PART I.  FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

READY CAPITAL CORPORATION

unaudited CONSOLIDATED BALANCE SHEETS

(In Thousands)		March 31, 2020			December 31, 2019
Assets
Cash and cash equivalents		$	122,265		$	67,928
Restricted cash			93,164			51,728
Loans, net (including $19,813 and $20,212 held at fair value)			1,969,052			1,727,984
Loans, held for sale, at fair value			306,328			188,077
Mortgage backed securities, at fair value			78,540			92,466
Loans eligible for repurchase from Ginnie Mae			77,605			77,953
Investment in unconsolidated joint ventures			53,379			58,850
Purchased future receivables, net			49,150			43,265
Derivative instruments			17,756			2,814
Servicing rights (including $78,631 and $91,174 held at fair value)			110,111			121,969
Real estate, held for sale			48,292			58,573
Other assets			114,891			106,925
Assets of consolidated VIEs			2,229,517			2,378,486
Total Assets		$	5,270,050		$	4,977,018
Liabilities
Secured borrowings			1,698,937			1,189,392
Securitized debt obligations of consolidated VIEs, net			1,692,074			1,815,154
Convertible notes, net			111,310			111,040
Senior secured notes, net			179,387			179,289
Corporate debt, net			150,074			149,986
Guaranteed loan financing			457,032			485,461
Liabilities for loans eligible for repurchase from Ginnie Mae			77,605			77,953
Derivative instruments			16,585			5,250
Dividends payable			21,747			21,302
Accounts payable and other accrued liabilities			89,740			97,407
Total Liabilities		$	4,494,491		$	4,132,234
Stockholders’ Equity
Common stock, $0.0001 par value, 500,000,000 shares authorized, 52,091,850 and 51,127,326 shares issued and outstanding, respectively			5			5
Additional paid-in capital			837,064			822,837
Retained earnings			(69,605)			8,746
Accumulated other comprehensive loss			(9,536)			(6,176)
Total Ready Capital Corporation equity			757,928			825,412
Non-controlling interests			17,631			19,372
Total Stockholders’ Equity		$	775,559		$	844,784
Total Liabilities and Stockholders’ Equity		$	5,270,050		$	4,977,018

 

See Notes To Unaudited Consolidated Financial Statements

READY CAPITAL CORPORATION

Unaudited CONSOLIDATED STATEMENTS OF INCOME

 

		Three Months Ended March 31,
(In Thousands, except share data)		2020			2019
Interest income		$	69,551		$	48,753
Interest expense			(46,930)			(35,775)
Net interest income before provision for loan losses		$	22,621		$	12,978
Provision for loan losses			(39,804)			(518)
Net interest income after provision for loan losses		$	(17,183)		$	12,460
Non-interest income
Residential mortgage banking activities			36,669			14,587
Net realized gain on financial instruments and real estate owned			7,172			7,282
Net unrealized gain (loss) on financial instruments			(33,434)			(6,912)
Servicing income, net of amortization and impairment of $1,725 and $1,763			8,097			6,752
Income on purchased future receivables, net of allowance for doubtful accounts of $6,917			3,483			—
Income (loss) on unconsolidated joint ventures			(3,537)			2,929
Other income			4,073			900
Gain on bargain purchase			—			30,728
Total non-interest income		$	22,523		$	56,266
Non-interest expense
Employee compensation and benefits			(18,936)			(11,448)
Allocated employee compensation and benefits from related party			(1,250)			(853)
Variable expenses on residential mortgage banking activities			(20,129)			(9,176)
Professional fees			(2,556)			(1,829)
Management fees – related party			(2,561)			(1,997)
Loan servicing expense			(5,570)			(3,648)
Merger related expenses			(47)			(5,467)
Other operating expenses			(13,744)			(6,861)
Total non-interest expense		$	(64,793)		$	(41,279)
Income (loss) before provision for income taxes		$	(59,453)		$	27,447
Income tax benefit			7,937			3,003
Net income (loss)		$	(51,516)		$	30,450
Less: Net income (loss) attributable to non-controlling interest			(1,064)			983
Net income (loss) attributable to Ready Capital Corporation		$	(50,452)		$	29,467
Earnings (loss) per common share - basic		$	(0.98)		$	0.90
Earnings (loss) per common share - diluted		$	(0.98)		$	0.90
Weighted-average shares outstanding
Basic			51,984,040			32,556,875
Diluted			51,990,013			32,563,644
Dividends declared per share of common stock		$	0.40		$	0.40

 

See Notes To Unaudited Consolidated Financial Statements

 

READY CAPITAL CORPORATION

UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

	Three Months Ended March 31,
(In Thousands)		2020			2019
Net Income (loss)	$	(51,516)		$	30,450
Other comprehensive income (loss) - net change by component
Net change in hedging derivatives (cash flow hedges)	$	(3,128)		$	(420)
Foreign currency translation adjustment		(304)			—
Other comprehensive loss	$	(3,432)		$	(420)
Comprehensive income (loss)	$	(54,948)		$	30,030
Comprehensive income (loss) attributable to non-controlling interests		(1,136)			969
Comprehensive income (loss) attributable to Ready Capital Corporation	$	(53,812)		$	29,061

See Notes To Unaudited Consolidated Financial Statements

 

READY CAPITAL CORPORATION

Unaudited CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

 

 

		Three Months Ended March 31, 2019
										Retained				Accumulated Other		Total
		Common Stock					Additional Paid-			Earnings				Comprehensive		Ready Capital			Non-controlling			Total Stockholders'
(in thousands, except share data)		Shares		Par Value			In Capital			(Deficit)				Loss		Corporation Equity			Interests			Equity
Balance at January 1, 2019		32,105,112		$	3		$	540,478		$	5,272		$	(922)		$	544,831		$	19,244		$	564,075
Dividend declared on common stock ($0.40 per share)		—			—			—			(12,949)			—			(12,949)			—			(12,949)
Dividend declared on OP units		—			—			—			—			—			—			(447)			(447)
Shares issued pursuant to merger transactions		12,223,552			1			179,320			—			—			179,321			—			179,321
Equity component of 2017 convertible note issuance		—			—			(84)			—			—			(84)			—			(84)
Distributions, net		—			—			—			—			—			—			(20)			(20)
Stock-based compensation		52,110			—			733			—			—			733			—			733
Manager incentive fee paid in stock		14,939			—			233			—			—			233			(3)			230
Net income		—			—			—			29,467			—			29,467			983			30,450
Other comprehensive loss		—			—			—			—			(406)			(406)			(14)			(420)
Balance at March 31, 2019		44,395,713		$	4		$	720,680		$	21,790		$	(1,328)		$	741,146		$	19,743		$	760,889

 

		Three Months Ended March 31, 2020
										Retained				Accumulated Other		Total
		Common Stock					Additional Paid-			Earnings				Comprehensive		Ready Capital			Non-controlling			Total Stockholders'
(in thousands, except share data)		Shares		Par Value			In Capital			(Deficit)				Loss		Corporation Equity			Interests			Equity
Balance at January 1, 2020		51,127,326		$	5		$	822,837		$	8,746		$	(6,176)		$	825,412		$	19,372		$	844,784
Cumulative-effect adjustment upon adoption of ASU 2016-13, net of taxes (note 4)		—			—			—			(6,599)			—			(6,599)			(155)			(6,754)
Dividend declared on common stock ($0.40 per share)		—			—			—			(21,300)			—			(21,300)			—			(21,300)
Dividend declared on OP units		—			—			—			—			—			—			(447)			(447)
Equity issuances		900,000			—			13,410			—			—			13,410			—			13,410
Offering costs		—			—			(38)			—			—			(38)			(1)			(39)
Equity component of 2017 convertible note issuance		—			—			(92)			—			—			(92)			(2)			(94)
Stock-based compensation		60,370			—			894			—			—			894			—			894
Manager incentive fee paid in stock		4,154			—			53			—			—			53			—			53
Net loss		—			—			—			(50,452)			—			(50,452)			(1,064)			(51,516)
Other comprehensive loss		—			—			—			—			(3,360)			(3,360)			(72)			(3,432)
Balance at March 31, 2020		52,091,850		$	5		$	837,064		$	(69,605)		$	(9,536)		$	757,928		$	17,631		$	775,559

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

See Notes To Unaudited Consolidated Financial Statements

READY CAPITAL CORPORATION

Unaudited CONSOLIDATED STATEMENT OF CASH FLOWS

 

		Three Months Ended March 31,
(In Thousands, except share information)		2020			2019
Cash Flows From Operating Activities:
Net income (loss)		$	(51,516)		$	30,450
Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities:
Amortization of premiums, discounts, and debt issuance costs, net			9,366			7,975
Provision for loan losses			39,804			518
Impairment loss on real estate, held for sale			2,969			305
Change in repair and denial reserve			(136)			89
Net settlement of derivative instruments			(8,818)			(795)
Origination of loans, held for sale, at fair value			(881,549)			(445,455)
Proceeds from disposition and principal payments of loans, held for sale, at fair value			793,428			458,503
Realized gains, net			(40,538)			(20,126)
Unrealized losses, net			33,488			6,912
Gain on bargain purchase			—			(30,728)
Equity in net loss (income) of unconsolidated joint ventures, net of distributions			3,537			(2,707)
Purchased future receivables, net of payoffs			(12,802)			—
Allowance for doubtful accounts on purchased future receivables			6,917			—
Net changes in operating assets and liabilities
Assets of consolidated VIEs (excluding loans, net), accrued interest and due from servicers			17,764			2,406
Receivable from third parties			674			8,170
Other assets			(8,646)			(7,814)
Accounts payable and other accrued liabilities			(3,954)			(6,647)
Net cash (used in) provided by operating activities			(100,012)			1,056
Cash Flow From Investing Activities:
Origination of loans			(328,509)			(245,367)
Purchase of loans			(52,067)			(128,991)
Purchase of mortgage backed securities, at fair value			(1,576)			—
Funding of unconsolidated joint ventures			(1,644)			—
Proceeds on unconsolidated joint venture in excess of earnings recognized			3,578			5,739
Proceeds from disposition and principal payment of loans			222,868			183,800
Proceeds from sale and principal payment of mortgage backed securities, at fair value			5,031			3,277
Proceeds from sale of real estate			7,851			285
Cash acquired in connection with the ORM Merger			—			10,822
Net cash (used in) investing activities			(144,468)			(170,435)
Cash Flows From Financing Activities:
Proceeds from secured borrowings			1,866,732			951,342
Payment of secured borrowings			(1,356,573)			(950,377)
Proceeds from issuance of securitized debt obligations of consolidated VIEs			—			355,846
Payment of securitized debt obligations of consolidated VIEs			(125,468)			(118,893)
Payment of guaranteed loan financing			(34,672)			(20,526)
Payment of deferred financing costs			(1,602)			(7,538)
Equity issuance, net of offering costs			13,372			—
Payment of contingent consideration			—			(1,207)
Distributions from non-controlling interests, net			—			(20)
Dividend payments			(21,302)			(13,346)
Net cash (used in) provided by financing activities			340,487			195,281
Net increase (decrease) in cash, cash equivalents, and restricted cash			96,007			25,902
Cash, cash equivalents, and restricted cash at beginning of period			127,980			94,970
Cash, cash equivalents, and restricted cash at end of period		$	223,987		$	120,872
Supplemental disclosure of operating cash flow
Cash paid for interest		$	44,576		$	34,471
Cash (received) paid for income taxes		$	—		$	(3,125)
Stock-based compensation		$	894		$	733
Supplemental disclosure of non-cash investing activities
Loans transferred from Loans, held for sale, at fair value to Loans, net		$	509		$	—
Deconsolidation of assets in securitization trusts		$	—		$	177,815
Supplemental disclosure of non-cash financing activities
Common stock issued in connection with merger transactions		$	—		$	179,321
Deconsolidation of borrowings in securitization trusts		$	—		$	177,815
Share-based component of incentive fees		$	53		$	233
Cash and restricted cash reconciliation
Cash and cash equivalents		$	122,265		$	47,597
Restricted cash			93,164			29,979
Cash, cash equivalents, and restricted cash in Assets of consolidated VIEs			8,558			43,296
Cash, cash equivalents, and restricted cash at end of period		$	223,987		$	120,872

 

See Notes to Unaudited Consolidated Financial Statements

 

 

READY CAPITAL CORPORATION

NOTES TO the CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

Note 1 – Organization

 

Ready Capital Corporation (the “Company” or “Ready Capital” and together with its subsidiaries “we”, “us” and “our”) is a Maryland corporation. The Company is a multi-strategy real estate finance company that originates, acquires, finances and services small to medium balance commercial (“SBC”) loans, Small Business Administration (“SBA”) loans, residential mortgage loans, and to a lesser extent, mortgage backed securities (“MBS”) collateralized primarily by SBC loans, or other real estate-related investments.

 

The Company is externally managed and advised by Waterfall Asset Management, LLC (“Waterfall” or the “Manager”), an investment advisor registered with the United States Securities and Exchange Commission under the Investment Advisors Act of 1940, as amended.

 

Sutherland Partners, LP (the “Operating Partnership”) holds substantially all of our assets and conducts substantially all of our business. As of March 31, 2020 and December 31, 2019, the Company owned approximately 97.9% of the operating partnership units (“OP units”) of the Operating Partnership. The Company, as sole general partner of the Operating Partnership, has responsibility and discretion in the management and control of the Operating Partnership, and the limited partners of the Operating Partnership, in such capacity, have no authority to transact business for, or participate in the management activities of the Operating Partnership. Therefore, the Company consolidates the Operating Partnership.

 

SBC loans represent a special category of commercial loans, sharing both commercial and residential loan characteristics. SBC loans are generally secured by first mortgages on commercial properties, but because SBC loans are also often accompanied by collateralization of personal assets and subordinate lien positions, aspects of residential mortgage credit analysis are utilized in the underwriting process.

 

The Company reports its results of operations through the following four business segments: i) Acquisitions, ii) SBC Originations, iii) SBA Originations, Acquisitions and Servicing, and iv) Residential Mortgage Banking, with the remaining amounts recorded in Corporate- Other. Our acquisition and origination platforms consist of the following four operating segments:

 

·

Acquisitions.  We acquire performing and non-performing SBC loans as part of our business strategy. We hold performing SBC loans to term, and we seek to maximize the value of the non-performing SBC loans acquired by us through borrower based resolution strategies.  We typically acquire non-performing loans at a discount to their unpaid principal balance (“UPB”) when we believe that resolution of the loans will provide attractive risk-adjusted returns. We also acquire purchased future receivables through our Knight Capital, LLC (“Knight Capital”) funding platform.

 

·

SBC Originations. We originate SBC loans secured by stabilized or transitional investor properties using multiple loan origination channels through our wholly-owned subsidiary, ReadyCap Commercial, LLC (“ReadyCap Commercial”). These originated loans are generally held-for-investment or placed into securitization structures. Additionally, as part of this segment, we originate and service multi-family loan products under the Federal Home Loan Mortgage Corporation’s Small Balance Loan Program (“Freddie Mac” and the “Freddie Mac program”). These originated loans are held for sale, then sold to Freddie Mac.

 

·

SBA Originations, Acquisitions, and Servicing. We acquire, originate and service owner-occupied loans guaranteed by the SBA under its Section 7(a) loan program (the “SBA Section 7(a) Program”) through our wholly-owned subsidiary, ReadyCap Lending, LLC (“ReadyCap Lending”). We hold an SBA license as one of only 14 non-bank Small Business Lending Companies (“SBLCs”) and have been granted preferred lender status by the SBA. These originated loans are either held-for-investment, placed into securitization structures, or sold.

 

·

Residential Mortgage Banking.  We operate our residential mortgage loan origination segment through our wholly-owned subsidiary, GMFS, LLC ("GMFS").  GMFS originates residential mortgage loans eligible to be purchased, guaranteed or insured by the Federal National Mortgage Association (“Fannie Mae”), Freddie Mac, Federal Housing Administration (“FHA”), U.S. Department of Agriculture (“USDA”) and U.S. Department of

 

On March 29, 2019, the Company completed the acquisition of Owens Realty Mortgage, Inc. (“ORM”), through a merger of ORM with and into a wholly-owned subsidiary of the Company, in exchange for approximately 12.2 million shares of the Company’s common stock (“ORM Merger”). In accordance with the Merger Agreement, the number of shares of the Company’s common stock issued was based on an exchange ratio of 1.441 per share. The total purchase price for the merger of $179.3 million consists exclusively of the Company’s common stock issued in exchange for shares of ORM common stock and cash paid in lieu of fractional shares of the Company’s common stock, and was based on the $14.67 closing price of the Company’s common stock on March 29, 2019. Upon the closing of the transaction, the Company’s historical stockholders owned approximately 72% of the combined Company’s stock, while historical ORM stockholders owned approximately 28% of the combined Company’s stock.

The acquisition of ORM increased the Company’s equity capitalization, supported continued growth of the Company’s platform and execution of the Company’s strategy, and provided the Company with improved scale, liquidity and capital alternatives, including additional borrowing capacity.  Also, the stockholder base resulting from the acquisition of ORM enhanced the trading volume and liquidity for our stockholders. The combination of the Company and ORM created cost savings and efficiencies resulting from the allocation of operating expenses over a larger portfolio and has allowed the Company to harvest value from ORM's real property assets.

 

On October 25, 2019, the Company acquired Knight Capital. Knight Capital is a technology-driven platform that provides working capital to small and medium businesses across the U.S. Through its platform, Knight Capital supports business operations by offering a faster alternative to conventional bank funding. The total purchase price for the merger of $27.8 million consists of $17.5 million of cash and $10.3 million of Ready Capital common stock.

 

The Company qualifies as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”), commencing with its first taxable year ended December 31, 2011. To maintain its tax status as a REIT, the Company distributes at least 90% of its taxable income in the form of distributions to shareholders.

 

 

Note 2 – Basis of Presentation

 

The unaudited interim consolidated financial statements presented herein are as of March 31, 2020 and December 31, 2019 and for the three months ended March 31, 2020 and 2019.  These unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”)—as prescribed by the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) and the rules and regulations of the U.S. Securities and Exchange Commission.

 

The accompanying interim consolidated financial statements, including the notes thereto, are unaudited and exclude some of the disclosures required in audited financial statements.  Accordingly, certain information and footnote disclosures normally included in the consolidated financial statements have been condensed or omitted.   In the opinion of management, the accompanying unaudited interim consolidated financial statements contain all normal recurring adjustments necessary for a fair statement of the results for the interim periods presented.  Such operating results may not be indicative of the expected results for any other interim period or the entire year.  The accompanying unaudited consolidated interim financial statements should be read in conjunction with the audited consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019 filed with the Securities and Exchange Commission, or the SEC.

 

 

Note 3 – Summary of Significant Accounting Policies

 

Risks and uncertainties

 

      The recent outbreak of the coronavirus pandemic (“COVID-19”) around the globe continues to adversely impact global commercial activity and has contributed to significant volatility in financial markets. The impact of the outbreak has been rapidly evolving around the globe, with several countries taking drastic measures to limit the spread of the virus by instituting quarantines or lockdowns and imposing travel restrictions. Such actions are creating significant disruptions

to global supply chains, and adversely impacting several industries, including but not limited to, airlines, hospitality, retail and the broader real estate industry.

 

      The major disruption caused by COVID-19 halted most economic activity in most of the United States resulting in a significant increase in unemployment claims and will likely result in a significant decline in the U.S. Gross Domestic Product (“GDP”). COVID-19 could have a continued and prolonged adverse impact on economic and market conditions and trigger a period of global economic slowdown which could have a material adverse effect on the Company’s results and financial condition.

 

     The full impact of COVID-19 on the real estate industry, the credit markets and consequently on the Company’s financial condition and results of operations is uncertain and cannot be predicted at the current time as it depends on several factors beyond the control of the Company including, but not limited to (i) the uncertainty around the severity and duration of the outbreak, (ii) the effectiveness of the United States public health response, (iii) the pandemic’s impact on U.S. and global economies, (iv) the timing, scope and effectiveness of additional governmental responses to the pandemic, (v) the timing and speed of economic recovery, (vi) the availability of a treatment or vaccination for COVID-19, and (vii) the negative impact on our borrowers, real estate values and cost of capital.

 

Use of estimates

 

The preparation of the Company’s unaudited interim consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the unaudited interim consolidated financial statements and the reported amounts of income and expenses during the reporting period. Management makes subjective estimates to project cash flows the Company expects to receive on its loans and securities as well as the related market discount rates, which significantly impacts the interest income, impairments, allowance for loan loss, and fair values recorded or disclosed. The effects of COVID-19 may negatively and materially impact significant estimates and assumptions used by the Company including, but not limited to estimates of expected credit losses, valuation of our equity method investments and the fair value estimates of the Company’s assets and liabilities. The uncertainty over the ultimate impact COVID-19 will have on the U.S. economony and global economy generally, and on our business in particular, makes any estimates and assumptions as of March 31, 2020 inherently less certain than they would be absent the current and potential impacts of COVID-19. Actual results could materially differ from those estimates.

 

Basis of consolidation

 

The accompanying unaudited interim consolidated financial statements of the Company include the accounts and results of operations of the Operating Partnership and other consolidated subsidiaries and VIEs in which we are the primary beneficiary. The unaudited interim consolidated financial statements are prepared in accordance with ASC 810, Consolidations. Intercompany accounts and transactions have been eliminated.

 

Reclassifications

 

Certain amounts reported for the prior periods in the accompanying unaudited interim consolidated financial statements have been reclassified in order to conform to the current period’s presentation.

 

Cash and cash equivalents

 

The Company accounts for cash and cash equivalents in accordance with ASC 305, Cash and Cash Equivalents. The Company defines cash and cash equivalents as cash, demand deposits, and short-term, highly liquid investments with original maturities of 90 days or less when purchased. Cash and cash equivalents are exposed to concentrations of credit risk. We deposit our cash with institutions that we believe to have highly valuable and defensible business franchises, strong financial fundamentals, and predictable and stable operating environments.

 

Restricted cash

 

Restricted cash represents cash held by the Company as collateral against its derivatives, borrowings under repurchase agreements, borrowings under credit facilities with counterparties, construction and mortgage escrows, as well as cash held for remittance on loans serviced for third parties. Restricted cash is not available for general corporate purposes, but

may be applied against amounts due to counterparties under existing swaps and repurchase agreement borrowings, or returned to the Company when the restriction requirements no longer exist or at the maturity of the swap or repurchase agreement.

 

Loans, net

 

Loans, net consists of loans, held-for-investment, net of allowance for loan losses and loans, held at fair value.

 

Loans, held-for-investment

 

Loans, held-for-investment are loans acquired from third parties (“acquired loans”), loans originated by the Company that we do not intend to sell, or securitized loans that were previously originated by us. Securitized loans remain on the Company’s balance sheet because the securitization vehicles are consolidated under ASC 810.  Acquired loans are recorded at cost at the time they are acquired. 

 

The Company uses the interest method to recognize, as a constant effective yield adjustment, the difference between the initial recorded investment in the loan and the principal amount of the loan. The calculation of the constant effective yield necessary to apply the interest method uses the payment terms required by the loan contract, and prepayments of principal are not anticipated to shorten the loan term.

 

Recognition of interest income is suspended when any loans are placed on non-accrual status. Generally, all classes of loans are placed on non-accrual status when principal or interest has been delinquent for 90 days or when full collection is determined to be not probable. Interest income accrued, but not collected, at the date loans are placed on non-accrual status is reversed and subsequently recognized only to the extent it is received in cash or until the loan qualifies for return to accrual status. However, where there is doubt regarding the ultimate collectability of loan principal, all cash received is applied to reduce the carrying value of such loans. Loans are restored to accrual status only when contractually current and the collection of future payments is reasonably assured.

 

Loans, held at fair value

 

Loans, held at fair value represent certain loans originated by the Company for which we have elected the fair value option. Interest is recognized as interest income in the unaudited interim consolidated statements of income when earned and deemed collectible. Changes in fair value are recurring and are reported as net unrealized gain (loss) on the unaudited interim consolidated statements of income.

 

Allowance for loan losses

 

 The allowance for loan losses is intended to provide for credit losses inherent in the loans, held-for-investment portfolio and is reviewed quarterly for adequacy considering credit quality indicators, including probable and historical losses, collateral values, loan-to-value (“LTV”) ratio and economic conditions.  The allowance for loan losses is increased through provisions for loan losses charged to earnings and reduced by charge-offs, net of recoveries.

   

     On January 1, 2020, the Company adopted ASU No. 2016-13, Financial Instruments-Credit Losses, and subsequent amendments (“ASU 2016-13”), which replaces the incurred loss methodology with an expected loss model known as the Current Expected Credit Loss ("CECL") model. CECL amends the previous credit loss model to reflect a reporting entity's current estimate of all expected credit losses, not only based on historical experience and current conditions, but also by including reasonable and supportable forecasts incorporating forward-looking information. The measurement of expected credit losses under CECL is applicable to financial assets measured at amortized cost. The allowance for loan losses required under ASU 2016-13 is deducted from the respective loans’ amortized cost basis on our unaudited consolidated balance sheets. The guidance also requires a cumulative-effect adjustment to retained earnings as of the beginning of the reporting period of adoption.

 

    In connection with the Company’s adoption of ASU 2016-13 on January 1, 2020, the Company implemented new processes including the utilization of loan loss forecasting models, updates to the Company’s reserve policy documentation, changes to internal reporting processes and related internal controls. The Company has implemented loan loss forecasting models for estimating expected life-time credit losses, at the individual loan level, for its loan portfolio. The CECL forecasting methods used by the Company include (i) a probability of default and loss given default method

using underlying third-party CMBS/CRE loan database with historical loan losses from 1998 to 2019 and (ii) probability weighted expected cash flow method, depending on the type of loan and the availability of relevant historical market loan loss data. The Company might use other acceptable alternative approaches in the future depending on, among other factors, the type of loan, underlying collateral, and availability of relevant historical market loan loss data.

 

   The Company estimates the CECL expected credit losses for its loan portfolio at the individual loan level. Significant inputs to the Company’s forecasting methods include (i) key loan-specific inputs such as LTV, vintage year, loan-term, underlying property type, occupancy, geographic location, and others, and (ii) a macro-economic forecast, including unemployment rates, interest rates, commercial real estate prices, and others.  These estimates may change in future periods based on available future macro-economic data and might result in a material change in the Company’s future estimates of expected credit losses for its loan portfolio.

 

   In certain instances, the Company considers relevant loan-specific qualitative factors to certain loans to estimate its CECL expected credit losses. The Company considers loan investments that are both (i) expected to be substantially repaid through the operation or sale of the underlying collateral, and (ii) for which the borrower is experiencing financial difficulty, to be “collateral-dependent” loans. For such loans that the Company determines that foreclosure of the collateral is probable, the Company measures the expected losses based on the difference between the fair value of the collateral and the amortized cost basis of the loan as of the measurement date. For collateral-dependent loans that the Company determines foreclosure is not probable, the Company applies a practical expedient to estimate expected losses using the difference between the collateral’s fair value (less costs to sell the asset if repayment is expected through the sale of the collateral) and the amortized cost basis of the loan.

 

While we have a formal methodology to determine the adequate and appropriate level of the allowance for loan losses, estimates of inherent loan losses involve judgment and assumptions as to various factors, including current economic conditions. Our determination of adequacy of the allowance for loan losses is based on quarterly evaluations of the above factors. Accordingly, the provision for loan losses will vary from period to period based on management's ongoing assessment of the adequacy of the allowance for loan losses.

 

Non-accrual loans

 

Non-accrual loans are the loans for which we are not accruing interest income. Non-accrual loans include PCD (“purchased credit-deteriorated”) loans when principal or interest has been delinquent for 90 days or more.

 

Troubled debt restructurings

 

In situations where, for economic or legal reasons related to the borrower’s financial difficulties, we grant concessions for a period of time to the borrower that we would not otherwise consider, the related loans are classified as troubled debt restructurings (“TDR”). These modified terms may include interest rate reductions, principal forgiveness, term extensions, payment forbearance and other actions intended to minimize our economic loss and to avoid foreclosure or repossession of collateral. For modifications where we forgive principal, the entire amount of such principal forgiveness is immediately charged off. Other than resolutions such as foreclosures and sales, we may remove loans held-for-investment from TDR classification, but only if they have been refinanced or restructured at market terms and qualify as a new loan.

 

Generally, all loans modified in a TDR are placed or remain on non-accrual status at the time of the restructuring. However, certain accruing loans modified in a TDR that are current at the time of restructuring may remain on accrual status if payment in full under the restructured terms is expected.

 

Additionally, based on recently issued regulatory guidance provided by federal and state regulatory agencies, loan modifications made in response to the COVID-19 pandemic are not considered TDRs if loans were considered current at the date the modification program was implemented.

 

 Loans, held for sale, at fair value

 

Loans, held for sale, at fair value are loans that are expected to be sold to third parties in the near term. Interest is recognized as interest income in the unaudited interim consolidated statements of income when earned and deemed collectible. For loans originated by our SBC originations and SBA originations segments, changes in fair value are

recurring and are reported as net unrealized gain (loss) in the unaudited interim consolidated statements of income. For originated SBA loans, the guaranteed portion is held for sale, at fair value. For loans originated by GMFS, changes in fair value are reported as residential mortgage banking activities in the unaudited interim consolidated statements of income.

 

Mortgage backed securities, at fair value

 

The Company accounts for MBS as trading securities and carries them at fair value under ASC 320, Investments-Debt and Equity Securities. Our MBS portfolio is comprised of asset-backed securities collateralized by interest in or obligations backed by pools of SBC loans.

 

Purchases and sales of MBS are recorded as of the trade date. Our MBS securities pledged as collateral against borrowings under repurchase agreements are included in mortgage backed securities, at fair value on our unaudited interim consolidated balance sheets.

 

MBS are recorded at fair value as determined by market prices provided by independent broker dealers or other independent valuation service providers. The fair values assigned to these investments are based upon available information and may not reflect amounts that may be realized. We generally intend to hold our investment in MBS to generate interest income; however, we have and may continue to sell certain of our investment securities as part of the overall management of our assets and liabilities and operating our business.

 

Loans eligible for repurchase from Ginnie Mae 

 

When the Company has the unilateral right to repurchase Ginnie Mae pool loans it has previously sold (generally loans that are more than 90 days past due), the Company then records the right to repurchase the loan as an asset and liability in its unaudited interim consolidated balance sheets. Such amounts reflect the unpaid principal balance of the loans.

 

Derivative instruments, at fair value

 

Subject to maintaining our qualification as a REIT for U.S. federal income tax purposes, we utilize derivative financial instruments, currently comprised of credit default swaps (“CDSs”), interest rate swaps, and interest rate lock commitments (“IRLCs”) as part of our risk management. The Company accounts for derivative instruments under ASC 815, Derivatives and Hedges.

 

All derivatives are reported as either assets or liabilities in the unaudited interim consolidated balance sheets at the estimated fair value with the changes in the fair value recorded in earnings, unless hedge accounting is elected.

 

As of March 31, 2020, the Company has offset $8.4 million of cash collateral receivable against our gross derivative liability positions. As of March 31, 2020 and December 31, 2019, the cash collateral receivable for derivatives that has not been offset againt our derivative liability positions is $11.7 million and $9.5 million, respectively, and is included in restricted cash in the unaudited interim consolidated balance sheets.

 

Interest rate swap agreements

 

An interest rate swap is an agreement between two counterparties to exchange periodic interest payments where one party to the contract makes a fixed-rate payment in exchange for a floating-rate payment from the other party. The dollar amount each party pays is an agreed-upon periodic interest rate multiplied by some pre-determined dollar principal (notional amount). No principal (notional amount) is exchanged between the two parties at trade initiation date. Only interest payments are exchanged. Interest rate swaps are classified as Level 2 in the fair value hierarchy. The fair value adjustments are reported within net unrealized gain (loss) on financial instruments, while the related interest income or interest expense, are reported within net realized gain (loss) on financial instruments in the unaudited interim consolidated statements of income.

 

IRLCs

 

IRLCs are agreements under which GMFS agrees to extend credit to a borrower under certain specified terms and conditions in which the interest rate and the maximum amount of the loan are set prior to funding. Unrealized gains and

losses on the IRLCs, reflected as derivative assets and derivative liabilities, respectively, are measured based on the value of the underlying mortgage loan, quoted government-sponsored enterprise Fannie Mae, Freddie Mac, and the Government National Mortgage Association ((“Ginnie Mae”), collectively, “GSEs”) or MBS prices, estimates of the fair value of the mortgage servicing rights (“MSRs”) and the probability that the mortgage loan will fund within the terms of the IRLC, net of commission expense and broker fees. The realized and unrealized gains or losses are reported in the unaudited interim consolidated statements of income as residential mortgage banking activities. IRLCs are classified as Level 3 in the fair value hierarchy.

 

FX forwards

 

      FX forwards are agreements between two counterparties to exchange a pair of currencies at a set rate on a future date. FX forward contracts are used to convert the foreign currency risk to U.S. dollars to mitigate exposure to fluctuations in FX rates. The fair value adjustments are reported within net unrealized gain (loss) on financial instruments in the consolidated statements of income. FX forwards are classified as Level 2 in the fair value hierarchy.

 

CDSs

 

CDSs are contracts between two parties, a protection buyer, who makes fixed periodic payments, and a protection seller, who collects the premium in exchange for making the protection buyer whole in the case of default. The fair value adjustments are reported within net unrealized gain (loss) on financial instruments, while the related interest income or interest expense, are reported within net realized gain (loss) on financial instruments in the unaudited interim consolidated statements of income. CDS are classified as Level 2 in the fair value hierarchy.

 

Hedge accounting

 

As a general rule, hedge accounting is permitted where the Company is exposed to a particular risk, such as interest rate risk, that causes changes in the fair value of an asset or liability or variability in the expected future cash flows of an existing asset, liability, or forecasted transaction that may affect earnings.

 

To qualify as an accounting hedge under the hedge accounting rules (versus an economic hedge where hedge accounting is not applied), a hedging relationship must be highly effective in offsetting the risk designated as being hedged. We use cash flow hedges to hedge the exposure to variability in cash flows from forecasted transactions, including the anticipated issuance of securitized debt obligations. ASC 815 requires that a forecasted transaction be identified as either: 1) a single transaction, or 2) a group of individual transactions that share the same risk exposures for which they are designated as being hedged. Hedges of forecasted transactions are considered cash flow hedges since the price is not fixed, hence involve variability of cash flows.

 

For qualifying cash flow hedges, the change in the fair value of the derivative (the hedging instrument) is recorded in other comprehensive income (loss) ("OCI"), and is reclassified out of OCI and into the consolidated statements of income when the hedged cash flows affect earnings. These amounts are recognized consistent with the classification of the hedged item, primarily interest expense (for hedges of interest rate risk). If the hedge relationship is terminated, then the value of the derivative recorded in accumulated other comprehensive income (loss) ("AOCI") is recognized in earnings when the cash flows that were hedged affect earnings, so long as the forecasted transaction remains probable of occurring. For hedge relationships that are discontinued because a forecasted transaction is probable of not occurring according to the original hedge forecast (including an additional two month window), any related derivative values recorded in AOCI are immediately recognized in earnings. Hedge accounting is generally terminated at the debt issuance date because we are no longer exposed to cash flow variability subsequent to issuance. Accumulated amounts recorded in AOCI at that date are then released to earnings in future periods to reflect the difference in 1) the fixed rates economically locked in at the inception of the hedge and 2) the actual fixed rates established in the debt instrument at issuance. Because of the effects of the time value of money, the actual interest expense reported in earnings will not equal the effective yield locked in at hedge inception multiplied by the par value. Similarly, this hedging strategy does not actually fix the interest payments associated with the forecasted debt issuance.

 

Servicing rights

 

Servicing rights initially represent the fair value of expected future cash flows for performing servicing activities for others. The fair value considers estimated future servicing fees and ancillary revenue, offset by estimated costs to service

the loans, and generally declines over time as net servicing cash flows are received, effectively amortizing the servicing right asset against contractual servicing and ancillary fee income.

 

Servicing rights are recognized upon sale of loans, including a securitization of loans accounted for as a sale in accordance with GAAP, if servicing is retained. For servicing rights, gains related to servicing rights retained is included in net realized gain (loss) in the unaudited interim consolidated statements of income. For residential mortgage servicing rights, gains on servicing rights retained upon sale of a loan are included in residential mortgage banking activities in the unaudited interim consolidated statements of income.

 

The Company treats its servicing rights and residential mortgage servicing rights as two separate classes of servicing assets based on the class of the underlying mortgages and it treats these assets as two separate pools for risk management purposes. Servicing rights relating to the Company’s servicing of loans guaranteed by the SBA under its Section 7(a) loan program and servicing rights related to the Freddie Mac program are accounted for under ASC 860, Transfers and Servicing, while the Company’s residential mortgage servicing rights are accounted for under the fair value option under ASC 825, Financial Instruments.

 

Servicing rights – SBA and Freddie Mac

 

SBA and Freddie Mac servicing rights are initially recorded at fair value and subsequently carried at amortized cost. We capitalize the value expected to be realized from performing specified servicing activities for others. Servicing rights are amortized in proportion to and over the period of estimated servicing income, and are evaluated for potential impairment quarterly.

 

For purposes of testing our servicing rights for impairment, we first determine whether facts and circumstances exist that would suggest the carrying value of the servicing asset is not recoverable. If so, we then compare the net present value of servicing cash flow with its carrying value. The estimated net present value of servicing cash flows is determined using discounted cash flow modeling techniques, which require management to make estimates regarding future net servicing cash flows, taking into consideration historical and forecasted loan prepayment rates, delinquency rates and anticipated maturity defaults. If the carrying value of the servicing rights exceeds the net present value of servicing cash flows, the servicing rights are considered impaired and an impairment loss is recognized in earnings for the amount by which carrying value exceeds the net present value of servicing cash flows.

 

We estimate the fair value of servicing rights by determining the present value of future expected servicing cash flows using modeling techniques that incorporate management's best estimates of key variables including estimates regarding future net servicing cash flows, forecasted loan prepayment rates, delinquency rates, and return requirements commensurate with the risks involved. Cash flow assumptions are modeled using our internally forecasted revenue and expenses, and where possible, the reasonableness of assumptions is periodically validated through comparisons to market data. Prepayment speed estimates are determined from historical prepayment rates or obtained from third-party industry data. Return requirement assumptions are determined using data obtained from market participants, where available, or based on current relevant interest rates plus a risk-adjusted spread. We also consider other factors that can impact the value of the servicing rights, such as surety provider termination clauses and servicer terminations that could result if we failed to materially comply with the covenants or conditions of our servicing agreements and did not remedy the failure. Since many factors can affect the estimate of the fair value of servicing rights, we regularly evaluate the major assumptions and modeling techniques used in our estimate and review these assumptions against market comparables, if available. We monitor the actual performance of our servicing rights by regularly comparing actual cash flow, credit, and prepayment experience to modeled estimates.

 

Servicing rights - Residential (carried at fair value)

 

The Company’s residential mortgage servicing rights consist of conforming conventional residential loans sold to Fannie Mae and Freddie Mac or loans securitized in Ginnie Mae securities. Government insured loans serviced by the Company are securitized through Ginnie Mae, whereby the Company is insured against loss by the Federal Housing Administration or partially guaranteed against loss by the Department of Veterans Affairs.

 

The Company has elected to account for its portfolio of residential mortgage servicing rights (“MSRs”) at fair value. For these assets, the Company uses a third-party vendor to assist management in estimating the fair value. The third-party vendor uses a discounted cash flow approach which consists of projecting servicing cash flows discounted at a rate that

management believes market participants would use in their determinations of fair value. The key assumptions used in the estimation of the fair value of MSRs include prepayment rates, discount rates, default rates, and cost of servicing rates. Residential MSRs are classified as Level 3 in the fair value hierarchy.

 

Real estate, held for sale

 

Real estate, held for sale, includes purchased real estate and real estate acquired in full or partial settlement of loan obligations, generally through foreclosure, that is being marketed for sale. Real estate, held for sale is recorded at acquisition at the property’s estimated fair value less estimated costs to sell.

 

After acquisition, costs incurred relating to the development and improvement of property are capitalized to the extent they do not cause the recorded value to exceed the net realizable value, whereas costs relating to holding and disposition of the property are expensed as incurred. After acquisition, real estate held for sale is analyzed periodically for changes in fair values and any subsequent write down is charged through impairment.

 

The Company records a gain or loss from the sale of real estate when control of the property transfers to the buyer, which generally occurs at the time of an executed deed. When the Company finances the sale of real estate to the buyer, the Company assesses whether the buyer is committed to perform their obligations under the contract and whether the collectability of the transaction price is probable. Once these criteria are met, the real estate is derecognized and the gain or loss on sale is recorded upon transfer of control of the property to the buyer. In determining the gain or loss on the sale, the Company adjusts the transaction price and related gain (loss) on sale if a significant financing component is present. This adjustment is based on management’s estimate of the fair value of the loan extended to the buyer to finance the sale.

 

 Investment in unconsolidated joint ventures

 

According to ASC 323, Equity Method and Joint Ventures, investors in unincorporated entities such as partnerships and unincorporated joint ventures generally shall account for their investments using the equity method of accounting if the investor has the ability to exercise significant influence over the investee. Under the equity method, we recognize our allocable share of the earnings or losses of the investment monthly in earnings and adjust the carrying amount for our share of the distributions that exceed our earnings.  

 

Purchased future receivables

 

Through Knight Capital, the Company provides working capital advances to small businesses through the purchase of their future revenues. The Company enters into a contract with the business whereby the Company pays the business an upfront amount in return for a specific amount of the business’s future revenue receivables, known as payback amounts. The payback amounts are primarily received through daily payments initiated by automated clearing house (“ACH”) transactions.

 

Revenues from purchased future receivables are realized when funds are received under each contract. The allocation of the amount received is determined by apportioning the amount received based upon the factor (discount) rate of the business's contract. Management believes that this methodology best reflects the effective interest method.  

 

The Company has established an allowance for doubtful purchased future receivables. An increase in the allowance for doubtful purchased future receivables results in a charge to income and is reduced when purchased future receivables are charged-off. Purchased future receivables are charged-off after 90 days past due. Management believes that the allowance reflects the risk elements and is adequate to absorb losses inherent in the portfolio. Although management has performed this evaluation, future adjustments may be necessary based on changes in economic conditions or other factors.

 

Intangible assets

 

The Company accounts for intangible assets under ASC 350, Intangibles- Goodwill and Other. The Company’s intangible assets include an SBA license, capitalized software, a broker network, trade names, and an acquired favorable lease. The Company capitalizes software costs expected to result in long-term operational benefits, such as replacement systems or new applications that result in significantly increased operational efficiencies or functionality. All other costs incurred in connection with internal use software are expensed as incurred. The Company initially records its intangible assets at cost or fair value and will test for impairment if a triggering event occurs. Intangible assets are included within

other assets in the consolidated balance sheets. The Company amortizes intangible assets with identified estimated useful lives on a straight-line basis over their estimated useful lives.

 

Goodwill

 

The Company recorded goodwill in connection with the Company’s acquisition of Knight Capital. Goodwill is not amortized, but rather, is tested for impairment annually or more frequently if events or changes in circumstances indicate potential impairment. Goodwill represents the excess of the consideration paid over the fair value of net assets acquired in connection with the acquisition of Knight.

 

In testing goodwill for impairment, the Company follows ASC 350, Intangibles- Goodwill and Other, which permits a qualitative assessment of whether it is more likely than not that the fair value of the reporting unit is less than its carrying value including goodwill. If the qualitative assessment determines that it is not more likely than not that the fair value of a reporting unit is less than its carrying value including goodwill, then no impairment is determined to exist for the reporting unit. However, if the qualitative assessment determines that it is more likely than not that the fair value of the reporting unit is less than its carrying value including goodwill, we compare the fair value of that reporting unit with its carrying value, including goodwill. If the carrying value of a reporting unit exceeds its fair value, goodwill is considered impaired with the impairment loss equal to the amount by which the carrying value of the goodwill exceeds the implied fair value of that goodwill.

 

Deferred financing costs

 

Costs incurred in connection with our secured borrowings are accounted for under ASC 340, Other Assets and Deferred Costs. Deferred costs are capitalized and amortized using the effective interest method over the respective financing term with such amortization reflected on our unaudited interim consolidated statements of income as a component of interest expense. Deferred financing costs may include legal, accounting and other related fees. Unamortized deferred financing costs are expensed when the associated debt is refinanced or repaid before maturity. Pursuant to the adoption of ASU 2015-03, unamortized deferred financing costs related to securitizations and note issuances are presented in the unaudited interim consolidated balance sheets as a direct deduction from the associated liability.

 

Due from servicers

 

The loan servicing activities of the Company’s acquisitions and SBC originations reportable segments are performed primarily by third-party servicers. SBA loans originated by and held at RCL are internally serviced. Residential mortgage loans originated by and held at GMFS are both serviced by third-party servicers and internally serviced. The Company’s servicers hold substantially all of the cash owned by the Company related to loan servicing activities. These amounts include principal and interest payments made by borrowers, net of advances and servicing fees. Cash is generally received within thirty days of recording the receivable.

 

The Company is subject to credit risk to the extent any servicer with whom the Company conducts business is unable to deliver cash balances or process loan-related transactions on the Company’s behalf. The Company monitors the financial condition of the servicers with whom the Company conducts business and believes the likelihood of loss under the aforementioned circumstances is remote.

 

Secured borrowings

 

Secured borrowings include borrowings under credit facilities, borrowings under repurchase agreements, and promissory notes.

 

Borrowings under credit facilities

 

The Company accounts for borrowings under credit facilities under ASC 470, Debt. The Company partially finances its loans, net through credit agreements with various counterparties. These borrowings are collateralized by loans, held-for-investment, and loans, held for sale, at fair value and have maturity dates within two years from the unaudited interim consolidated balance sheet date. If the fair value (as determined by the applicable counterparty) of the collateral securing these borrowings decreases, we may be subject to margin calls during the period the borrowings are outstanding. In instances where we do not satisfy the margin calls within the required time frame, the counterparty may retain the collateral

and pursue collection of any outstanding debt amount from us. Interest paid and accrued in connection with credit facilities is recorded as interest expense in the unaudited interim consolidated statements of income.

 

Borrowing under repurchase agreements

 

Borrowings under repurchase agreements are accounted for under ASC 860, Transfers and Servicing. Investment securities financed under repurchase agreements are treated as collateralized borrowings, unless they meet sale treatment or are deemed to be linked transactions. Through March 31, 2020,  none of our repurchase agreements have been accounted for as components of linked transactions. All securities financed through a repurchase agreement have remained on our unaudited interim consolidated balance sheets as an asset and cash received from the lender was recorded on our unaudited interim consolidated balance sheets as a liability. Interest paid and accrued in connection with our repurchase agreements is recorded as interest expense in the unaudited interim consolidated statements of income.

 

Securitized debt obligations of consolidated VIEs, net

 

Since 2011, we have engaged in several securitization transactions, which the Company accounts for under ASC 810. Securitization involves transferring assets to an SPE, or securitization trust, and this SPE issues debt instruments. The entity that has a controlling financial interest in a VIE is referred to as the primary beneficiary and is required to consolidate the VIE. The consolidation of the SPE includes the issuance of senior securities to third parties, which are shown as securitized debt obligations of consolidated VIEs in the consolidated balance sheets.

 

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

 

Convertible note, net

 

ASC 470 requires the liability and equity components of convertible debt instruments that may be settled in cash upon conversion to be separately accounted for in a manner that reflects the issuer’s nonconvertible debt borrowing rate. ASC 470-20 requires that the initial proceeds from the sale of these notes be allocated between a liability component and an equity component in a manner that reflects interest expense at the interest rate of similar nonconvertible debt that could have been issued by the Company at such time. We measured the estimated fair value of the debt component of our convertible notes as of the issuance date based on our nonconvertible debt borrowing rate. The equity components of the convertible senior notes have been reflected within additional paid-in capital in our unaudited interim consolidated balance sheet, and the resulting debt discount is amortized over the period during which the convertible notes are expected to be outstanding (through the maturity date) as additional non-cash interest expense.

 

Upon repurchase of convertible debt instruments, ASC 470-20 requires the issuer to allocate total settlement consideration, inclusive of transaction costs, amongst the liability and equity components of the instrument based on the fair value of the liability component immediately prior to repurchase.  The difference between the settlement consideration allocated to the liability component and the net carrying value of the liability component, including unamortized debt issuance costs, would be recognized as gain (loss) on extinguishment of debt in our unaudited interim consolidated statements of operations.  The remaining settlement consideration allocated to the equity component would be recognized as a reduction of additional paid-in capital in our unaudited interim consolidated balance sheets.

 

Senior secured notes, net

 

The Company accounts for secured debt offerings under ASC 470. Pursuant to the adoption of ASU 2015-03, the Company’s senior secured notes are presented net of debt issuance costs. These senior secured notes are collateralized by loans, MBS, and retained interests of consolidated VIE’s. Interest paid and accrued in connection with senior secured notes is recorded as interest expense in the unaudited interim consolidated statements of income.

 

Corporate debt, net

 

The Company accounts for corporate debt offerings under ASC 470. The Company’s corporate debt is presented net of debt issuance costs. Interest paid and accrued in connection with corporate debt is recorded as interest expense in the unaudited interim consolidated statements of income.

 

Guaranteed loan financing

 

Certain partial loan sales do not qualify for sale accounting under ASC 860 because these sales do not meet the definition of a “participating interest,” as defined in the guidance, in order for sale treatment to be allowed. Participations or other partial loan sales which do not meet the definition of a participating interest remain as an investment in the unaudited interim consolidated balance sheets and the proceeds from the portion sold is recorded as guaranteed loan financing in the liabilities section of the unaudited interim consolidated balance sheets. For these partial loan sales, the interest earned on the entire loan balance is recorded as interest income and the interest earned by the buyer in the partial loan sale is recorded within interest expense in the accompanying unaudited interim consolidated statements of income.

 

Repair and denial reserve

 

The repair and denial reserve represents the potential liability to the SBA in the event that we are required to make the SBA whole for reimbursement of the guaranteed portion of SBA loans. We may be responsible for the guaranteed portion of SBA loans if there are lien and collateral issues, unauthorized use of proceeds, liquidation deficiencies, undocumented servicing actions or denial of SBA eligibility. This reserve is calculated using an estimated frequency of a repair and denial event upon default, as well as an estimate of the severity of the repair and denial as a percentage of the guaranteed balance.

 

Variable interest entities

 

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

 

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

 

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

 

Non-controlling interests

 

Non-controlling interests, which are presented in the unaudited interim consolidated balance sheets and the unaudited interim consolidated statements of income, represent direct investment in the Operating Partnership by Sutherland OP Holdings II, Ltd., which is managed by our Manager, and third parties.

 

Fair value option

 

ASC 825, Financial Instruments, provides a fair value option election that allows entities to make an election of fair value as the initial and subsequent measurement attribute for certain eligible financial assets and liabilities. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. The decision to elect the fair value option is determined on an instrument by instrument basis and must be applied to an entire instrument and is irrevocable once elected. Assets and liabilities measured at fair value pursuant to this guidance are required to be reported separately in our unaudited interim consolidated balance sheets from those instruments using another accounting method.

 

We have elected the fair value option for certain loans held-for-sale originated by the Company that we intend to sell in the near term. The fair value elections for loans, held for sale at fair value originated by the Company were made due to the short-term nature of these instruments.

 

We have elected the fair value option for loans held-for-sale originated by GMFS that the Company intends to sell in the near term. We have elected the fair value option for certain residential mortgage servicing rights acquired as part of the merger transaction.

 

Earnings per share

 

We present both basic and diluted earnings per share (“EPS”) amounts in our unaudited interim consolidated financial statements. Basic EPS excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Diluted EPS reflects the maximum potential dilution that could occur from our share-based compensation, consisting of unvested restricted stock units (“RSUs”), unvested restricted stock awards (“RSAs”), as well as “in-the-money” conversion options associated with our outstanding convertible senior notes. Potential dilutive shares are excluded from the calculation if they have an anti-dilutive effect in the period.

 

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

 

Income taxes

 

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

 

We provide for exposure in connection with uncertain tax positions, which requires significant judgment by management including determination, based on the weight of the tax law and available evidence, that it is more-likely-than-not that a tax result will be realized. Our policy is to recognize interest and/or penalties related to income tax matters in income tax expense on our unaudited interim consolidated statements of income. As of March 31, 2020 and December 31, 2019, we accrued no taxes, interest or penalties related to uncertain tax positions. In addition, we do not anticipate a change in this position in the next 12 months.

 

Revenue recognition

 

Revenue is recognized upon the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Revenue is recognized through the following five-step process:

 

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

Step 2: Identify the performance obligations in the contract.

Step 3: Determine the transaction price.

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

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

 

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

nonfinancial assets where the seller has continuing involvement.  These additional revisions also did not materially impact the Company.

 

Interest income

 

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

 

Realized gains (losses)

 

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

 

Origination income and expense

 

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

 

Residential mortgage banking activities

 

Residential mortgage banking activities, reflects revenue within our residential mortgage banking business directly related to loan origination and sale activity. This primarily consists of the realized gains on sales of residential loans held for sale and loan origination fee income, Residential mortgage banking activities also consists of unrealized gains and losses associated with the changes in fair value of the loans held for sale, the fair value of retained MSR additions, and the realized and unrealized gains and losses from derivative instruments.

 

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

 

Loan origination fee income represents revenue earned from originating mortgage loans held for sale and are reflected in residential mortgage banking activities, when loans are sold.

 

Variable expenses on residential mortgage banking activities

 

Loan expenses include indirect costs related to loan origination activities, such as correspondent fees, and are expensed as incurred and are included within variable expenses on residential mortgage banking activities on the Company’s unaudited interim consolidated statements of income. The provision for loan indemnification includes the fair value of the incurred liability for mortgage repurchases and indemnifications recognized at the time of loan sale and any other

provisions recorded against the loan indemnification reserve. Loan origination costs directly attributable to the processing, underwriting, and closing of a loan are included in the gain on sale of mortgage loans held for sale when loans are sold.

 

Foreign currency transactions

 

Assets and liabilities denominated in non-U.S. currencies are translated into U.S. dollars using foreign currency exchange rates prevailing at the end of the reporting period. Revenue and expenses are translated at the average exchange rates for each reporting period. Foreign currency remeasurement gains or losses on transactions in nonfunctional currencies are recognized in earnings. Gains or losses on translation of the financial statements of a non-U.S. operation, when the functional currency is other than the U.S. dollar, are included, net of taxes, in the consolidated statements of comprehensive income.

 

 

 

Note 4 – Recently issued accounting pronouncements

 

Financial Accounting Standards Board ("FASB") Standards adopted during 2020

 

Standard	Summary of guidance		Effects on financial statements
ASU 2016-13, Financial Instruments—Credit Losses (Topic 326) – Measurement of Credit Losses on Financial Instruments		Replaces existing incurred loss impairment guidance and establishes a single allowance framework for financial assets carried at amortized cost, which will reflect management's estimate of credit losses over the full remaining expected life of the financial assets and will consider expected future changes in macroeconomic conditions.		Adopted January 1, 2020.
Issued June 2016		Eliminates existing guidance for PCI loans, and requires recognition of the accretable difference as an increase to the allowance for expected credit losses on financial assets purchased with more than insignificant credit deterioration since origination, with a corresponding increase in the recorded investment of related loans.		The Company adopted ASU 2016-13 using the modified retrospective method for all loans carried at amortized cost. We recorded a $6.8 million cumulative-effect adjustment to the opening retained earnings (net of taxes) in our consolidated statement of equity as of January 1, 2020. The Company's total increase in the allowance for loan losses was $11.1 million, which included a $3.6 million allowance for loan loss balance sheet gross up, relating to purchased credit deteriorated loans.
		Requires inclusion of expected recoveries, limited to the cumulative amount of prior write-offs, when estimating the allowance for credit losses for in scope financial assets (including collateral dependent assets).	
		Requires a cumulative-effect adjustment to retained earnings as of the beginning of the reporting period of adoption.	
ASU 2017-4, Intangibles — Goodwill and Other (Topic 350) – Simplifying the Test for Goodwill Impairment		Requires an impairment loss to be recognized when the estimated fair value of a reporting unit falls below its carrying value.		Adopted January 1, 2020.
Issued January 2017		Eliminates the second condition in the current guidance that requires an impairment loss to be recognized only if the estimated implied fair value of the goodwill is below its carrying value.		Based on current impairment test results, the adoption did not have a material effect on the consolidated financial statements.
				The guidance may result in more frequent goodwill impairment losses in future periods due to the removal of the second condition.
ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement		Provides guidance on increasing the transparency and comparability of the disclosure requirements for fair value measurement.		The adoption did not have a material impact on our consolidated financial statements.
Issued August 2018			

 

 

 

 

 

 

 

Note 5 – Business Combinations

 

Acquisition of Owens Realty Mortgage, Inc.    

   On November 7, 2018, the Company entered into an Agreement and Plan of Merger as amended, (the “Merger Agreement”) with ORM, a specialty finance company that focused on the origination, investment, and management of commercial real estate loans. Pursuant to the Merger Agreement, the Company acquired ORM in a stock-for-stock transaction with an aggregate purchase price equal to 99.0% of ORM’s book value. Upon the closing, each outstanding share of ORM’s common stock was converted into the right to receive 1.441 shares of the Company common stock, based on a fixed exchange ratio.  

   On March 29, 2019, the Company completed the acquisition of ORM, through a merger of ORM with and into a wholly owned subsidiary of the Company, in exchange for approximately 12.2 million shares of the Company’s common stock. The total purchase price for the merger of $179.3 million consisted exclusively of the Company’s common stock issued in exchange for shares of ORM common stock and cash paid in lieu of fractional shares of the Company’s common stock, and was based on the $14.67 closing price of the Company’s common stock on March 29, 2019.

    The consideration transferred was allocated to the assets acquired and liabilities assumed based on their respective fair values.  The methodologies used and key assumptions made to estimate the fair value of the assets acquired and liabilities assumed are primarily based on future cash flows and discount rates. The following table summarizes the fair value of assets acquired and liabilities assumed from the merger:

(In Thousands)		March 29, 2019
Assets
Cash and cash equivalents		$	10,822
Loans			130,449
Real estate, held for sale			67,973
Investment in unconsolidated joint ventures			8,619
Other assets
Deferred tax assets			4,660
Accrued interest			1,209
Other			379
Total assets acquired		$	224,111
Liabilities
Secured borrowings			12,713
Accounts payable and other accrued liabilities			1,000
Due to Manager			228
Deferred tax liabilities			123
Total liabilities assumed		$	14,064
Net assets acquired		$	210,047

    For acquired loan receivables, the gross contractual unpaid principal acquired is $134.8 million and we expect to collect all contractual amounts.

   The aggregate consideration transferred, net assets acquired, and the related bargain purchase gain was as follows:

 

    Based on the calculation, the Company has determined the transaction resulted in a bargain purchase gain, which is predominantly the result of changes in the market price of the Company’s common stock between the determination date and the closing date of the transaction. This gain is reflected separately within the unaudited interim consolidated statements of income under gain on bargain purchase.

         Acquisition-related costs directly attributable to the ORM Merger, including legal, accounting, valuation, and other professional or consulting fees, totaling $5.5 million for the three months ended March 31, 2019, were expensed as incurred and are reflected separately within the unaudited interim consolidated statements of income.