pending securitization. Both agreements are short-term borrowing facilities. The borrowings are collateralized by pools of primarily performing loans, bearing interest at one-month LIBOR plus a margin that ranges from 2.75% to 3.00%. Borrowings under these repurchase facilities were $158.6 million and $417.2 million as of June 30, 2020 and December 31, 2019, respectively.

In addition to the two warehouse repurchase agreements, we also have a longer term warehouse agreement, which was added in September 2018. The borrowings are collateralized by pools of primarily performing loans, with a maximum borrowing capacity of $50 million, bearing interest at one-month LIBOR plus a margin of 3.50%. The warehouse agreement has a maturity date of September 12, 2021 and allows loans to be financed for a period of up to three years. Borrowings under this warehouse agreement were zero and $2.5 million as of June 30, 2020 and December 31, 2019, respectively.

All warehouse facilities fund less than 100% of the principal balance of the mortgage loans we own requiring us to use working capital to fund the remaining portion. We may need to use additional working capital if loans become delinquent, because the amount permitted to be financed by the facilities may change based on the delinquency performance of the pledged collateral.

All borrower payments on loans financed under the warehouse agreements are segregated into pledged accounts with the loan servicer. All principal amounts in excess of the interest due are applied to reduce the outstanding borrowings under the warehouse repurchase facilities. The warehouse repurchase facilities also contain customary covenants, including financial covenants that require us to maintain minimum liquidity, a minimum net worth, a maximum debt-to- net worth ratio and a ratio of a minimum earnings before interest, taxes, depreciation and amortization to interest expense. If we fail to meet any of the covenants or otherwise default under the facilities, the lenders have the right to terminate their facility and require immediate repayment, which may require us to sell our loans at less than optimal terms. As of June 30, 2020, we were in compliance with these covenants.

On April 6, 2020, we entered into amendments to the master repurchase agreements on both of our warehouse repurchase agreements with the lenders under such agreements. Each of these agreements were completely paid down with the 2020-MC1 securitization that closed in July. Pursuant to the terms of the warehouse repurchase amendments, (i) we must maintain unrestricted cash and cash equivalents of at least $7.5 million, (ii) we were required to make aggregate payments of $20.0 million to reduce our obligations under the warehouse repurchase agreements on April 6, 2020, and (iii) we ensured that payments of at least $3.0 million per month were made to each lender, from the cash flow of the underlying financed loans and/or corporate cash each month from April 6 through August 3, 2020, in reduction of its obligations thereunder. In addition, the interest rate under each warehouse repurchase facility was increased by 25 basis points, effective as of April 6, 2020.

We successfully issued two securitizations, June and July, that resulted in approximately $273.0 million in proceeds that were used to fully pay off our existing warehouse lines. As of July 31, 2020, all of our loans are securitized with long-term financing.

Securitizations

From May 2011 through June 2020, we have completed fourteen securitizations of $3.1 billion of investor real estate loans, issuing $2.9 billion in principal amount of securities to third parties through fourteen respective transactions. All borrower payments are segregated into remittance accounts at the primary servicer and remitted to the trustee of each trust monthly. We are the sole beneficial interest holder of the applicable trusts, which are variable interest entities included in our consolidated financial statements. The transactions are accounted for as secured borrowings under U.S. GAAP. The following table summarizing the investor real estate loans securitized, securities issued, securities retained by us at the time of the securitization, and as of June 30, 2020 and December 31, 2019, and the stated maturity for each securitization. The securities are callable by us when the stated principal balance is less than a certain percentage, ranging from 5%—30%, of the original stated principal balance of loans at issuance. As a result, the actual maturity date of the securities issued will likely be earlier than their respective stated maturity date.

($ in thousands)					Securities Retained as of
Trusts	Mortgage Loans		Securities Issued		Issuance Date		June 30, 2020		December 31, 2019		Stated Maturity Date
2011-1 Trust	$	74,898	$	61,042	$	13,856	$	—	$	—	August 2040
2014-1 Trust		191,757		161,076		30,682		—		—	September 2044
2015-1 Trust		312,829		285,457		27,372		15,521		15,569	July 2045
2016-1 Trust		358,601		319,809		38,792		17,931		17,931	April 2046
2016-2 Trust		190,255		166,853		23,402		9,514		9,514	October 2046
2017-1 Trust		223,064		211,910		11,154		11,154		11,154	April 2047
2017-2 Trust		258,528		245,601		12,927		7,480		8,293	October 2047
2018-1 Trust		186,124		176,816		9,308		6,486		6,884	April 2048
2018-2 Trust		324,198		307,988		16,210		11,465		12,853	October 2048
2019-1 Trust		247,979		235,580		12,399		11,540		11,767	March 2049
2019-2 Trust		217,921		207,020		10,901		9,728		10,491	July 2049
2019-3 Trust		162,546		154,419		8,127		7,267		7,913	October 2049
2020-1 Trust		261,859		248,700		13,159		13,085		—	February 2050
2020-2 Trust		128,470		96,352		32,118		32,118		—	June 2050
Total	$	3,139,029	$	2,878,623	$	260,407	$	153,289	$	112,367

The following table summarizes outstanding bond balances for each securitization as of June 30, 2020 and December 31, 2019:

($ in thousands)	June 30, 2020		December 31, 2019
2014-1 Trust	$	26,659	$	31,139
2015-1 Trust		44,394		50,631
2016-1 Trust		67,333		86,901
2016-2 Trust		52,341		63,983
2017-1 Trust		88,950		113,540
2017-2 Trust		146,611		163,295
2018-1 Trust		118,605		134,700
2018-2 Trust		219,591		247,580
2019-1 Trust		200,484		214,709
2019-2 Trust		183,578		200,345
2019-3 Trust		137,789		150,725
2020-1 Trust		240,334		—
2020-2 Trust		95,963		—
	$	1,622,632	$	1,457,548

As of June 30, 2020 and December 31, 2019, the weighted average rate on the securities and certificates for the Trusts were as follows:

	June 30, 2020			December 31, 2019
2014-1 Trust		7.29	%		8.33	%
2015-1 Trust		7.12	%		6.37	%
2016-1 Trust		7.42	%		6.75	%
2016-2 Trust		6.34	%		5.59	%
2017-1 Trust		4.79	%		4.56	%
2017-2 Trust		3.34	%		3.50	%
2018-1 Trust		4.01	%		3.95	%
2018-2 Trust		4.49	%		4.44	%
2019-1 Trust		4.04	%		4.00	%
2019-2 Trust		3.41	%		3.44	%
2019-3 Trust		3.27	%		3.27	%
2020-1 Trust		2.85	%		—
2020-2 Trust		4.50	%		—

Our intent is to use the proceeds from the issuance of new securities primarily to repay our warehouse borrowings and originate new investor real estate loans in accordance with our underwriting guidelines, as well as for general corporate purposes. Our financing sources may include borrowings in the form of additional bank credit facilities (including term loans and revolving credit facilities), repurchase agreements, warehouse repurchase facilities and other sources of private financing. We also plan to continue using securitization as long-term financing for our portfolio, and we do not plan to structure any securitizations as sales or utilize off-balance-sheet vehicles. We believe any financing of assets and/or securitizations we may undertake will be sufficient to fund our working capital requirements.

Preferred Stock and Warrants

On April 7, 2020, we sold 45,000 shares of Preferred Stock and Warrants to purchase 3,013,125 shares of our common stock in a private placement to two of our largest stockholders. These offerings resulted in net proceeds of $43.2 million.

Beginning on October 5, 2022, but in no event later than November 28, 2024, each holder of Preferred Stock has the option to cause us to repurchase all or a portion of such holder’s shares of Preferred Stock, for an amount in cash equal to the liquidation preference of each share repurchased. The Preferred Stock has a liquidation preference equal to the greater of (i) $2,000 per share from April 7, 2020 through October 5, 2022, which amount increases ratably to $3,000 per share between October 6, 2022 and November 28, 2024 and to $3,000 per share from and after November 28, 2024 and (ii) the amount such Preferred Stock holder would have received if the Preferred Stock had converted into common stock immediately prior to such liquidation. We also have an obligation to repurchase the Preferred Stock for cash at a price per share equal to the liquidation preference in the event of a change of control (as defined in the certificate of designation governing the Preferred Stock).

Contractual Obligations and Commitments

As of June 30, 2020, we maintained warehouse facilities to finance our investor real estate loans and had approximately $158.6 million in outstanding borrowings.

The following table illustrates our contractual obligations existing as of June 30, 2020:

	Remainder of		January 1, 2021 -		January 1, 2023 -
($ in thousands)	2020		December 31, 2022		December 31, 2022		Thereafter		Total
Warehouse repurchase facilities	$	158,620	$	2,820	$	—	$	—	$	161,440	(1)
Notes payable (corporate debt)		195		1,560		76,245		—		78,000	(2)
Leases payments under noncancelable operating leases		963		3,184		2,460		55		6,662
Total	$	159,778	$	7,564	$	78,705	$	55	$	246,102

(1)	Amount represents gross warehouse and repurchase borrowing. Balance of $160.8 million in the consolidated balance sheets as of June 30, 2020 is net of $0.6 million debt issuance costs.

(2)	Amount represents gross corporate debt. Balance of $74.6 million in the consolidated balance sheets as of June 30, 2020 is net of $3.4 million debt issuance costs.

Off-Balance-Sheet Arrangements

At no time have we maintained any relationships with unconsolidated entities or financial partnerships, such as entities referred to as structured finance, or special-purpose or variable interest entities, established for the purpose of facilitating off-balance-sheet arrangements or other contractually narrow or limited purposes. Further, we have never guaranteed any obligations of unconsolidated entities or entered into any commitment or intent to provide funding to any such entities.

Forward-Looking Statements

This Form 10-Q contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by those sections. All statements (other than statements of historical facts) in this Quarterly Report regarding the prospects of the industry and our prospects, plans, financial position and business strategy may constitute forward-looking statements. In addition, forward-looking statements generally can be identified by the use of forward-looking terminology such as “may,” “should,” “expect,” “intend,” “will,” “estimate,” “anticipate,” “plan,” “believe,” “predict,” “potential” or “continue” or the negatives of these terms or variations of them or similar terminology. Forward-looking statements may contain expectations regarding our operations, including the cessation and resumption of loan originations, and other results, and may include statements of future performance, plans and objectives. Forward looking statements also include statements pertaining to our strategies for future funding and development of our business and products. Although we believe that the expectations reflected in these forward-looking statements have a reasonable basis, we cannot provide any assurance that these expectations will prove to be correct. Such statements reflect the current views of our management with respect to our operations, results of operations and future financial performance. It is possible that the actual results may differ, possibly materially, from the anticipated results indicated in these forward-looking statements. Information regarding important factors that could cause actual results to differ, perhaps materially, from those in our forward-looking statements is contained in this Quarterly Report and other documents we file. You should read and interpret any forward-looking statement together with these documents, including the following:

•

the description of our business and risk factors contained in our Annual Report on Form 10-K for the year ended December 31, 2019 and filed with the Securities and Exchange Commission (“SEC”) on April 7, 2020

•

the risk factors contained in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2020 and filed with the SEC on May 14, 2020

•

the discussion of our analysis of financial condition and results of operations contained in this Quarterly Report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations”

•

the notes to the consolidated financial statements contained in this Quarterly Report

•

cautionary statements we make in our public documents, reports and announcements

Any forward-looking statement speaks only as of the date on which that statement is made. We will not update any forward-looking statement to reflect events or circumstances that occur after the date on which the statement is made, except as required by applicable law.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Not applicable.

Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures.

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rules 13a-15(e) and 15d-15(e) under the Exchange Act as of the end of the period covered by this report. Our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms, and that such information is accumulated and communicated to the our management, including the our Chief Executive Officer and Chief Financial Officer to allow timely decisions regarding required disclosure. Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objective, and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2019, in reviewing the accounting for a certain transaction we completed in January 2018, as part of our 2018 election to be treated as a corporation for U.S. federal and state income tax purposes, our management identified a deficiency in the effectiveness of a control intended to properly document and review relevant facts and apply the appropriate tax accounting under U.S. GAAP, which impacted the beginning of year deferred tax asset and income tax benefit accounts and related disclosures. Management concluded that it had not implemented an effective control structure to prevent or detect the material misstatement in calculating the beginning of year deferred tax position. In 2019, we implemented a plan to remediate this material weakness by contracting with a nationally recognized accounting firm to have experienced tax personnel supplement and train our current accounting team. As a result, additional internal controls over our income tax processes have been designed and implemented. In 2020, management will assess whether these internal controls over income taxes are performing as designed. Management has concluded that the material weakness will remain as of June 30, 2020, pending further testing of the internal controls.

In accordance with Rule 13a-15(b) of the Exchange Act, our management, including our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this quarterly report and has concluded that, notwithstanding the identified material weakness in our internal controls, our disclosure controls and procedures, as of such date, were effective to accomplish their objectives at a reasonable assurance level. Management concluded that, notwithstanding the material weakness in our internal controls, the consolidated financial statements for the periods covered by and included in this Quarterly Report on Form 10-Q fairly present, in all material respects, our financial position, results of operations and cash flows for the periods presented in conformity with U.S. GAAP.

Changes in Internal Control over Financial Reporting.

During the period to which this report relates, there have not been any changes in the Company's internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that have materially affected, or that are reasonably likely to materially affect, such controls.

PART II—OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time, in the ordinary course of business, we are involved in various judicial, regulatory or administrative claims, proceedings and investigations. These proceedings and actions may include, among other things, allegations of violation of banking and other applicable regulations, competition law, labor laws and consumer protection laws, as well as claims or litigation relating to intellectual property, securities, breach of contract and tort. We intend to defend ourselves vigorously against any pending or future judicial, regulatory or administrative claims or proceedings. Although occasional adverse decisions or settlements may occur, our management does not believe that the final disposition of any currently pending or threatened matter will have a material adverse effect on our business, financial position, results of operations or cash flows.

On July 9, 2020, a class action complaint was filed in the United States District Court for the Central District of California, naming us, certain of our directors, officers and shareholders and others alleging violations of securities laws, including making false and misleading statements and omissions in our offering materials for our January 2020 initial public offering of our common stock. The complaints seek unspecified damages and an award of costs and expenses, including attorneys’ fees. We intend to vigorously defend against this action.

Item 1A. Risk Factors.

Intentionally omitted pursuant to smaller reporting company reduced disclosure requirements.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

As previously disclosed, on April 7, 2020, we issued and sold 45,000 shares of our newly designated Series A Convertible Preferred Stock and warrants to purchase 3,013,125 shares of our common stock in a private placement resulting in gross proceeds to us of $45.0 million.

Item 3. Defaults Upon Senior Securities.

Not applicable.

Item 4. Mine Safety Disclosures.

Not applicable.

Item 5. Other Information.

None.

Item 6. Exhibits.

The exhibits listed in the accompanying index to exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.


		Incorporated by Reference
Exhibit Number	Exhibit Title	Form	File No.	Exhibit	Filing Date

3.1	Certificate of Conversion	8-K	001-39183	3.1	1/22/2020

3.2	Certificate of Incorporation of Velocity Financial, Inc.	8-K	001-39183	3.2	1/22/2020

3.3	Bylaws of Velocity Financial, Inc.	8-K	001-39183	3.3	1/22/2020

3.4	Certificate of Designation of Series A Convertible Preferred Stock of Velocity Financial, Inc.	8-K	001-39183	3.1	4/7/2020

4.1	Form of Warrant to Purchase Common Stock	8-K	001-39183	4.1	4/7/2020

10.1	Stockholders Agreement, dated as of January 16, 2020	10-K	001-39183	10.1	4/7/2020

10.2	Registration Rights Agreement, dated as of January 16, 2020	10-K	001-39183	10.2	4/7/2020

10.3	Velocity Financial, Inc. 2020 Omnibus Incentive Plan*	8-K	001-39183	10.1	1/22/2020

10.4	Form of Nonqualified Stock Option Award Notice and Agreement under the 2020 Omnibus Incentive Plan*	S-1/A	333-234250	10.6	1/6/2020

10.5	Form of Nonqualified Stock Option Award Notice and Agreement (Director Grant-IPO) under the 2020 Omnibus Incentive Plan*	S-1/A	333-234250	10.7	1/6/2020

10.6	Form of Nonqualified Stock Option Award Notice and Agreement (Executive Officer Grant-IPO) under the 2020 Omnibus Incentive Plan*	S-1/A	333-234250	10.8	1/6/2020

10.7	Form of Restricted Stock Unit Grant and Agreement (Director Grant) under the 2020 Omnibus Incentive Plan*	S-1/A	333-234250	10.9	1/6/2020

10.8	Form of Restricted Stock Unit Grant and Agreement (Standard Grant) under the 2020 Omnibus Incentive Plan*	S-1/A	333-234250	10.10	1/6/2020

10.9	Form of Restricted Stock Grant and Agreement under the 2020 Omnibus Incentive Plan*	S-1/A	333-234250	10.11	1/6/2020

10.10	Amendment No. 2 to the Credit Agreement among Velocity Financial, LLC, Velocity Commercial Capital, LLC and Owl Rock Capital Corporation, dated as of February 5, 2020	10-K	001-39183	10.39(b)	4/7/2020

10.11	Form of Officer and Director Indemnity Agreement*	S-1/A	333-234250	10.37	11/6/2019

10.12	Securities Purchase Agreement, dated as of April 5, 2020	8-K	001-39183	10.1	4/6/2020

10.13	Registration Rights Agreement, dated as of April 7, 2020	8-K	001-39183	10.1	4/7/2020

10.14	Voting and Support Agreement, dated April 5, 2020, between Velocity Financial, Inc. and Snow Phipps Group AIV, L.P. and Snow Phipps Group (RPV), L.P.	8-K	001-39183	10.2	4/7/2020


10.15	Voting and Support Agreement, dated April 5, 2020, between Velocity Financial, Inc. and TOBI III SPE I LLC	8-K	001-39183	10.3	4/7/2020

31.1	Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2	Certification of Principal Financial and Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1	Certification of Principal Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002+

32.2	Certification of Principal Financial and Accounting Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002+

101.INS	XBRL Instance Document

101.SCH	XBRL Taxonomy Extension Schema Document

101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document

101.DEF	XBRL Taxonomy Extension Definition Linkbase Document

101.LAB	XBRL Taxonomy Extension Label Linkbase Document

101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document

*	Management contract or compensatory plan or arrangement.

+	This certification is deemed not filed for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, nor shall it be deemed incorporated by reference into any filing under the Securities Act or the Exchange Act

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	VELOCITY FINANCIAL, INC.

Date: August 13, 2020	By:	/s/ Christopher D. Farrar
		Christopher D. Farrar
		Chief Executive Officer

Date: August 13, 2020	By:	/s/ Mark R. Szczepaniak
		Mark R. Szczepaniak
		Chief Financial Officer