Ready Capital Corp (RC) FY 2022 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

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Introduction

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in five main sections:

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The following discussion should be read in conjunction with our consolidated financial statements and accompanying Notes included in Item 8, “Financial Statements and Supplementary Data,” of this annual report on Form 10-K. In addition to historical data, this discussion contains forward-looking statements about our business, operations and financial performance based on current expectations that involve risks, uncertainties and assumptions. See “Forward-Looking Statements” and “Critical Accounting Estimates” in this annual report on Form 10-K for certain other factors that may cause actual results to differ, materially, from those anticipated in the forward-looking statements included in this annual report on Form 10-K. Our actual results may differ materially from those in this discussion as a result of various factors, including but not limited to those discussed in Part, 1. Item 1A, “Risk Factors” in this annual report on Form 10-K.

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Overview

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Our Business

We are a multi-strategy real estate finance company that originates, acquires, finances, and services SBC loans, SBA loans, residential mortgage loans, construction loans, and to a lesser extent, MBS collateralized primarily by SBC loans, or other real estate-related investments. Our loans generally range in original principal amounts up to $40 million and are used by businesses to purchase real estate used in their operations or by investors seeking to acquire multi-family, office, retail, mixed use or warehouse properties. Our objective is to provide attractive risk-adjusted returns to our stockholders, primarily through dividends as well as through capital appreciation. In order to achieve this objective, we continue to grow our investment portfolio and believe that the breadth of our full-service real estate finance platform will allow us to adapt to market conditions and deploy capital in our asset classes and segments with the most attractive risk-adjusted returns. We report our activities in the following three operating segments:

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Prior to the fourth quarter of 2021, we reported our activities in the following four business segments: Acquisitions, SBC Originations, Small Business Lending and Residential Mortgage Banking. Our Chief Executive Officer, as our CODM, realigned our business segments to incorporate results from our Acquisitions segment in our SBC Lending and Acquisitions segment. We believe this to be more closely aligned with the activities for and projections of our business models. We have recast prior period amounts and segment information to conform to this presentation.

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We are organized and conduct our operations to qualify as a REIT under the Code. So long as we qualify as a REIT, we are generally not subject to U.S. federal income tax on our net taxable income to the extent that we annually distribute substantially all of our net taxable income to stockholders. We are organized in a traditional UpREIT format pursuant to which we serve as the general partner of and conduct substantially all of our business through our operating partnership. We also intend to operate our business in a manner that will permit us to be excluded from registration as an investment company under the 1940 Act.

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Acquisitions

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Mosaic. On March 16, 2022, pursuant to the terms of that certain Merger Agreement, dated as of November 3, 2021, as amended on February 7, 2022, the Company acquired, in a series of mergers (collectively, the “Mosaic Mergers”), a group of privately held, real estate structured finance opportunities funds, with a focus on construction lending (collectively, the “Mosaic Funds”), managed by MREC Management, LLC (“the “Mosaic Manager”).

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As consideration for the Mosaic Mergers, each former investor was entitled to receive an equal number of shares of each of Class B-1 Common Stock, $0.0001 par value per share (the “Class B-1 Common Stock”), Class B-2 Common Stock, $0.0001 par value per share (the “Class B-2 Common Stock”) Class B-3 Common Stock, $0.0001 par value per share (the “Class B-3 Common Stock”), and Class B-4 Common Stock, $0.0001 par value per share (the “Class B-4 Common Stock” and, together with the Class B-1 Common Stock, the Class B-2 Common Stock and the Class B-3 Common Stock, the “Class B Common Stock”), of Ready Capital, contingent equity rights (“CERs”) representing the potential right to receive shares of common stock, par value $0.0001 per share (“Common Stock”), as of the end of the three-year period following the closing date of the Mosaic Mergers based upon the performance of the assets acquired by Ready Capital pursuant to the Mosaic Mergers, and cash consideration in lieu of any fractional shares of Class B Common Stock.

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The Class B Common Stock ranked equally with the Common Stock, except that the shares of Class B Common Stock were not listed on the New York Stock Exchange. On May 11, 2022, each issued and outstanding share of Class B Common Stock, pursuant to a Board resolution, automatically converted, on a one-for-one basis, into an equal number of shares of Common Stock, and as such, no shares of Class B Common Stock remain outstanding.

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The CERs are contractual rights and do not represent any equity or ownership interest in Ready Capital or any of its affiliates. If any shares of Common Stock are issued in settlement of the CERs, each former investor will also be entitled to receive a number of additional shares of Common Stock equal to (i) the amount of any dividends or other distributions paid with respect to the number of whole shares of Common Stock received in respect of CERs and having a record date on or after the closing date of the Mosaic Mergers and a payment date prior to the issuance date of such shares of Common Stock, divided by (ii) the greater of (a) the average of the volume weighted average prices of one share of Common Stock over the ten trading days preceding the determination date and (b) the most recently reported book value per share of Common Stock as of the determination date.

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The acquisition further expanded the Company’s investment portfolio and origination platform to include a diverse portfolio of construction assets with attractive portfolio yields. Refer to Note 5, included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this annual report on Form 10-K, for assets acquired and liabilities assumed in the merger.

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Red Stone. On July 31, 2021, the Company acquired Red Stone, a privately owned real estate finance and investment company that provides innovative financial products and services to multifamily affordable housing, in exchange for an initial purchase price of approximately $63 million paid in cash, retention payments to key executives aggregating $7 million in cash and 128,533 shares of common stock of the Company issued to Red Stone executives under the Company’s 2013 equity incentive plan (the “Equity Incentive Plan”). Additional purchase price payments may be made over the three

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years following the acquisition date if the Red Stone business achieves certain hurdles. The acquisition of Red Stone supported a significant growth opportunity for the Company by expanding presence in a sector with otherwise low correlation to our assets. In acquiring Red Stone, we considered the value of the anticipated synergies arising from the acquisition and the value of the acquired assembled workforce, neither of which qualify for recognition as an intangible asset.

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Anworth Mortgage Asset Corporation. On March 19, 2021, we completed the acquisition of Anworth, through a merger of Anworth with and into a wholly-owned subsidiary of ours, in exchange for approximately 16.8 million shares of our common stock (“Anworth Merger”). In accordance with the Agreement and Plan of Merger, dated as of December 6, 2020 (the “Anworth Merger Agreement”), by and among us, RC Merger Subsidiary, LLC and Anworth, the number of shares of our common stock issued was based on an exchange ratio of 0.1688 per share plus $0.61 in cash per share. The total purchase price for the merger of $417.9 million consists of our common stock issued in exchange for shares of Anworth common stock and cash paid in lieu of fractional shares of our common stock, which was based on a price of $14.28 per share of our common stock on the acquisition date and $0.61 in cash per share.

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In addition, we issued 1,919,378 shares of newly designated 8.625% Series B Cumulative Preferred Stock, par value $0.0001 per share (the "Series B Preferred Stock"), 779,743 shares of newly designated 6.25% Series C Cumulative Convertible Preferred Stock, par value $0.0001 per share (the "Series C Preferred Stock") and 2,010,278 shares of newly designated 7.625% Series D Cumulative Redeemable Preferred Stock, par value $0.0001 per share (the "Series D Preferred Stock"), in exchange for all shares of Anworth’s 8.625% Series A Cumulative Preferred Stock, 6.25% Series B Cumulative Convertible Preferred Stock and 7.625% Series C Cumulative Redeemable preferred stock outstanding prior to the effective time of the Anworth Merger. On July 15, 2021, the Company redeemed all of the outstanding Series B and Series D Preferred Stock, in each case at a redemption price equal to $25.00 per share, plus accrued and unpaid dividends up to, but excluding, the redemption date.

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Upon the closing of the transaction and after giving effect to the issuance of shares of common stock as consideration in the merger, our historical stockholders owned approximately 77% of our outstanding common stock, while historical Anworth stockholders owned approximately 23% of our outstanding common stock.

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The acquisition of Anworth increased our equity capitalization, supported continued growth of our platform and execution of our strategy, and provided us with improved scale, liquidity and capital alternatives, including additional borrowing capacity. Also, the stockholder base resulting from the acquisition of Anworth enhanced the trading volume and liquidity for our stockholders. In addition, part of our strategy in acquiring Anworth was to manage the liquidation and runoff of certain assets within the Anworth portfolio and repay certain indebtedness on the Anworth portfolio following the completion of the Anworth Merger, and to redeploy the capital into opportunities in our core SBC strategies and other assets we expect will generate attractive risk-adjusted returns and long-term earnings accretion.

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In addition, concurrently with entering into the Anworth Merger Agreement, we, our operating partnership and the Manager entered into the First Amendment to the Amended and Restated Management Agreement (the “Amendment”), pursuant to which, upon the closing of the Anworth Merger, the Manager’s base management fee was reduced by $1,000,000 per quarter for each of the first full four quarters following the effective time of the Anworth Merger (the “Temporary Fee Reduction”). Other than the Temporary Fee Reduction set forth in the Amendment, the terms of the Management Agreement remain the same.

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For additional information on our business, refer to Part I, Item 1, “Business” in this Annual Report on Form 10-K.

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Factors Impacting Operating Results

We expect that our results of operations will be affected by a number of factors and will primarily depend on the level of interest income from our assets, the market value of our assets and the supply of, and demand for, SBC loans, SBA loans, residential loans, construction loans, MBS and other assets we may acquire in the future, demand for housing, population trends, construction costs, the availability of alternative real estate financing from other lenders and the financing and other costs associated with our business. These factors may have an impact on our ability to originate new loans or the performance of our existing loan portfolio. Our net investment income, which includes the amortization of purchase premiums and accretion of purchase discounts, varies primarily as a result of changes in market interest rates, the rate at which our distressed assets are liquidated and the prepayment speed of our performing assets. Interest rates and prepayment speeds vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty. Our operating results may also be impacted by our available borrowing capacity, conditions in the financial markets, credit losses in excess of initial estimates or unanticipated credit events experienced by borrowers whose loans are held directly by us or are included in our MBS. Difficult market conditions as well as inflation, energy costs, geopolitical issues, health epidemics and outbreaks of contagious diseases, such as the outbreak of COVID-19 and the emergence and severity of variants, unemployment and the availability and cost of credit are factors which could also impact our operating results.

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Changes in Market Interest Rates. We own and expect to acquire or originate fixed rate mortgages (“FRMs”) and ARMs with maturities ranging from two to 30 years. Our loans typically have amortization periods of 15 to 30 years or balloon payments due in two to 10 years. FRM loans bear interest that is fixed for the term of the loan and we typically utilize derivative financial and hedging instruments in an effort to hedge the interest rate risk associated with such FRMs. As of December 31, 2022, 72% of fixed rate loans are match funded in securitization. ARM loans generally have an adjustable interest rate equal to the sum of a fixed spread plus an index rate, such as the Secured Overnight Financing Rate (“SOFR”), which typically resets monthly. As of December 31, 2022, approximately 86% of the loans in our portfolio were ARMs, and 14% were FRMs, based on UPB.

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With respect to our business operations, increases in interest rates may generally over time cause the interest expense associated with our variable-rate borrowings to increase, the value of fixed-rate loans, MBS and other real estate-related assets to decline, coupons on variable-rate loans and MBS to reset to higher interest rates, and prepayments on loans and MBS to slowdown. Conversely, decreases in interest rates generally tend to have the opposite effect.

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Non-performing loans are not as interest rate sensitive as performing loans, as earnings on non-performing loans are often generated from restructuring the assets through loss mitigation strategies and opportunistically disposing of them. Because non-performing loans are short-term assets, the discount rates used for valuation are based on short-term market interest rates, which may not move in tandem with long-term market interest rates.

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Changes in Fair Value of Our Assets. Certain originated loans, MBS, and servicing rights are carried at fair value, while future assets may also be carried at fair value. Accordingly, changes in the fair value of our assets may impact the results of our operations in the period such changes occur. The expectation of changes in real estate prices is a key determinant for the value of loans and ABS. This factor is beyond our control.

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Prepayment Speeds. Prepayment speeds on loans vary according to interest rates, the type of investment, conditions in the financial markets, competition, foreclosures and other factors that cannot be predicted with any certainty. In general, when interest rates rise, it is relatively less attractive for borrowers to refinance their mortgage loans and, as a result, prepayment speeds tend to decrease. This can extend the period over which we earn interest income and servicing fee income. When interest rates fall, prepayment speeds increase on loans, thereby decreasing the period over which we earn interest income or servicing fee income. Additionally, other factors such as the credit rating of the borrower, the rate of property value appreciation or depreciation, financial market conditions, foreclosures and lender competition, none of which can be predicted with any certainty, may affect prepayment speeds on loans.

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Credit Spreads. Our investment portfolio may be subject to changes in credit spreads. Credit spreads measure the yield demanded on loans and securities by the market based on their credit relative to a specific benchmark and is a measure of the perceived risk of the investment. Fixed rate loans and securities are valued based on a market credit spread over the rate payable on fixed rate swaps or fixed rate U.S. Treasuries of similar maturity. Floating rate securities are typically valued based on a market credit spread over SOFR (or another floating rate index) and are affected similarly by changes in SOFR spreads. Excessive supply of these loans and securities, or reduced demand, may cause the market to require a higher yield on these securities, resulting in the use of a higher, or “wider,” spread over the benchmark rate to value such assets. Under such conditions, the value of our portfolios would tend to decline. Conversely, if the spread used to value such assets were to decrease, or “tighten,” the value of our loans and securities would tend to increase. Such changes in the market value of these assets may affect our net equity, net income or cash flow directly through their impact on unrealized gains or losses.

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The spread between the yield on our assets and our funding costs is an important factor in the performance of this aspect of our business. Wider spreads imply greater income on new asset purchases but may have a negative impact on our stated book value. Wider spreads generally negatively impact asset prices. In an environment where spreads are widening, counterparties may require additional collateral to secure borrowings which may require us to reduce leverage by selling assets. Conversely, tighter spreads imply lower income on new asset purchases but may have a positive impact on our stated book value. Tighter spreads generally have a positive impact on asset prices. In this case, we may be able to reduce the amount of collateral required to secure borrowings.

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Loan and ABS Extension Risk. The Company estimates the projected weighted-average life of our investments based on assumptions regarding the rate at which the borrowers will prepay the underlying mortgages and/or the speed at which we are able to liquidate an asset. If the timeline to resolve non-performing assets extends, this could have a negative impact on our results of operations, as carrying costs may therefore be higher than initially anticipated. This situation may also cause the fair market value of our investment to decline if real estate values decline over the extended period. In extreme situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses.

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Credit Risk. We are subject to credit risk in connection with our investments in loans and ABS and other target assets we may acquire in the future. Increases in defaults and delinquencies will adversely impact our operating results, while declines in rates of default and delinquencies will improve our operating results from this aspect of our business. Default rates are influenced by a wide variety of factors, including, property performance, property management, supply and demand factors, construction trends, consumer behavior, regional economics, interest rates, the strength of the United States economy and other factors beyond our control. All loans are subject to the possibility of default. We seek to mitigate this inherent risk by seeking to acquire assets at appropriate prices given anticipated and unanticipated losses and by deploying a value-driven approach to underwriting and diligence, consistent with our historical investment strategy, with a focus on projected cash flows and potential risks to cash flow. We further mitigate our risk of potential losses while managing and servicing our loans by performing various workout and loss mitigation strategies with delinquent borrowers. Nevertheless, unanticipated credit losses could occur which could adversely impact operating results.

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Current market conditions. The fourth quarter occurred in an environment of market volatility caused by significant inflationary pressures, macroeconomic concerns and geopolitical shifts. In an effort to combat inflation and restore price stability, the U.S. Federal Reserve has raised interest rates. Although the full impact of recent changes remains uncertain and difficult to predict, there has been a recent shift towards a less aggressive monetary policy amid easing inflation. In addition, the persistence of COVID-19 and its impact on us and our borrowers will largely depend on future developments beyond our control including, but not limited to the emergence and severity of variants, the efficacy of vaccinations and booster programs, the impact and reactions on the U.S. and global economies, the effectiveness of governmental responses thereto and the timing and speed of economic recovery. Concerns and uncertainties about the economic outlook may adversely impact our financial condition, results of operations and cash flows.

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Results of Operations

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Key Financial Measures and Indicators

As a real estate finance company, we believe the key financial measures and indicators for our business are earnings per share, dividends declared per share, distributable earnings, and net book value per share. As further described below, distributable earnings is a measure that is not prepared in accordance with GAAP. We use distributable earnings to evaluate our performance and determine dividends, excluding the effects of certain transactions and GAAP adjustments that we believe are not necessarily indicative of our current loan activity and operations. See “—Non-GAAP Financial Measures” below for a reconciliation of net income to distributable earnings.

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The table below sets forth certain information on our operating results.

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In the table above,

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Our Loan Pipeline

We have a large and active pipeline of potential acquisition and origination opportunities that are in various stages of our investment process. We refer to assets as being part of our acquisition or origination pipeline if (i) an asset or portfolio opportunity has been presented to us and we have determined, after a preliminary analysis, that the assets fit within our investment strategy and exhibit the appropriate risk/reward characteristics (ii) in the case of acquired loans, we have executed a non-disclosure agreement (“NDA”) or an exclusivity agreement and commenced the due diligence process or we have executed more definitive documentation, such as a letter of intent (“LOI”); and (iii) in the case of originated loans, we have issued an LOI, and the borrower has paid a deposit.

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We operate in a competitive market for investment opportunities and competition may limit our ability to originate or acquire the potential investments in the pipeline. The consummation of any of the potential loans in the pipeline depends upon, among other things, one or more of the following: available capital and liquidity, our Manager’s allocation policy, satisfactory completion of our due diligence investigation and investment process, approval of our Manager’s Investment Committee, market conditions, our agreement with the seller on the terms and structure of such potential loan, and the execution and delivery of satisfactory transaction documentation. Historically, we have acquired less than a majority of the assets in our pipeline at any one time and there can be no assurance the assets currently in our pipeline will be acquired or originated by us in the future.

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The table below presents information on our investment portfolio originations and acquisitions (based on fully committed amounts).

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The table below presents information on our acquisition and origination pipeline opportunities (based on fully committed amounts).

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(1) Includes 2023 fundings

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Balance Sheet Analysis and Metrics

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As of December 2022, total assets in our consolidated balance sheet were $11.6 billion, an increase of $2.1 billion from December 2021, primarily reflecting an increase in Assets of consolidated VIEs and Loans, net, partially offset by a decrease in PPP loans. Assets of consolidated VIEs increased $2.4 billion, due to the closings of RCMF 2022-FL8, RCMT 2022-7, RCMF 2022-FL9 and RCMF 2022-FL10, partially offset by paydowns including the collapse of SCMT 2020-SBC9 and RCMT 2014-1. Loans, net increased $661 million, primarily reflecting increases in loan originations, partially

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offset by paydowns. PPP loans decreased $683 million due to principal forgiveness. Additionally, the Mosaic Mergers added $763 million of assets.

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As of December 2022, total liabilities in our consolidated balance sheet were $9.7 billion, an increase of $1.5 billion from December 2021, primarily reflecting an increase in Securitized debt obligations of consolidated VIEs, net and Secured borrowings, partially offset by a decrease in Paycheck Protection Program Liquidity Facility (“PPPLF”) borrowings. Securitized debt obligations of consolidated VIEs, net increased $1.7 billion due to the closings of RCMF 2022-FL8, RCMT 2022-7, RCMF 2022-FL9 and RCMF 2022-FL10, partially offset by paydowns including the collapse of SCMT 2020-SBC9 and RCMT 2014-1. Secured borrowings increased $329 million reflecting increased borrowings on originations and acquisitions of loans, partially offset by payments. PPPLF borrowings decreased $740 million due to PPP principal forgiveness.

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As of December 2022, total stockholders’ equity was $1.9 billion, an increase of $610 million from December 2021, primarily due to equity raised in connection with the Mosaic Mergers, the issuance of common equity through an underwritten public offering and the issuance of common equity through the at-the-market program, partially offset by common stock repurchased through the Company’s share repurchase program.

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Selected Balance Sheet Information by Business Segment. The table below presents certain selected balance sheet data by each of our three business segments, with the remaining amounts reflected in Corporate –Other.

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In the table above,

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Income Statement Analysis and Metrics

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Results of Operations – Supplemental Information. Realized and unrealized gains (losses) on financial instruments are recorded in the consolidated statements of income and classified based on the nature of the underlying asset or liability.

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The table below presents the components of realized and unrealized gains (losses) on financial instruments.

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SBC Lending and Acquisitions Segment Results.

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2022 versus 2021. Interest income of $565.1 million for 2022 represented an increase of $286.7 million from the prior year, primarily due to loan acquisitions and originations, driven by higher loan balances and increases in interest rates. Interest expense of $364.3 million for 2022 represented an increase of $199.5 million from the prior year, driven by an increase in borrowings to finance originations and increases in interest rates. Provision for loan losses of $31.5 million for 2022 represented an increase of $24.1 million from the prior year, due to changes in forecasted macroeconomic inputs for reserve modeling, particularly related to the tightening of monetary policy driven by rising inflation, and geopolitical tensions. Non-interest income of $90.9 million for 2022 represented an increase of $23.6 million from the prior year, driven by origination income on affordable housing, rental income as a result of the Mosaic Mergers, net realized and unrealized gains on financial instruments and income from unconsolidated subsidiaries. Non-interest expense of $91.3 million for 2022 represented an increase of $27.7 million from the prior year, primarily due to an increase in compensation and loan servicing expenses.

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2021 versus 2020. Interest income of $278.5 million for 2021 represented an increase of $66.9 million from the prior year, primarily due to SBC loan originations, resulting in higher average loan balances. Interest expense of $164.8 million for 2021 represented an increase of $26.4 million from the prior year, primarily due to an increase in borrowing needs required to finance new originations. Provision for loan losses of $7.4 million for 2021 represented a decrease of $19.5 million from the prior year, due to loan payoffs and stabilizing economic assumptions. Non-interest income of $67.3 million for 2021 represented an increase of $50.8 million from the prior year, primarily due to net realized and unrealized gains on financial instruments. Non-interest expense of $63.5 million for 2021 represented an increase of $13.3 million from the prior year, primarily due to an increase in compensation and operating expenses, driven by an increase in SBC loan originations.

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Small Business Lending Segment Results.

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2022 versus 2021. Interest income of $98.1 million for 2022 represented a decrease of $18.7 million from the prior year, due to forgiveness of PPP loans. Interest expense of $27.4 million for 2022 represented a decrease of $9.5 million from the prior year, driven by forgiveness of PPP loans, partially offset by an increase in interest rates. Provision for loan losses of $3.0 million for 2022 represented an increase of $2.3 million from the prior year, primarily due to increased origination volume. Non-interest income of $63.2 million for 2022 represented a decrease of $2.4 million from the prior year, primarily due to lower realized gains on loan sales and a decrease in servicing income on PPP loans as compared to the respective prior period, partially offset by releases in repair and denial reserves related to PPP loans and employee retention credit consulting income. Non-interest expense of $64.4 million was essentially unchanged from the respective prior year period.

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2021 versus 2020. Interest income of $116.7 million for 2021 represented an increase of $77.3 million from the prior year, due to increased loan balances, including PPP loans. Interest expense of $36.9 million for 2021 represented an increase of $9.4 million from the prior year, due to an increase in costs associated with borrowings to support PPP loan activities. Provision for loan losses of $0.7 million for 2021 represented a decrease of $7.1 million from the prior year, primarily due to higher CECL reserves taken during 2020, driven by the outlook towards COVID-19’s impact on small businesses. Non-interest income of $65.6 million for 2021 represented a decrease of $11.6 million from the prior year, primarily due to revenue from originated PPP loans. Non-interest expense of $64.1 million for 2021 represented an increase of $9.0 million from the prior year, due to an increase in expenses related to originated PPP loans.

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Residential Mortgage Banking Segment Results.

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2022 versus 2021. Interest income of $8.0 million for 2022 represented a decrease of $0.3 million from the prior year, due to a decrease in loan originations, partially offset by an increase in interest rates. Interest expense of $8.4 million for 2022 represented a decrease of $0.8 million from the prior year, due to a decrease in loan originations. Non-interest income of $104.6 million for 2022 represented a decrease of $82.2 million from the prior year, primarily due to a decrease in loan originations, partially offset by gains on MSRs. Non-interest expense of $46.2 million for 2022 represented a decrease of $82.7 million from the prior year, due to a decrease in loan origination expenses.

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2021 versus 2020. Interest income of $8.3 million for 2021 represented an increase of $0.6 million from the prior year, due to a slight increase in the holding periods of loans held for sale at fair value. Interest expense of $9.2 million for 2021 represented an increase of $0.9 million from the prior year, due to a slight increase in the holding periods of loans held for sale at fair value. Non-interest income of $186.8 million for 2021 represented a decrease of $54.1 million from the prior year, primarily due to a decrease in revenue generated on residential mortgage banking activities. Non-interest expense of

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$129.0 million for 2021 represented a decrease of $57.2 million from the prior year, primarily due to a decrease in variable expenses on residential mortgage banking activities due to decreased loan origination volumes.

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Corporate – Other.

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2022 versus 2021. Non-interest income of $0.8 million for 2022 represented an increase of $0.7 million from the prior year, due to interest income on cash held with banks. Interest expense of $0.6 million for 2022 represented a decrease of $2.1 million from the prior year, due to a decrease in unallocated corporate debt. All interest expense from corporate debt offerings were deployed to the business segments. Non-interest expense of $60.7 million for 2022 represented an increase of $4.7 million from the prior year, primarily due to an increase in incentive fees.

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2021 versus 2020. Non-interest income of $0.1 million for 2021 was essentially unchanged from the prior year. Interest expense of $2.7 million for 2021 represented an increase of $1.4 million from the prior year, due to repo borrowings for general business purposes. All interest expense from corporate debt offerings were deployed to the business segments. Non-interest expense of $56.0 million for 2021 represented an increase of $18.8 million from the prior year, primarily due to one-time transaction expenses and allocated employee compensation, partially offset by other professional fees, management fees and incentive fees.

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Non-GAAP financial measures

We believe that providing investors with distributable earnings, formerly referred to as core earnings, gives investors greater transparency into the information used by management in our financial and operational decision-making, including the determination of dividends. Distributable earnings is a non-U.S. GAAP financial measure and because distributable earnings is an incomplete measure of our financial performance and involves differences from net income computed in accordance with U.S. GAAP, it should be considered along with, but not as an alternative to, our net income as a measure of our financial performance. In addition, because not all companies use identical calculations, our presentation of distributable earnings may not be comparable to other similarly-titled measures of other companies.

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We calculate distributable earnings as GAAP net income (loss) excluding the following:

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In calculating distributable earnings, net income (in accordance with GAAP) is adjusted to exclude unrealized gains and losses on MBS acquired by us in the secondary market but is not adjusted to exclude unrealized gains and losses on MBS retained by us as part of our loan origination businesses, where we transfer originated loans into an MBS securitization and retain an interest in the securitization. In calculating distributable earnings, we do not adjust net income (in accordance with GAAP) to take into account unrealized gains and losses on MBS retained by us as part of our loan origination businesses because we consider the unrealized gains and losses that are generated in the loan origination and securitization process to be a fundamental part of this business and an indicator of the ongoing performance and credit quality of our historical loan originations. In calculating distributable earnings, net income (in accordance with GAAP) is adjusted to exclude realized gains and losses on certain MBS securities due to a variety of reasons which may include collateral type, duration, and size. In 2016, we liquidated the majority of our MBS portfolio excluded from distributable earnings to fund our recurring operating segments.

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In addition, in calculating distributable earnings, net income (in accordance with GAAP) is adjusted to exclude unrealized gains or losses on residential MSRs, held at fair value. We treat our commercial MSRs and residential MSRs as two separate classes based on the nature of the underlying mortgages and our treatment of these assets as two separate pools for risk management purposes. Servicing rights relating to our small business commercial business are accounted for under ASC 860, Transfer and Servicing, while our residential MSRs are accounted for under the fair value option under ASC 825, Financial Instruments. In calculating distributable earnings, we do not exclude realized gains or losses on either

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commercial MSRs or residential MSRs, held at fair value, as servicing income is a fundamental part of our business and an indicator of the ongoing performance.

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To qualify as a REIT, we must distribute to our stockholders each calendar year dividends equal to at least 90% of our REIT taxable income (including certain items of non-cash income), determined without regard to the deduction for dividends paid and excluding net capital gain. There are certain items, including net income generated from the creation of MSRs, that are included in distributable earnings but are not included in the calculation of the current year’s taxable income. These differences may result in certain items that are recognized in the current period’s calculation of distributable earnings not being included in taxable income, and thus not subject to the REIT dividend distribution requirement, until future years.

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The table below presents an annual reconciliation of net income to distributable earnings.

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2022 versus 2021. Consolidated net income of $203.2 million for 2022 represented an increase of $43.2 million from the prior year, primarily due to an increase in net interest income after provision for loan losses driven by higher loan volumes and increases in interest rates. Consolidated distributable earnings of $218.7 million for 2022 represented an increase of $50.7 million from the prior year, primarily due to unrealized gains on residential MSRs and the impact of CECL on accrual loans.

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2021 versus 2020. Consolidated net income of $160.0 million for 2021 represented an increase of $113.9 million from the prior year, primarily due to an increase in net interest income after provision for loan losses driven by higher loan volumes and interest income recognized from PPP. Consolidated distributable earnings of $168.0 million for 2021 represented an increase of $66.7 million from the prior year, primarily due to unrealized gains on residential MSRs and the impact of the adoption of ASU 2016-13 on accrual loans, partially offset by merger transaction costs.

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The table below presents a quarterly reconciliation of net income to distributable earnings.

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QTD 2022 versus QTD 2021. Consolidated net income of $13.7 million for the three months ended December 31, 2022 represented a decrease of $39.9 million from the prior year respective period, primarily due to changes in forecasted macroeconomic inputs for reserve modeling, particularly related to the tightening of monetary policy driven by rising inflation, and geopolitical tensions. Consolidated distributable earnings of $51.6 million for the three months ended December 31, 2022 represented a decrease of $1.0 million from the prior year respective period, primarily due to a decrease in net income, partially offset by the impact of CECL on accrual loans.

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COVID-19 Impact on Operating Results

There has been a wide-ranging response of international, federal, state and local public health and governmental authorities to the COVID-19 pandemic in regions across the United States and the world. The full magnitude and duration of the COVID-19 pandemic and the extent to which it impacts our financial condition, results of operations and cash flows will depend on future developments, which continue to be uncertain. We will continue to monitor for any material or adverse effects on our business resulting from the COVID-19 pandemic. Further discussion of the potential impacts on our business from the COVID-19 pandemic is provided in the section entitled “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K.

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Incentive distribution payable to our Manager

Under the partnership agreement of our operating partnership, our Manager, the holder of the Class A special unit in our operating partnership, is entitled to receive an incentive distribution, distributed quarterly in arrears in an amount, not less than zero, equal to the difference between (i) the product of (A) 15% and (B) the difference between (x) distributable earnings (as described below) of our operating partnership, on a rolling four-quarter basis and before the incentive distribution for the current quarter, and (y) the product of (1) the weighted average of the issue price per share of common stock or operating partnership unit (“OP unit”) (without double counting) in all of our offerings multiplied by the weighted average number of shares of common stock outstanding (including any restricted shares of common stock and any other shares of common stock underlying awards granted under the Equity Incentive Plan) and OP units (without double counting) in such quarter and (2) 8%, and (ii) the sum of any incentive distribution paid to our Manager with respect to the first three quarters of such previous four quarters; provided, however, that no incentive distribution is payable with respect to any calendar quarter unless cumulative distributable earnings is greater than zero for the most recently completed 12 calendar quarters.

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The incentive distribution shall be calculated within 30 days after the end of each quarter and such calculation shall promptly be delivered to our Company. We are obligated to pay the incentive distribution 50% in cash and 50% in either common stock or OP units, as determined in our discretion, within five business days after delivery to our Company of the written statement from the holder of the Class A special unit setting forth the computation of the incentive distribution for such quarter. Subject to certain exceptions, our Manager may not sell or otherwise dispose of any portion of the incentive distribution issued to it in common stock or OP units until after the three year anniversary of the date that such shares of common stock or OP units were issued to our Manager. The price of shares of our common stock for purposes of determining the number of shares payable as part of the incentive distribution is the closing price of such shares on the last trading day prior to the approval by our board of the incentive distribution.

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For purposes of determining the incentive distribution payable to our Manager, distributable earnings (which is referred to as core earnings in the partnership agreement of our operating partnership) is defined under the partnership agreement of our operating partnership in a manner that is similar to the definition of distributable earnings described above under "Non-GAAP Financial Measures" but with the following additional adjustments which (i) further exclude: (a) the incentive distribution, (b) non-cash equity compensation expense, if any, (c) unrealized gains or losses on SBC loans (not just MBS and MSRs), (d) depreciation and amortization (to the extent we foreclose on any property), and (e) one-time events pursuant to changes in U.S. GAAP and certain other non-cash charges after discussions between our Manager and our independent directors and after approval by a majority of the independent directors and (ii) add back any realized gains or losses on the sales of MBS and on discontinued operations which were excluded from the definition of distributable earnings described above under "Non-GAAP Financial Measures".

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Liquidity and Capital Resources

Liquidity is a measure of our ability to turn non-cash assets into cash and to meet potential cash requirements. We use significant cash to purchase SBC loans and other target assets, originate new SBC loans, pay dividends, repay principal and interest on our borrowings, fund our operations and meet other general business needs. Our primary sources of liquidity will include our existing cash balances, borrowings, including securitizations, re-securitizations, repurchase agreements, warehouse facilities, bank credit facilities and other financing agreements (including term loans and revolving facilities), the net proceeds of offerings of equity and debt securities, including our senior secured notes, corporate debt, and convertible notes, and net cash provided by operating activities.

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We are continuing to monitor the impact of rising interest rates, credit spreads and inflation on the Company, the borrowers underlying our real estate-related assets, the tenants in the properties we own, our financing sources, and the economy as a whole. Because the severity, magnitude and duration of these economic events remain uncertain, rapidly changing and difficult to predict, the impact on our operations and liquidity also remains uncertain and difficult to predict.

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Cash flow

Year Ended December 31, 2022. Cash and cash equivalents decreased by $26.3 million to $297.0 million at the end of 2022, primarily due to net cash used for investing activities, partially offset by net cash provided by financing and operating activities. The net cash used for investing activities primarily reflected loan originations and purchases, partially offset by paydowns. The net cash provided by financing activities primarily reflected net proceeds from issuances of securitized debt and secured borrowings, partially offset by the repayment of PPPLF borrowings. The net cash provided by operating activities primarily reflected an increase in loans, held for sale, at fair value, net.

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Year Ended December 31, 2021. Cash and cash equivalents increased by $122.8 million to $323.3 million at the end of 2021, primarily due to net cash provided by financing activities, partially offset by net cash used for investing and operating activities. The net cash provided by financing activities primarily reflected net proceeds from issuances of securitized debt and net proceeds from PPPLF borrowings due to timing of funds designated for PPP originations, partially offset by paydowns of secured borrowings. The net cash used for investing activities primarily reflected loan originations and purchases, partially offset by paydowns. The net cash used for operating activities primarily reflected an increase in operating assets, partially offset by an increase in operating liabilities.

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Year Ended December 31, 2020. Cash and cash equivalents increased by $72.5 million to $200.5 million at the end of 2020, primarily due to net cash provided by operating and financing activities, partially offset by net cash used for investing activities. The net cash provided by operating activities primarily reflected net realized gains on financial instruments and net proceeds on the origination and sale of loans, held for sale, at fair value. The net cash provided by financing activities primarily reflected proceeds from issuances of securitized debt and net proceeds from secured borrowings as a result of an increase in our origination and acquisition activities, partially offset by paydowns of secured debt and dividend payments. The net cash used for investing activities primarily reflected loan originations and purchases, partially offset by paydowns.

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Financing Strategy and Leverage

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In addition to raising capital through offerings of our public equity and debt securities, we finance our investment portfolio through securitization and secured borrowings. We generally seek to match-fund our investments to minimize the differences in the terms of our investments and our liabilities. Our secured borrowings have various recourse levels including full recourse, partial recourse and non-recourse, as well as varied mark-to-market provisions including full mark-to-market, credit mark only and non-mark-to-market. Securitizations allow us to match fund loans pledged as collateral on a long-term, non-recourse basis. Securitization structures typically consist of trusts with principal and interest collections allocated to senior debt and losses on liquidated loans to equity and subordinate tranches, and provide debt equal to 50% to 90% of the cost basis of the assets.

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We also finance originated Freddie Mac SBL and residential loans with secured borrowings until the loans are sold, generally within 30 days.

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As of December 31, 2022, we had a total leverage ratio of 5.1x and recourse leverage ratio of 1.5x. Our operating segments have different levels of recourse debt according to the differentiated nature of each segment. Our SBC Lending and Acquisitions, Small Business Lending and Residential Mortgage Banking segments have recourse leverage ratios of 0.4x, 1.5x and 1.2x, respectively. The remaining recourse leverage ratio is from our corporate debt offerings.

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Secured Borrowings

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Credit Facilities and Other Financing Agreements. We utilize credit facilities and other financing arrangements to finance our business. The financings are collateralized by the underlying mortgages, assets, related documents, and instruments, and typically contain index-based financing rate and terms, haircut and collateral posting provisions which depend on the types of collateral and the counterparties involved. These agreements often contain customary negative covenants and financial covenants, including maintenance of minimum liquidity, minimum tangible net worth, maximum debt to net worth ratio and current ratio and limitations on capital expenditures, indebtedness, distributions, transactions with affiliates and maintenance of positive net income.

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The table below presents certain characteristics of our credit facilities and other financing arrangements.

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(1) Represents the total number of facility lenders.

(2) Current maturity does not reflect extension options available beyond original commitment terms.

(3) Asset class pricing is determined using an index rate plus a weighted average spread.

(4) Non-USD denominated credit facilities have been converted into USD for purposes of this disclosure.

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Repurchase Agreements. Under the loan repurchase facilities and securities repurchase agreements, we may be required to pledge additional assets to our counterparties in the event that the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral, which may take the form of additional assets or cash. Generally, the loan repurchase facilities and securities repurchase agreements contain a SOFR-based financing rate, term and haircuts depending on the types of collateral and the counterparties involved. The loan repurchase facilities also include financial maintenance covenants.

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If the estimated fair values of the assets increase due to changes in market interest rates or other market factors, lenders may release collateral back to us. Margin calls may result from a decline in the value of the investments securing the loan repurchase facilities and securities repurchase agreements, prepayments on the loans securing such investments and from changes in the estimated fair value of such investments generally due to principal reduction of such investments from scheduled amortization and resulting from changes in market interest rates and other market factors. Counterparties also may choose to increase haircuts based on credit evaluations of our Company and/or the performance of the assets in question. Historically, disruptions in the financial and credit markets have resulted in increased volatility in these levels, and this volatility could persist as market conditions continue to change. Should prepayment speeds on the mortgages underlying our investments or market interest rates suddenly increase, margin calls on the loan repurchase facilities and securities repurchase agreements could result, causing an adverse change in our liquidity position. To date, we have satisfied all of our margin calls and have never sold assets in response to any margin call under these borrowings.

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Our borrowings under repurchase agreements are renewable at the discretion of our lenders and, as such, our ability to roll-over such borrowings are not guaranteed. The terms of the repurchase transaction borrowings under our repurchase agreements generally conform to the terms in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association, as to repayment, margin requirements and the segregation of all assets we have initially sold under the repurchase transaction. In addition, each lender typically requires that we include supplemental terms and conditions to the standard master repurchase agreement. Typical supplemental terms and conditions, which differ by lender, may include changes to the margin maintenance requirements, required haircuts and purchase price maintenance requirements, requirements that all controversies related to the repurchase agreement be litigated in a particular jurisdiction, and cross default and setoff provisions.

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We maintain certain assets, which, from time to time, may include cash, unpledged SBC loans, SBC ABS and short-term investments (which may be subject to various haircuts if pledged as collateral to meet margin requirements) and collateral in excess of margin requirements held by our counterparties, or collectively, the “Cushion”, to meet routine margin calls

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and protect against unforeseen reductions in our borrowing capabilities. Our ability to meet future margin calls will be impacted by the Cushion, which varies based on the fair value of our investments, our cash position and margin requirements. Our cash position fluctuates based on the timing of our operating, investing and financing activities and is managed based on our anticipated cash needs.

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The table below presents certain characteristics of our repurchase agreements.

(1) Represents the total number of facility lenders

(2) Asset class pricing is determined using an index rate plus a weighted average spread.

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Collateralized borrowings under repurchase agreements

The table below presents the amount of collateralized borrowings outstanding under repurchase agreements as of the end of each quarter, the average amount of collateralized borrowings outstanding under repurchase agreements during the quarter and the highest balance of any month end during the quarter.

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Year Ended December 31, 2022. The net increase in the outstanding balances during 2022 was primarily due to increased borrowings to fund SBC originations and acquisitions volumes.

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Year Ended December 31, 2021. The net increase in the outstanding balances during 2021 was primarily due to increased borrowings to fund SBC originations and acquisitions volumes.

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Year Ended December 31, 2020. The net increase in the outstanding balances during 2020 was primarily due to increased borrowings during the first quarter of 2020 for liquidity needs, followed by a securitization of our acquired and originated loan assets in the second quarter of 2020.

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PPP borrowing facilities

On March 27, 2020, the U.S. Congress approved, and President Trump signed into law the CARES Act. The CARES Act provides approximately $2 trillion in financial assistance to individuals and businesses resulting from the outbreak of COVID-19. The CARES Act, among other things, provides certain measures to support individuals and businesses in maintaining solvency through monetary relief, including in the form of financing and loan forgiveness and/or forbearance. The primary catalyst of small business stimulus in the CARES Act is the PPP, an SBA loan that temporarily supports businesses in order to retain their workforce during the COVID-19 pandemic.

In January 2021, PPP was reopened to provide funding to new borrowers and certain existing borrowers. We elected to participate again in PPP in 2021 as both a direct lender and a service provider. We used the following two facilities in order to participate in funding PPP loans.

PPP Participant Bank financing agreements. In late January 2021 ReadyCap Lending (“RCL”) entered into two agreements with a certain PPP participant bank, as follows:

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The termination date of the agreement was the date as of which all of the PPP loans related to a participation sold have been paid in full and all collections with respect thereto have been paid, or when we no longer hold legal title to any PPP loan related to a participation sold. As such, this financing agreement was fully repaid in June 2021 and therefore, has been terminated.

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Paycheck Protection Program Facility borrowings. RCL utilizes the ability to receive advances from the Federal Reserve through the Paycheck Protection Program Liquidity Facility (“PPPLF”). Loans are participated with a PPP participant bank in accordance with the financing agreement described above, repurchased from such PPP participant bank, and then pledged using PPPLF. The program charges an interest rate of 0.35%. As of December 31, 2022, we had $201.0 million outstanding under this credit facility.

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Senior Secured Notes, Convertible Notes and Corporate Debt, Net

The table below presents information about senior secured notes, convertible notes and corporate debt issued through public and private transactions.

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The table below presents the contractual maturities for senior secured notes, convertible notes and corporate debt.

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ReadyCap Holdings 4.50% senior secured notes due 2026. On October 20, 2021, ReadyCap Holdings, an indirect subsidiary of the Company, completed the offer and sale of $350.0 million of its 4.50% Senior Secured Notes due 2026 (the “Senior Secured Notes”). The Senior Secured Notes are fully and unconditionally guaranteed by the Company, each direct parent entity of ReadyCap Holdings, and other direct or indirect subsidiaries of the Company from time to time that is a direct parent entity of Sutherland Asset III, LLC or otherwise pledges collateral to secure the Senior Secured Notes (collectively, the “SSN Guarantors”).

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ReadyCap Holdings’ and the Guarantors’ respective obligations under the Senior Secured Notes are secured by a perfected first-priority lien on certain capital stock and assets (collectively, the “SSN Collateral”) owned by certain subsidiaries of the Company.

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The Senior Secured Notes are redeemable by ReadyCap Holdings’ following a non-call period, through the payment of the outstanding principal balance of the Senior Secured Notes plus a “make-whole” or other premium that decreases the closer the Senior Secured Notes are to maturity.  ReadyCap Holdings is required to offer to repurchase the Senior Secured Notes at 101% of the principal balance of the Senior Secured Notes in the event of a change in control and a downgrade of the rating on the Senior Secured Notes in connection therewith, as set forth more fully in the note purchase agreement.

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The Senior Secured Notes were issued pursuant to a note purchase agreement, which contains certain customary negative covenants and requirements relating to the collateral and our company, including maintenance of minimum liquidity, minimum tangible net worth, maximum debt to net worth ratio and limitations on transactions with affiliates.

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Convertible notes. On August 9, 2017, we closed an underwritten public sale of $115.0 million aggregate principal amount of our 7.00% convertible senior notes due 2023 (the “Convertible Notes”). As of December 31, 2022, the conversion rate was 1.6498 shares of common stock per $25 principal amount of the Convertible Notes, which is equivalent to a conversion price of approximately $15.15 per share of our common stock. Upon conversion, holders will receive, at our discretion, cash, shares of our common stock or a combination thereof.

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We may redeem all or any portion of the Convertible Notes on or after August 15, 2021, if the last reported sale price of our common stock has been at least 120% of the conversion price in effect for at least 20 trading days (whether or not consecutive) during any 30 consecutive trading day period ending on, and including, the trading day immediately preceding the date on which we provide notice of redemption, at a redemption price payable in cash equal to 100% of the principal amount of the Convertible Notes to be redeemed, plus accrued and unpaid interest. Additionally, upon the occurrence of certain corporate transactions, holders may require us to purchase the Convertible Notes for cash at a purchase price equal to 100% of the principal amount of the Convertible Notes to be purchased, plus accrued and unpaid interest.

The Convertible Notes will be convertible only upon satisfaction of one or more of the following conditions: (1) the closing market price of our common stock is greater than or equal to 120% of the conversion price of the respective Convertible Notes for at least 20 out of 30 days prior to the end of the preceding fiscal quarter, (2) the trading price of the Convertible Notes is less than 98% of the product of (i) the conversion rate and (ii) the closing price of our common stock during any five consecutive trading day period, (3) we issue certain equity instruments at less than the 10 day average closing market price of our common stock or the per-share value of certain distributions exceeds the market price of our common stock by more than 10%, or (4) certain other specified corporate events (significant consolidation, sale, merger share exchange, etc.) occur.

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Corporate debt

We issue senior unsecured notes in public and private transactions. The notes are governed by a base indenture and supplemental indentures. Often, the notes are redeemable by us following a non-call period, through the payment of the outstanding principal balance plus a “make-whole” or other premium that typically decreases the closer the notes are to maturity. We are often required to offer to repurchase the notes in some cases at 101% of the principal balance of the notes in the event of a change in control or fundamental change pertaining to our company, as defined in the applicable supplemental indentures. The notes rank equal in right of payment to any of our existing and future unsecured and unsubordinated indebtedness; effectively junior in right of payment to any of our existing and future secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness, other liabilities (including trade payables) and (to the extent not held by us) preferred stock, if any, of our subsidiaries. The supplemental indentures governing the notes often contain customary negative covenants and financial covenants relating to maintenance of minimum liquidity, minimum tangible net worth, maximum debt to net worth ratio and limitations on transactions with affiliates.

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The Debt ATM Agreement

On May 20, 2021, we entered into an At Market Issuance Sales Agreement (the “Sales Agreement”) with B. Riley Securities, Inc. (the “Agent”), pursuant to which we may offer and sell, from time to time, up to $100.0 million of the 6.20% 2026 Notes and the 5.75% 2026 Notes. Sales of the 6.20% 2026 Notes and the 5.75% 2026 Notes pursuant to the Sales Agreement, if any, may be made in transactions that are deemed to be “at the market offerings” as defined in Rule 415 under the Securities Act (the “Debt ATM Program”). The Agent is not required to sell any specific number of the notes, but the Agent will make all sales using commercially reasonable efforts consistent with its normal trading and sales practices on mutually agreed terms between the Agent and us. During the year ended December 31, 2022, the Company sold an aggregate of 215.3 thousand of the 6.20% 2026 Notes and 5.75% 2026 Notes at an average price of $25.40 per note and $25.05 per note, respectively, for net proceeds of $5.3 million after related expenses paid of $0.1 million through the Debt ATM Program. No such sales through the Debt ATM Program were made during the three months ended December 31, 2022.

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Securitization transactions

Our Manager’s extensive experience in loan acquisition, origination, servicing and securitization strategies has enabled us to complete several securitizations of SBC and SBA loan assets since January 2011. These securitizations allow us to match fund the SBC and SBA loans on a long-term, non-recourse basis. The assets pledged as collateral for these securitizations were contributed from our portfolio of assets. By contributing these SBC and SBA assets to the various securitizations, these transactions created capacity for us to fund other investments.

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The table below presents information on the securitization structures and related issued tranches of notes to investors.

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We used the proceeds from the sale of the tranches issued to purchase and originate SBC and SBA loans.  We are the primary beneficiary of all firm sponsored securitizations, therefore they are consolidated in our financial statements.

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Contractual Obligations and Off-Balance Sheet Arrangements

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The table below provides a summary of our contractual obligations.

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The table above does not include amounts due under our management agreement or derivative agreements as those contracts do not have fixed and determinable payments.

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Critical Accounting Estimates

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Our financial statements are prepared in accordance with GAAP, which requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We believe that all of the decisions and assessments upon which our financial statements are based were reasonable at the time made, based upon information available to us at that time. The following discussion describes the critical accounting estimates that apply to our operations and require complex management judgment. This summary should be read in conjunction with our accounting policies and use of estimates included in “Notes to Consolidated Financial Statements, Note 3 – Summary of Significant Accounting Policies” included in Item 8, “Financial Statements and Supplementary Data,” in the Company’s annual report on Form 10-K.

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Allowance for credit losses

The allowance for credit losses consists of the allowance for losses on loans and lending commitments accounted for at amortized cost. Such loans and lending commitments are reviewed quarterly considering credit quality indicators, including probable and historical losses, collateral values, LTV ratio and economic conditions. The allowance for credit losses increases through provisions charged to earnings and reduced by charge-offs, net of recoveries.

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ASC 326, Financial Instruments-Credit Losses (“ASC 326”), became effective for us on January 1, 2020 and replaced the “incurred loss” methodology previously required by GAAP 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 credit losses required under ASC 326 is deducted from the respective loans’ amortized cost basis on our consolidated balance sheets. The related Accounting Standards Update No. 2016-13 (“ASU 2016-13”) also requires a cumulative-effect adjustment to retained earnings as of the beginning of the reporting period of adoption.

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In connection with ASU 2016-13, we implemented new processes including the utilization of loan loss forecasting models, updates to our reserve policy documentation, changes to internal reporting processes and related internal controls. We 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 and (ii) probability weighted expected cash flow method, depending on the type of loan and the availability of relevant historical market loan loss data. We 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.

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We estimate the CECL expected credit losses for our loan portfolio at the individual loan level. Significant inputs to our 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. These estimates may change in future periods based on available future macro-economic data and might result in a material change in our future estimates of expected credit losses for its loan portfolio.

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In certain instances, we consider relevant loan-specific qualitative factors to certain loans to estimate its CECL expected credit losses. We consider 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 we determine that foreclosure of the collateral is probable, we measure the expected losses based on the difference between the fair value of the collateral (less costs to sell the asset if repayment is expected through the sale of the collateral) and the amortized cost basis of the loan as of the measurement date. For collateral-dependent loans that we determine foreclosure is not probable, we apply 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.

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While we have a formal methodology to determine the adequate and appropriate level of the allowance for credit 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 credit 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 credit losses.

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Significant judgment is required when evaluating loans for impairment; therefore, actual results over time could be materially different. Refer to “Notes to Consolidated Financial Statements, Note 6 – Loans and Allowance for Credit Losses” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for results of our loan impairment evaluation.

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Accretion of discounts associated with PPP loans, held for investment

The Company’s loan originations in the second round of the program are accounted for as loans, held-for-investment under ASC 310, Receivables. Loan origination fees and related direct loan origination costs are capitalized into the initial recorded investment in the loan and are deferred over the loan term. The net amount between the loan origination fees and direct loan origination costs is recognized as a discount in the carrying value of the loans, and the discount is required to be recognized in income at a constant effective yield over the life of the instrument.

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The effective yield is determined based on the payment terms required by the loan contract as well as with actual and expected prepayments from loan forgiveness by the federal government. Because prepayments from loan forgiveness often deviate from the estimates, the Company periodically recalculates the effective yield to reflect actual prepayments to date and anticipated future prepayments. Anticipated future prepayments are estimated based on past prepayment patterns, historical, current, and projected interest rate environments, among other factors, to predict future cash flows.

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Adjustments to anticipated future prepayments are recorded on a retrospective basis, meaning that the net investment or liability is adjusted to the amount that would have existed had the new effective yield been applied since the initial recognition of the instrument. As prepayment speeds change, these accounting requirements can be a source of income volatility. Accelerations of prepayments accelerate the accretion and increase current earnings. Conversely, when prepayments decline, thus lengthening the effective maturity of the instruments and shifting some of the discount accretion to future periods.

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Significant judgment is required when evaluating the effective yield on PPP loans; therefore, actual results over time could be materially different. Refer to “Notes to Consolidated Financial Statements, Note 20 – Other Income and Operating Expenses” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a more complete discussion of PPP loans, held for investment.

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Valuation of financial assets and liabilities carried at fair value

We measure our MBS, derivative assets and liabilities, residential MSRs, and any assets or liabilities where we have elected the fair value option at fair value, including certain loans we have originated that are expected to be sold to third parties or securitized in the near term.

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We have established valuation processes and procedures designed so that fair value measurements are appropriate and reliable, that they are based on observable inputs where possible, that the valuation approaches are consistently applied, and the assumptions and inputs are reasonable. We also have established processes to provide that the valuation methodologies, techniques and approaches for investments that are categorized within Level 3 of the ASC 820 Fair Value Measurement fair value hierarchy (the “fair value hierarchy”) are fair, consistent and verifiable. Our processes provide a framework that ensures the oversight of our fair value methodologies, techniques, validation procedures, and results.

When actively quoted observable prices are not available, we either use implied pricing from similar assets and liabilities or valuation models based on net present values of estimated future cash flows, adjusted as appropriate for liquidity, credit, market and/or other risk factors. Refer to “Notes to Consolidated Financial Statements, Note 7 – Fair Value Measurements” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a more complete discussion of our critical accounting estimates as they pertain to fair value measurements.

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Servicing rights impairment

Servicing rights, at amortized cost, are initially recorded at fair value and subsequently carried at amortized cost. We have elected the fair value option on our residential MSRs, which are not subject to impairment.

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For purposes of testing our servicing rights, carried at amortized cost, 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 of the intangibles 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 monitor the actual performance of our servicing rights by regularly comparing actual cash flow, credit, and prepayment experience to modeled estimates.

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Significant judgment is required when evaluating servicing rights for impairment; therefore, actual results over time could be materially different. Refer to “Notes to Consolidated Financial Statements, Note 9 – Servicing Rights” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a more complete discussion of our critical accounting estimates as they pertain to servicing rights impairment.

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Refer to “Notes to Consolidated Financial Statements, Note 4– Recently Issued Accounting Pronouncements” included in Item 8, “Financial Statements and Supplementary Data,” in this annual report on Form 10-K for a discussion of recent accounting developments and the expected impact to the Company.

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