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ZAIS Financial (NYSE:ZFC)

Q2 2014 Earnings Conference Call

August 12, 2014 10:00 a.m. ET

Executives

Scott Eckstein – Financial Relations Board

Michael Szymanski – CEO, President and Director

Paul McDade – CFO and Treasurer

Brian Hargrave – CIO

Analysts

Douglas Harter – Credit Suisse

Trevor Cranston – JMP Securities

Operator

Good day everyone and welcome to the ZAIS Financial Corporation’s Second Quarter 2014 Conference Call. (Operator Instructions). At this time I would like to turn the conference over to Scott Eckstein. Please go ahead sir.

Scott Eckstein

Thank you, operator. Good day everyone and welcome to ZAIS Financial Corp’s conference call to review the company’s results for the second quarter ended June 30. On the call today will be Michael Szymanski, President and Chief Executive Officer; Paul McDade, Chief Financial Officer and Treasurer; and Brian Hargrave, Chief Investment Officer.

As a reminder, this call is being recorded, also being webcast through the company’s website www.zaisfinancial.com. Additionally, a copy of the company’s second quarter investor presentation is available for your review on the company’s website on the Investor Relations page.

Before we begin, I’d like to remind everyone that during the course of this conference call, both in our prepared remarks and in answers to your questions, we may make certain statements and assumptions that contain or based upon forward-looking information pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995.

Such forward-looking statements are subject to numerous assumptions, uncertainties and known or unknown risks, which could cause actual results to differ materially from those anticipated. These risk factors are more fully discussed in the company’s filings with the Securities and Exchange Commission.

The forward-looking statements included in this conference call are only made as of the date of this call and the company is not obligated to publicly update or revise them. In addition, certain terms used in this call are non-GAAP financial measures, reconciliations of which are provided in the company’s earnings release and accompanying tables, which have been furnished to the SEC through the company’s Form 8-K this morning and may also be accessed through the company’s website at www.zaisfinancial.com. Each listener is encouraged to review those reconciliations provided in the earnings release together with all other information provided in the release.

I will now turn the call over to Michael Szymanski. Please go ahead sir.

Michael Szymanski

Good morning everyone, thanks for joining us today. We have a lot to update you on during this morning’s call, including our strong second quarter financial results, the recently announced agreement with GMFS and the substantive progress we’ve made in launching our mortgage credit platform.

During this morning’s call, I will briefly discuss our financial results as well as our other achievements and recent highlights I have just mentioned. After that, our CFO Paul McDade will review our financial results in more detail, our CIO lot more and more call over to the result of will treatment hundred and are you all alternate your result in more detail while our CIO Brian Hargrave will discuss mortgage credit market environment, recap our portfolio performance and highlight our strategic initiatives.

As noted in today’s press release, we reported strong second quarter results, including a sequential increase in book value per share as well as increases in net interest and core income metrics. For second quarter of 2014, we reported core earnings of $3.2 million or $0.36 per diluted weighted average share outstanding.

On a GAAP basis, net income for the quarter was $25.9 million or $2.47 per diluted weighted average share outstanding. Our core and GAAP earnings for the quarter were impacted by increased general and administrative expenses related to the GMFS acquisition as well as other professional fees which Paul discuss in more detail.

As of June 30, 2014, book value per share of common stock and OP unit was $22.37, an increase of 12.6% when compared with $19.36 at March 31, 2014. The book value increase was driven primarily by unrealized gains in our residential mortgage loan portfolio of 20 million or $2.47 per share. The increase reflects price increases in the secondary market for mortgage loans as market volatility remained low and the performance continued to improve and new investments were attracted to the sector.

As of June 30 2014, our capital allocation to these residential mortgage loans stood at 17%. During and subsequent to the second quarter, we took several significant strategic steps in the evolution of our business towards a mortgage operating company, which should increase our loan sourcing capabilities while expanding our investment options.

On August 6, we announced a definitive agreement to acquire GMFS, LLC, a Baton Rouge, LA-based mortgage company. This transaction is expected to close during the fourth quarter of this year. GMFS currently originates loans that are eligible to be purchased, guaranteed or insured, by Fannie Mae, Freddie Mac, FHA, VA and USDA through retail, correspondent and broker channels. GMFS also retains mortgage servicing rights on Fannie Mae, and Freddie Mac and [indiscernible]. For additional details, regarding the transaction and financial terms, please refer to our August 6, press release and the investor presentation on our website. We believe this transaction now offers several attractive, strategic and financial benefits to ZAIS Financial and its shareholders. Importantly it advances two of our core strategic objectives, first, to directly source newly originated mortgage loans while controlling the origination process, and second, to diversify revenue streams to include origination activities and mortgage servicing rights investment income. We expect this transaction to be accretive to earnings beginning in 2015. We anticipate it being slightly dilutive to earnings in 2014 primarily due to transaction related expenses of at least 1.3 million has been incurred in the first and second quarters.

During the second quarter we also continued to develop our residential whole loan platform which we expect to begin locking and funding newly originated non-agency mortgage loans on a flow basis in the coming months. Program will become an important of our sourcing strategy supplying out to the pipeline of potential credit investment opportunities. We will also act as a strong complement to the GMFS platform. While GMFS will become our proprietary origination platform we expect to purchase loans from a broader group of approved sellers that will complement GMFS’ existing and geographic footprint. Brian will provide additional details in the program and its current status.

In summary, our legacy whole loan investment strategy was largely responsible for our strong second quarter results both in terms of core income generation and book value accretion. At the same time we continue to look forward and have important strategic steps in our development as a mortgage-operating company. We are committed to executing on this strategy, which we believe will benefit our shareholders over the longer term.

With that I would like to turn the call over to our Chief Financial Officer, Paul McDade to review our financial performance.

Paul McDade

Thanks Mike. Good morning everyone. As Mike already mentioned for the quarter ended June 30, 2014 the Company reported GAAP net income of $25.9 million or $2.47 per diluted weighted average share outstanding.

Core earnings for the quarter were $3.2 million or $0.36 per diluted weighted average share outstanding. The difference between GAAP and core earnings was due to net realized and unrealized gains of $22.7 million on our portfolio recorded under GAAP. You can reference the section of our press release entitled “Use of non-GAAP financial information” for a further explanation of core earnings which is a non-GAAP financial measure.

As previously noted in our release in past calls, we believe providing investors core earnings information is important when assessing the performance of the quarter and it offers greater transparency to the information that our management team uses in its financial and operational decision-making process.

The Company recorded net interest income of $6.4 million for the second quarter of 2014 compared with $4.8 million in the prior year period. Interest income increased by $4.9 million to $10.8 million compared with the $5.9 million recognized in the second quarter of 2013. The change was mainly due to the deployment of capital raised in the February 2013 IPO and the November 2013 issuance of the convertible notes, which is now significantly allocated to whole loans.

The purchase of whole loans into the portfolio increased interest income by $5.9 million. The increase was partially offset by a decrease in the interest income from the RMBS portfolio due to the reallocation of the portfolio to whole loans consistent with our investment strategy.

We incurred interest expense of $4.4 million for the second quarter of 2014 compared with 1.2 million for the second quarter of 2013. The $3.2 million increase was from additional borrowings under the loan repurchase facility used to finance residential mortgage loans and the convertible notes.

As of June 30, 2014, the weighted average net interest spread between the yield on a Company’s assets and the cost of funds including the impact of interest rate hedging was 4.06% for mortgage loans and 5.11% for non-agency RMBS and other investment securities.

During the second quarter, the Company recognized a favorable change in unrealized gain or loss on mortgage loans, real estate securities and other investment securities of $24.4 million of which $22 million was attributable to the mortgage loan portfolio. We also recognized realized gains on mortgage loans of $0.2 million and losses on derivative instruments of $1.9 million during the quarter.

We incurred operating expenses of $3.2 million for the second quarter of 2014 compared with $1.8 million in last year’s second quarter.

Professional fees increased by $0.7 million due to 2014 audit and tax procedures performed by the independent auditors, additional legal and accounting expenses related to the company's registration statement filings on Form S3 and legal expenses related to funding and financing structures for newly originated whole loans.

Loan serving fees increased by $0.5 million from the prior year period due to the acquisition of whole loans as the company executed on its investment strategy. General and administrative expenses increased by $0.2 million. This increase was mainly due to the due-diligence costs and professional fees of $0.5 million related to the evaluation of the GMFS acquisition, which were partially offset by decrease in whole loan transaction costs.

That concludes our financial review. I’d now like to turn the call over to our Chief Investment Officer, Brian Hargrave to discuss our portfolio and strategic initiatives.

Brian Hargrave

Thanks Paul and good morning everyone. In the second quarter of 2014, our residential whole loan portfolio benefited from a variety of industry and macroeconomic factors generating $22 million of unrealised gains. Interest rates were made relatively low in the second quarter despite a rebound in economic activity.

At the same time Accommodative Central Bank Policy continued to put a damper on market volatility. Mortgage credit investments benefited from this lack of volatility as spreads tightened and at the same time continued home price appreciation albeit at a lower rate and a general strengthening of consumer credit led to improved fundamental mortgage credit performance. While market volatility has increased somewhat subsequent to quarter end, we have seen little change in the markets to which our portfolio is allocated.

Changes to our investment portfolio in the second quarter were minimal. As of June 30, 2014, we held $433.6 million of residential mortgage loans and $239.3 million of non-agency RMBS and other investment securities.

Our capital allocation to whole loans increased slightly to 70% as of June 30, primarily due to the impact of unrealized gains on the loan portfolio fair market value.

At June 30, we had a leverage ratio of 2.54 times with borrowings composed of $293.6 million outstanding under our loan repurchase facility used to finance residential mortgage loans and $156.3 million outstanding under repurchase agreements secured by our RMBS portfolio and $55 million book value of convertible notes outstanding.

The loan repurchase facility and repurchase agreements bear interest at rates that have historically moved in close relationship with LIBOR. We are in negotiations with counterparties and anticipate having additional available borrowing capacity from which we expect to be able to acquire additional assets.

Our interest rate derivative position at June 30 was unchanged from the prior quarter. We held an interest rate swaps, which gives us the right but not the obligation to enter into a previously agreed upon swap contract on a future date. The notional amount of this option was $225 million as of June 30, 2014. Economically, this position gives us increased protection if rates start to move higher this year.

We also have the interest rate swap agreements that provide for us to pay fixed interest rates and receive floating interest rates index off of LIBOR effectively fixing the floating interest rates on $17.2 million of repurchase agreement borrowings as of June 30.

As Mike mentioned, we have recently taken important steps to put ZAIS Financial in a solid position to capitalize from current industry trends as the mortgage market continues to evolve. We believe that sourcing will become an increasingly important component of a successful mortgage investment strategy going forward and as a result have pursued two important initiatives. First, the GMFS transaction provides us with direct sourcing capabilities, the ability to invest in mortgage servicing rights and the insight of a season management team as we seek to grow and expand in the market.

At the same time ZFC’s balance sheet and credit appetite are expected to enhance GMFS’s ability to grow market share and increase profitability. We expect GMFS will continue to originate and sell a full array of agency-guaranteed mortgages by retaining servicing rights similar to its current operations. At the same time GMFS is expected to add ZFC proprietary products to its origination mix over time and these loans could be retained by ZFC and its investment portfolio.

In addition to GMFS, we have developed our newly originated loan purchase program and expect to begin locking and funding loans on a flow basis in the coming months. We expect this program to be complementary to the GMFS platform and allow us to purchase loans from a group of approved sellers in a broader geographic footprint. At this time we have approved two sellers into the program and have executed one mortgage loan purchase agreement. We currently have an active pipeline of additional sellers moving through the due diligence process.

We are very excited about the progress we have made with our mortgage strategy and look forward to updating you on our continued progress with both of these initiatives on our next earnings call.

That concludes our prepared remarks and we will now open it up for your questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And we will hear first from Douglas Harter of Credit Suisse.

Douglas Harter – Credit Suisse

Thanks. I apologize if you said this and I might have missed it. Did you size the amount of incremental costs that you had related to this transaction that was included in your core earnings this quarter?

Michael Szymanski

I guess the two numbers we disclosed were an increase in G&A expense related to transaction which was about $500,000. And then in total in the first quarter and second quarter we disclosed the total expenses related to the transaction which were 1.3 million.

Douglas Harter – Credit Suisse

Do you expect that to be the last of or should we expect some more transaction costs in the third quarter?

Paul McDade

Doug, we don’t – as you know we don’t give earnings guidance going forward. We will have continuing expenses into the third quarter. But we have to be careful about being – selective about giving earning guidance but I think what you should take from our comments is that a significant amount of the transaction expenses have been incurred.

Douglas Harter – Credit Suisse

And I guess when thinking about the dividend – I mean I guess has the board been kind of excluding these expenses and looking at the earnings power of the franchise since you’ve been paying more than kind of the core earnings and I guess how is the board thinking about the dividend in light of these one-time costs?

Michael Szymanski

I think generally the board does look very much at the core earnings power of the business on a go forward basis. We have been – the board has been taking a look at the one-time expenses and factoring that into their thinking but generally speaking we feel very confident about where the different business is at this stage.

Douglas Harter – Credit Suisse

And then I guess just on the strategy – on the acquisition, I guess what are the key – I guess how quickly do you think you could ramp up the sourcing of nonagency loans sort of – to be able to get to a size where you could do a securitization and be able to create new credit assets?

Michael Szymanski

I think we are probably hesitant to throw a data but we are obviously in full operational mode in trying to achieve that. As we mentioned we are rolling out the newly originated purchase process through a number of sellers, we expect GMFS will be one of those obviously and then in post-closing we will be able to focus even more on the rollout of – I would imagine additional proprietary products through that platform. But I wouldn’t want to give you a date, a lot of that comes down to the market and the uptake of the origination side of the business not so much our appetite at the balance sheet level.

Paul McDade

I think obviously from a securities law perspective, we are required to file pro forma financial information on GMFS. When that filing comes out you will get a sense as to the scale of GMFS operation and at that point I think it will give you a better sense of the ability to give GMFS to generate products. As we said – well, we haven’t said much about this acquisition, one of the things that’s very attractive about the GMFS platform is that it has a quite significant purchase mortgage business and that has been historical strength of the franchise which attracted us to them as a target.

Douglas Harter – Credit Suisse

And just when should we expect to get those filing, how far out in – is that?

Michael Szymanski

The timing of the close is really driven by the consent process with a number of the states in which the company is licensed to do business as well as with the agencies and GSCs. So that puts a little bit of variability into the close date itself but –

Paul McDade

And then after closing we have 75 days to file an amended 8-K which would contain all the required financial information.

Operator

Next we will hear from Mike Wagner [ph] from KBW.

Unidentified Analyst

Just a couple questions also mostly related to the transaction. I guess just some simple ones first and looking at on the slide deck on page 7, you talked about the cost of the acquisition and just wanted to make sure I knew how to interpret these numbers properly. First, should we assume you’re paying mostly – that’s just going to be a cash transaction coming out your available cash balance – is that fair?

Michael Szymanski

That’s correct.

Unidentified Analyst

And then just looking at the total consideration I guess the way I am thinking about it is you show an $8 million acquisition premium over on the left side and you talked about two additional $1 million premium payments over two years, and then after that you talked about a $20 million cap and contingent consideration. If I think about that as 20 million in addition to the other, should we think kind of the total potential purchase price might be up to 30, obviously with a lot of that being contingent? Yeah, the 20 million cap is on top of the other 10 basically – that’s really what I am really asking.

Michael Szymanski

Yeah, so there is essentially the book value of the assets, the fair value of the MSR plus an upfront premium of 8 million, there is a small $2 million of additional premium that can be earned and then there's this essentially earn-out or contingent consideration that is capped at 20 million but it’s all especially at risk based on the company's performance.

Unidentified Analyst

So as far as the loans that you’ll be originating I think what I heard you say is you'd expect to originate at least for portfolio purposes the same -- generally the same types of loans through GMFS as you are through the other partners that you talked about signing up, is that correct?

Michael Szymanski

Yeah, I think our thought as day one that we will roll out that product through them as well as through other sellers. I think looking forward I can envision a scenario where we might be more comfortable rolling out additional proprietary products through that platform, the GMFS platform that maybe we didn't want to roll out through the other sellers or we might want to put them out in the GMFS platform first to gain some experience with them. But I think that initially it would be the same product with the obvious potential to expand that.

Unidentified Analyst

And I guess could you just describe what types of loans these are going to be a little more – I think it looked like – I guess you have a sort of seasoned mortgage loan portfolio already but is that sort of along that type or, are we talking about prime jumbo or non-QM or just maybe some more details on what kind of loan do you see coming through?

Michael Szymanski

I think in the short-term as we roll out the first the duration of the program out, the loans will be QM but will expand credit slightly beyond what’s available in the prime jumbo market today. So if you think about dimensions such as LTV transaction type, occupancy status things like that, we expect to see some expansion in our offering versus where the market is today.

Unidentified Analyst

So I mean – I guess the characterization I am getting from that is there’s still sort of prime loans, I mean we should expect FICO scores in the 700s, not 500s and when you say expanded LTVs, I mean are we talking 97% or 85% or I guess just trying to figure out sort of what the niche is here?

Michael Szymanski

Yeah, I mean it’s hard to generalize. Prime is a big term that can describe a lot of things but it’s – I would view as very incremental credit expansions. So if you think about the edges of the credit availability in the prime jumbo market today I would think of it as just going the next step on a number of those dimensions and it’s obviously very – it’s tiered based on layered risks, so you could see some higher LTVs above 85 in your example but certainly not 97 and in the cases where we did go above that there would be obviously mitigating factors that we felt were a good offset and a good risk to take.

Unidentified Analyst

I mean I guess there are some other curious things here, I am just trying to figure out how to think about this in model and whatnot going forward, I mean are these – are you guys thinking primarily ARM type loans, 71s, 51s, 101s or are we doing 30 year fixed or – and then with that comes the question kind of what kind of yields would you see or expect to see on these kind of loans?

Michael Szymanski

Yeah probably not prepared to comment on yield, other than to say that it is an incremental expansion in credit and you would expect to be compensated for that. I guess so probably wouldn’t want to get much more specific to that on the yield front.

Unidentified Analyst

Okay, but – so the yield – it’s going to be highly dependent on whether you’re doing 30 year fixed which would be 4.5 versus –

Michael Szymanski

Yeah, I apologize, I didn’t answer the second part of your question. So we would offer across the ARM and fixed rate spectrum, so to your point on the shape of the curve, you are going to see higher yield obviously on a fixed rate product but moderation.

Unidentified Analyst

And then ultimately with those kind of loans, yeah, I think Doug kind of got at this, but ultimately the plan is that those would be securitized as opposed to just held as whole loans on balance sheet?

Michael Szymanski

Yeah, I think we want to be opportunistic and flexible to explore the financing alternatives that are out and available in the market but certainly assuming a competitive cost of financing the securitization market remains an attractive alternative, just by its very nature that is nonrecourse and term funded, match funded.

Unidentified Analyst

I mean I suppose, the other – we haven’t seen a lot of jumbo securitizations in the other source of financing so to speak is just selling the loans. I mean I guess the question then is – could you envision just selling these to whoever just general whole loan buyers, selling these whole loans –

Michael Szymanski

That’s not probably the – I think we would do that more on opportunistic basis but our core business is really to source and retain mortgage credit risk so that’s as we construct the product our mind-set is that we’re going to be owning these risks for a considerable period of time.

Unidentified Analyst

Yeah I mean that’s sort of what I figured but someone is going to pay you a lot -- but you always look at best execution. I think that’s all the questions for me guys, thanks, appreciate it, and nice quarter.

Operator

And next we will hear from Trevor Cranston, JMP Securities.

Trevor Cranston – JMP Securities

Hey lot of my questions have been covered already. But there is a big gain obviously on the performing loan portfolio this quarter. So I was just curious if you guys can talk about how you are viewing that market now and how you think about that portfolio if the bid for the loans remains extremely strong, is that something you would potentially consider starting to sell off at some point?

Michael Szymanski

I mean we could. It’s probably not in our baseline expectation, not something that we’re looking to do in the short term but it’s always an option. That market, as you see in our market value on the portfolio, the market has run up both in the higher risk re-performing space as well as in the nonperforming space and I think a fair number of market participants have commented around that. So we think that it’s certainly less compelling than it was a year ago and probably more -- a little bit more of a selective approach but I do think that there is likely to continue to be some opportunity there on a more selective basis going forward.

Trevor Cranston – JMP Securities

So the leverage on that book came down a little bit this quarter with the increase in fair value .So as you find selective opportunities, would it be reasonable to expect that leverage will kind of incrementally pickup little bit there?

Michael Szymanski

Yeah, the majority of the gains in that portfolio came late in the quarter. So I would expect that the leverage would move back towards kind of a more normalized level. The leverage on that portfolios has been relatively stable over time with the exception of this quarter. So I think that that will correct itself, it’s primarily just due to the timing of the gains.

Operator

And it appears there are no further questions at this time. I would like to turn the conference back over to management for any additional or closing comments.

Michael Szymanski

Well, thank you very much, thank all of you for your participation today and we look forward to speaking with you again in our next earnings call. Thanks again.

Operator

A replay of today’s conference will be available beginning today at 12 o’clock Central Time through August 19. You may dial into the replay by dialing 888-203-1112 or 7194570820 and entering code 3771538. That does conclude today's conference. Thank you all for your participation.

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