UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

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

For the Quarterly Period Ended June 30, 2014

 

OR

 

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from                      to
Commission file number _________

 

 

 

(Exact name of registrant as specified in its charter)

 

Delaware		57-1039673
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
288 Meeting Street, Charleston, South Carolina		29401
(Address of principal executive offices)		(Zip Code)

 

843-723-7700
(Registrant’s telephone number, including area code)

Not Applicable
(Former name, former address, and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes x No o

 

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

Large accelerated filer	o	Accelerated filer	o
Non-accelerated filer	o (Do not check if a smaller reporting company)	Smaller Reporting Company	x

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 4,048,868 shares of common stock, par value $0.01 per share, were issued and outstanding as of August 11, 2014.

TABLE OF CONTENTS

 

		Page
PART 1 –	FINANCIAL INFORMATION
Item 1.	Financial statements	3
Item 2.	Management’s Discussion and Analysis of Financial Conditions and Results of Operations	39
Item 3.	Quantitative and Qualitative Disclosure about Market Risks	62
Item 4.	Controls and Procedures	62
PART II -	OTHER INFORMATION	62
Item 1.	Legal Proceedings	62
Item 1A.	Risk Factors	62
Item 2.	Unregistered Sale of Equity Securities and Use of Proceeds	62
Item 3.	Defaults Upon Senior Securities	62
Item 4.	Mine Safety Disclosures	62
Item 5.	Other Information	62
Item 6.	Exhibits	62

CONSOLIDATED BALANCE SHEETS

		June 30, 2014 (Unaudited)				December 31, 2013 (Audited)
ASSETS		(In thousands)
Cash and due from banks		$	9,560				4,489
Interest-bearing cash			17,132				34,176
Cash and cash equivalents			26,692				38,665
Securities available-for-sale (cost of $202,570 at June 30, 2014 and $166,997 at December 31, 2013)			207,301				167,535
Securities held-to-maturity (fair value of $25,910 at June 30, 2014 and $23,547 at December 31, 2013)			24,254				24,554
Federal Home Loan Bank stock, at cost			4,730				4,103
Other investments			1,944				1,858
Derivative assets			2,255				1,412
Loans held for sale			47,859				36,897
Loans receivable, net of allowance for loan losses of $8,662 at June 30, 2014 and $8,091 at December 31, 2013			605,295				535,221
Premises and equipment, net			18,667				17,585
Accrued interest receivable			3,059				2,802
Real estate acquired through foreclosure, net			5,655				6,273
Deferred tax assets, net			5,700				7,419
Income taxes receivable			509				—
Mortgage servicing rights			9,843				10,908
Cash value life insurance			21,228				20,910
Other assets			3,421				5,442
Total assets		$	988,412				881,584
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Noninterest-bearing deposits		$	102,376				83,500
Interest-bearing deposits			677,160				614,081
Total deposits			779,536				697,581
Short-term borrowed funds			35,300				10,300
Long-term debt			69,390				74,540
Derivative liabilities			730				55
Drafts outstanding			2,544				2,703
Advances from borrowers for insurance and taxes			709				284
Accrued interest payable			325				311
Income taxes payable			—				749
Reserve for mortgage repurchase losses			5,533				6,109
Dividends payable to stockholders			202				—
Accrued expenses and other liabilities			4,866				6,725
Total liabilities			899,135				799,357
Commitments and contingencies
Stockholders’ equity:
Preferred stock, par value $.01; 1,000,000 and 200,000 shares authorized at June 30, 2014 and December 31, 2013, respectively; no shares issued or outstanding			—				—
Common stock, par value $.01; 10,000,000 and 6,800,000 shares authorized at June 30, 2014 and December 31, 2013, respectively; 4,041,460 and 4,015,204 issued and outstanding at June 30, 2014 and December 31, 2013, respectively			40				40
Additional paid-in capital			22,921				22,393
Retained earnings			65,951				62,169
Accumulated other comprehensive income (loss), net of tax benefit			365				(2,375	)
Total stockholders’ equity			89,277				82,227
Total liabilities and stockholders’ equity		$	988,412				881,584

 

See accompanying notes to consolidated financial statements.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

		For the Three Months Ended June 30,								For the Six Months Ended June 30,
		2014				2013				2014				2013
		(In thousands, except share data)
Interest income
Loans		$	7,157				7,005				13,990				14,084
Debt securities			1,526				1,205				3,047				2,308
Dividends from FHLB			35				31				69				60
Other interest income			25				40				49				58
Total interest income			8,743				8,281				17,155				16,510
Interest expense
Deposits			898				842				1,713				1,708
Short-term borrowed funds			11				80				16				194
Long-term debt			512				546				1,023				1,068
Total interest expense			1,421				1,468				2,752				2,970
Net interest income			7,322				6,813				14,403				13,540
Provision for loan losses			—				(700	)			—				(700	)
Net interest income after provision for loan losses			7,322				7,513				14,403				14,240
Noninterest income
Net gain on sale of loans held for sale			3,426				10,199				5,880				21,549
Deposit service charges			517				371				948				689
Net loss on extinguishment of debt			(31	)			(19	)			(31	)			(19	)
Net gain (loss) on sale of securities			164				(62	)			480				(46	)
Fair value adjustments on interest rate swaps			(263	)			263				(518	)			263
Net gain on sale of servicing assets			—				—				775				—
Net increase in cash value life insurance			187				—				373				1
Mortgage loan servicing income			1,254				1,836				2,531				3,328
Other			195				217				380				423
Total noninterest income			5,449				12,805				10,818				26,188
Noninterest expense
Salaries and employee benefits			5,515				6,248				10,859				12,708
Occupancy and equipment			1,051				847				2,035				1,661
Marketing and public relations			297				263				571				498
FDIC insurance			136				157				263				413
Legal expense			191				290				361				440
Other real estate expense, net			60				335				307				411
Mortgage subservicing expense			326				469				689				935
Amortization of mortgage servicing rights			441				738				913				1,331
Settlement of employment agreements			—				119				—				1,902
Other			1,474				2,139				3,100				4,329
Total noninterest expense			9,491				11,605				19,098				24,628
Income before income taxes			3,280				8,713				6,123				15,800
Income tax expense			1,031				3,180				1,930				5,844
Net income		$	2,249				5,533				4,193				9,956
Earnings per common share:
Basic		$	0.58				1.44				1.08				2.60
Diluted		$	0.57				1.40				1.07				2.53
Weighted average common shares outstanding:
Basic			3,881,115				3,832,043				3,866,353				3,829,130
Diluted			3,951,478				3,935,880				3,929,948				3,925,920

 

See accompanying notes to consolidated financial statements. 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

		For the Three Months Ended June 30,								For the Six Months Ended June 30,
		2014				2013				2014				2013
		(In thousands)
Net income		$	2,249				5,533				4,193				9,956
Other comprehensive income (loss), net of tax:
Unrealized gain (loss) on securities			2,271				(4,302	)			4,663				(4,436	)
Tax effect			(817	)			1,549				(1,678	)			1,598
Reclassification adjustment for (gains) losses included in earnings			(164	)			62				(480	)			46
Tax effect			59				(22	)			173				(17	)
Accretion of unrealized losses on held-to-maturity securities previously recognized in other comprehensive income			49				49				98				98
Tax effect			(18	)			(18	)			(36	)			(36	)
Other comprehensive income (loss), net of tax			1,380				(2,682	)			2,740				(2,747	)
Comprehensive income		$	3,629				2,851				6,933				7,209

                     

See accompanying notes to consolidated financial statements.                    

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(Unaudited)

 

																		Accumulated
										Additional								Other
		Common Stock								Paid-in				Retained				Comprehensive
		Shares				Amount				Capital				Earnings				Income (Loss)				Total
		(In thousands, except share data)
Balance, December 31, 2012			3,837,984			$	39				22,048				45,752				(325	)			67,514
Stock awards			164,900				1				(1	)			—				—				—
Stock-based compensation expense, net			—				—				97				—				—				97
Net income			—				—				—				9,956				—				9,956
Other comprehensive loss, net of tax			—				—				—				—				(2,747	)			(2,747	)
Balance, June 30, 2013			4,002,884			$	40				22,144				55,708				(3,072	)			74,820
Balance, December 31, 2013			4,015,204			$	40				22,393				62,169				(2,375	)			82,227
Stock awards			21,936				—				132				—				—				132
Stock options exercised			4,320				—				44				—				—				44
Excess tax benefit in connection with equity awards			—				—				126				—				—				126
Stock-based compensation expense, net			—				—				226				—				—				226
Net income			—				—				—				4,193				—				4,193
Dividends declared to stockholders			—				—				—				(411	)			—				(411	)
Other comprehensive income, net of tax			—				—				—				—				2,740				2,740
Balance, June 30, 2014			4,041,460			$	40				22,921				65,951				365				89,277

 

See accompanying notes to consolidated financial statements.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

		For the Six Months Ended June 30,
		2014				2013
		(In thousands)
Cash flows from operating activities:
Net income		$	4,193				9,956
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Provision for loan losses			—				(700	)
Deferred tax expense			224				901
Amortization of unearned discount/premiums on investments, net			1,121				1,283
Amortization of deferred loan fees			(1,284	)			(2,658	)
Amortization of mortgage servicing rights			913				1,331
(Gain) loss on sale of available-for-sale securities, net			(480	)			46
Gain on sale of loans held for sale, net			(5,880	)			(21,549	)
Originations of loans held for sale			(450,444	)			(993,875	)
Proceeds from sale of loans held for sale			444,676				1,069,837
Loss on extinquishment of debt			31				19
Provision for mortgage loan repurchase losses			(250	)			1,152
Mortgage loan losses paid, net of recoveries			(326	)			(341	)
Fair value adjustments on interest rate swaps			518				(263	)
Stock-based compensation			226				97
Decrease in cash surrender value of bank owned life insurance			54				54
Depreciation			558				452
Gain on disposals of premises and equipment			—				(4	)
Gain on sale of real estate acquired through foreclosure			(92	)			(163	)
Write-down of real estate acquired through foreclosure			289				401
Gain on sale of servicing assets			(775	)			—
Proceeds from the sale of servicing assets			1,575				—
Originations of mortgage servicing assets			(648	)			(4,780	)
Decrease (increase) in:
Accrued interest receivable			(257	)			491
Income taxes receivable			(509	)			—
Prepaid FDIC insurance			—				2,035
Other assets			2,021				3,163
Increase (decrease) in:
Accrued interest payable			14				273
Income taxes payable			(698	)			(3,123	)
Dividends payable to stockholders			202				—
Accrued expenses and other liabilities			(1,859	)			1,416
Cash flows (used in) provided by operating activities			(6,887	)			65,451

 

Continued

		For the Six Months
		Ended June 30,
		2014				2013
		(In thousands)
Cash flows from investing activities:
Activity in available-for-sale securities:
Purchases		$	(82,376	)			(96,319	)
Maturities, payments and calls			17,708				29,375
Proceeds from sales			28,561				45,842
Activity in held-to-maturity securities:
Maturities, payments and calls			316				(42	)
Increase in other investments			(86	)			(38	)
(Increase) decrease in Federal Home Loan Bank stock			(627	)			2,760
Increase in loans receivable, net			(70,022	)			(2,035	)
Purchase of premises and equipment			(1,640	)			(219	)
Proceeds from disposals of premises and equipment			—				5
Proceeds from sale of real estate acquired through foreclosure			1,653				1,357
Purchase of bank owned life insurance			(372	)			(20,053	)
Distribution of bank owned life insurance			—				91
Cash flows used in investing activities			(106,885	)			(39,276	)
Cash flows from financing activities:
Net increase in deposit accounts			81,955				38,314
Net increase (decrease) in Federal Home Loan Bank advances			19,969				(56,420	)
Net decrease in other short-term borrowed funds			—				(100	)
Principal repayment of subordinated debt			(150	)			(150	)
Net decrease in drafts outstanding			(159	)			(328	)
Net increase in advances from borrowers for insurance and taxes			425				26
Cash dividends paid on common stock			(411	)			—
Net increase in excess tax benefit in connection with equity awards			126
Proceeds from exercise of stock options			44				—
Cash flows provided by (used in) financing activities			101,799				(18,658	)
Net (decrease) increase in cash and cash equivalents			(11,973	)			7,517
Cash and cash equivalents, beginning of period			38,665				17,839
Cash and cash equivalents, end of period		$	26,692				25,356
Supplemental disclosure:
Cash paid for:
Interest on deposits and borrowed funds		$	2,738				2,697
Income taxes paid, net of (refunds)			2,917				8,250
Noncash investing and financing activities:
Transfer of loans receivable to real estate acquired through foreclosure		$	1,232				3,189

 

See accompanying notes to consolidated financial statements.

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Organization

Carolina Financial Corporation (“Carolina Financial” or the “Company”), incorporated under the laws of the State of Delaware, is a bank holding company with two wholly-owned subsidiaries, CresCom Bank (the “Bank”) and Carolina Services Corporation of Charleston (“Carolina Services”). The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, the Bank and Carolina Services. In consolidation, all material intercompany accounts and transactions have been eliminated. The results of operations of the businesses acquired in transactions accounted for as purchases are included only from the dates of acquisition. All majority-owned subsidiaries are consolidated unless control is temporary or does not rest with the Company.

At June 30, 2014 and December 31, 2013, statutory business trusts (“Trusts”) created by the Company had outstanding trust preferred securities with an aggregate par value of $15,000,000. The principal assets of the Trusts are $15,465,000 of the Company’s subordinated debentures with identical rates of interest and maturities as the trust preferred securities. The Trusts have issued $465,000 of common securities to the Company and are included in other investments in the accompanying consolidated balance sheets. The Trusts are not consolidated subsidiaries of the Company.

Basis of Presentation

The accompanying unaudited consolidated financial statements and notes have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information or footnotes necessary for a complete presentation of financial position, results of operations and cash flows in conformity with GAAP. Because the accompanying unaudited consolidated financial statements do not include all of the information and footnotes required by GAAP, they should be read in conjunction with the Company’s audited consolidated financial statements and accompanying footnotes included in the Company’s Registration Statement on Form 10, as amended (File No. 000-19029) (the “Form 10”) filed with the Securities and Exchange Commission (“SEC”) on April 1, 2014. There have been no significant changes to the accounting policies as disclosed in the Company’s Form 10.

In management’s opinion, the accompanying unaudited consolidated financial statements reflect all normal, recurring adjustments necessary to present fairly the financial position of the Company as of June 30, 2014 and December 31, 2013, and the results of its operations and cash flows for the three-months and six-months ended June 30, 2014 and 2013. Operating results for the three-month and six-month periods ended June 30, 2014 are not necessarily indicative of the results that may be expected for the year or for other interim periods.

Management’s Estimates

The financial statements are prepared in accordance with GAAP in the United States of America, which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, including valuation for impaired loans, the valuation of real estate acquired in connection with foreclosure or in satisfaction of loans, the valuation of securities, the valuation of derivative instruments, the valuation of mortgage servicing rights, the determination of the reserve for mortgage loan repurchase losses, asserted and unasserted legal claims and deferred tax assets or liabilities. In connection with the determination of the allowance for loan losses and foreclosed real estate, management obtains independent appraisals for significant properties. Management must also make estimates in determining the estimated useful lives and methods for depreciating premises and equipment.

Management uses available information to recognize losses on loans and foreclosed real estate. However, future additions to the allowance may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses and foreclosed real estate. Such agencies may require the Bank to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the allowance for loan losses and valuation of foreclosed real estate may change materially in the near term.

Earnings Per Share

Basic earnings per share (“EPS”) represents income available to common stockholders divided by the weighted-average number of shares outstanding during the period. Diluted earnings per share reflects additional shares that would have been outstanding if dilutive potential shares had been issued. Potential shares that may be issued by the Company relate solely to outstanding stock options, restricted stock (non-vested shares), and warrants, and are determined using the treasury stock method. Under the treasury stock method, the number of incremental shares is determined by assuming the issuance of stock for the outstanding stock options and warrants, reduced by the number of shares assumed to be repurchased from the issuance proceeds, using the average market price for the period of the Company’s stock. Weighted-average shares for the basic and diluted EPS calculations have been reduced by the average number of unvested restricted shares.

On January 15, 2014, the Board of Directors of the Company declared a two-for-one stock split to stockholders of record dated February 10, 2014, payable on February 28, 2014. As such, all share, earnings per share, and per share data have been retroactively adjusted to reflect this stock split for all periods presented in accordance with GAAP.

Subsequent Events

Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. Non-recognized subsequent events are events that provide evidence about conditions that did not exist at the date of the statement of financial condition but arose after that date. Management has reviewed events occurring through the date the financial statements were issued and no subsequent events occurred requiring accrual or disclosure other than as disclosed in Note 10 regarding the Bank’s entry into an agreement on August 6, 2014 to purchase 13 branches in South Carolina and southeastern North Carolina.

Reclassification

Certain reclassifications of accounts reported for previous periods have been made in these consolidated financial statements. Such reclassifications had no effect on stockholders’ equity or the net income as previously reported.

Recently Issued Accounting Pronouncements

The Balance Sheet topic of the Accounting Standards Codification (the “ASC”) was amended in December 2011 for companies with financial instruments and derivative instruments that offset or are subject to a master netting agreement. The amendments require disclosure of both gross information and net information about instruments and transactions eligible for offset or subject to an agreement similar to a master netting agreement. The amendments were effective for reporting periods beginning on or after January 1, 2013 and required retrospective presentation for all comparative periods presented. Additionally, in January 2013 the Financial Accounting Standards Board (the “FASB”) clarified that the amendments apply only to derivatives, repurchase agreements and reverse purchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with specific criteria contained in GAAP or subject to a master netting arrangement or similar agreement. These amendments did not have a material effect on the Company’s financial statements.

The FASB amended the Comprehensive Income topic of the ASC in February 2013. The amendments address reporting of amounts reclassified out of accumulated other comprehensive income. Specifically, the amendments do not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the amendments do require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, in certain circumstances an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income. The amendments were effective for the Company on a prospective basis for reporting periods beginning after December 15, 2013. These amendments did not have a material effect on the Company’s financial statements.

In February 2013, the FASB also amended the Financial Instruments topic of the ASC to address the scope and applicability of certain disclosures to nonpublic companies. The amendments clarify that the requirement to disclose “the level of the fair value hierarchy within the fair value measurements are categorized in their entirety (Level 1, 2, or 3)” does not apply to nonpublic entities for items that are not measured at fair value in the statement of financial position but for which fair value is disclosed. The Company does not expect these amendments to have a material effect on its financial statements.

In April 2013, the FASB issued guidance addressing application of the liquidation basis of accounting. The guidance is intended to clarify when an entity should apply the liquidation basis of accounting. In addition, the guidance provides principles for the recognition and measurement of assets and liabilities and requirements for financial statements prepared using the liquidation basis of accounting. The amendments will be effective for entities that determine liquidation is imminent during annual reporting periods beginning after December 15, 2013, and interim reporting periods therein, and those requirements should be applied prospectively from the day that liquidation becomes imminent. Early adoption is permitted. These amendments did not have any effect on the Company’s financial statements.

In December 2013, the FASB amended the Master Glossary of the FASB Codification to define “Public Business Entity” to minimize the inconsistency and complexity of having multiple definitions of, or a diversity in practice as to what constitutes, a nonpublic entity and public entity within U.S. GAAP. The amendment does not affect existing requirements, however it will be used by the FASB, the Private Company Council (“PCC”), and the Emerging Issues Task Force (“EITF”) in specifying the scope of future financial accounting and reporting guidance. This amendment does not have any effect on the Company’s financial statements.

In January 2014, the FASB amended Receivables topic of the Accounting Standards Codification. The amendments are intended to resolve diversity in practice with respect to when a creditor should reclassify a collateralized consumer mortgage loan to other real estate owned (OREO). In addition, the amendments require a creditor to reclassify a collateralized consumer mortgage loan to OREO upon obtaining legal title to the real estate collateral, or the borrower voluntarily conveying all interest in the real estate property to the lender to satisfy the loan through a deed in lieu of foreclosure or similar legal agreement. The amendments will be effective for the Company for annual periods, and interim periods within those annual periods beginning after December 15, 2014, with early implementation of the guidance permitted. In implementing this guidance, assets that are reclassified from real estate to loans are measured at the carrying value of the real estate at the date of adoption. Assets reclassified from loans to real estate are measured at the lower of the net amount of the loan receivable or the fair value of the real estate less costs to sell at the date of adoption. The Company will apply the amendments prospectively. The Company does not expect these amendments to have a material effect on its financial statements.

In May 2014, the FASB issued guidance to change the recognition of revenue from contracts with customers. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. The guidance will be effective for the Company for reporting periods beginning after December 15, 2016. The Company will apply the guidance using a full retrospective approach. The Company does not expect these amendments to have a material effect on its financial statements.

In June 2014, the FASB issued guidance which makes limited amendments to the guidance on accounting for certain repurchase agreements. The new guidance (1) requires entities to account for repurchase-to-maturity transactions as secured borrowings (rather than as sales with forward repurchase agreements), (2) eliminates accounting guidance on linked repurchase financing transactions, and (3) expands disclosure requirements related to certain transfers of financial assets that are accounted for as sales and certain transfers (specifically, repos, securities lending transactions, and repurchase-to-maturity transactions) accounted for as secured borrowings. The amendments will be effective for the Company for the first interim or annual period beginning after December 15, 2014. The Company will apply the guidance by making a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption. The Company does not expect these amendments to have a material effect on its financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

NOTE 2 - SECURITIES

The amortized cost, gross unrealized gains, gross unrealized losses and fair value of investments securities available-for-sale and held-to-maturity at June 30, 2014 and December 31, 2013 follows:

		June 30, 2014																December 31, 2013
						Gross				Gross												Gross				Gross
		Amortized				Unrealized				Unrealized				Fair				Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				Losses				Value				Cost				Gains				Losses				Value
		(In thousands)
Securities available-for-sale:
Municipal securities		$	35,256				1,071				(230	)			36,097				39,790				99				(1,390	)			38,499
US government agencies			4,944				—				(23	)			4,921				5,199				—				(24	)			5,175
Collateralized loan obligations			9,708				—				(12	)			9,696				—				—				—				—
Mortgage-backed securities:
Agency			101,080				3,101				(39	)			104,142				68,813				1,433				(317	)			69,929
Non-agency			51,582				1,117				(254	)			52,445				53,195				826				(89	)			53,932
Total mortgage-backed securities			152,662				4,218				(293	)			156,587				122,008				2,259				(406	)			123,861
Total		$	202,570				5,289				(558	)			207,301				166,997				2,358				(1,820	)			167,535
Securities held-to-maturity:
Municipal securities		$	15,395				611				(52	)			15,954				15,488				30				(341	)			15,177
Asset-backed securities			8,859				3,066				(1,969	)			9,956				9,066				2,107				(2,803	)			8,370
Total		$	24,254				3,677				(2,021	)			25,910				24,554				2,137				(3,144	)			23,547

The asset-backed securities portfolio is collateralized with trust preferred securities issued by other financial institutions in pooled issuances.

The following table presents unrealized losses related to the trust preferred securities that were recognized within other comprehensive income at the time of transfer to held-to-maturity as well as the unrealized gains and losses that are not presented in other comprehensive income for June 30, 2014 and December 31, 2013.

		At June 30, 2014
														Recognized in OCI												Not Recognized in OCI
														Gross Unrealized												Gross Unrealized
		Purchased Face Value				Cumulative OTTI				Carrying Value				Gains				Losses				Amortized Cost				Gains				Losses				Estimated Fair Value				Collateralization Percentage
Held-to-Maturity:		(In thousands)
Trust Preferred Securities
Total A-Class		$	2,465				—				2,465				—				(572	)			1,893				363				—				2,256				179%-376%
Total B-Class			11,855				(2,635	)			9,221				—				(2,514	)			6,707				1,812				(1,969	)			6,550				94%-105%
Total C-Class			2,708				(1,340	)			1,367				—				(1,108	)			259				891				—				1,150				88%-88%
		$	17,028				(3,975	)			13,053				—				(4,194	)			8,859				3,066				(1,969	)			9,956
		At December 31, 2013
														Recognized in OCI												Not Recognized in OCI
														Gross Unrealized												Gross Unrealized
		Purchased Face Value				Cumulative OTTI				Carrying Value				Gains				Losses				Amortized Cost				Gains				Losses				Estimated Fair Value				Collateralization Percentage
Held-to-Maturity:		(In thousands)
Trust Preferred Securities
Total A-Class		$	2,841				—				2,841				—				(586	)			2,255				354				(99	)			2,510				164% - 324%
Total B-Class			11,804				(2,635	)			9,169				—				(2,569	)			6,600				1,190				(2,704	)			5,086				94% - 98%
Total C-Class			2,688				(1,340	)			1,348				—				(1,137	)			211				563				—				774				83% - 83%
		$	17,333				(3,975	)			13,358				—				(4,292	)			9,066				2,107				(2,803	)			8,370

The pooled trust preferred securities consisted of positions in seven different securities. The underlying issuers in the pools were primarily financial institutions and to a lesser extent, insurance companies and real estate investment trusts. The Company owns both senior and mezzanine tranches in pooled trust preferred securities; however, the Company does not own any income notes. The senior and mezzanine tranches of trust preferred collateralized debt obligations generally have some protection from defaults in the form of over-collateralization and excess spread revenues, along with waterfall structures that redirect cash flows in the event certain coverage test requirements are failed. Generally, senior tranches have the greatest protection, with mezzanine tranches subordinated to the senior tranches, and income notes subordinated to the mezzanine tranches. Unrealized losses recognized in other comprehensive income relate to unrealized losses at the time of transfer from available-for-sale to held-to-maturity and are accreted in accordance with GAAP.

As of June 30, 2014, $1.0 million of the pooled trust preferred securities were investment grade, $1.0 million were split-rated, and $6.9 million were below investment grade. As of December 31, 2013, $1.3 million of the pooled trust preferred securities were investment grade, $1.0 million were split-rated, and $6.8 million were below investment grade. In terms of risk-based capital calculation, the Company allocates additional risk-based capital to the below investment grade securities.

As of June 30, 2014, senior tranches represent $1.9 million of the Company’s pooled securities, while mezzanine tranches represented $7.0 million. All of the $7.0 million in mezzanine tranches are still subordinate to senior tranches as the senior notes have not been paid to a zero balance. As of December 31, 2013, senior tranches represent $2.3 million of the Company’s

pooled securities, while mezzanine tranches represented $6.8 million. All of the $6.8 million in mezzanine tranches are still subordinate to senior tranches as the senior notes have not been paid to a zero balance.

The amortized cost and fair value of debt securities by contractual maturity at June 30, 2014 follows:

		At June 30, 2014
		Amortized				Fair
		Cost				Value
		(In thousands)
Securities available-for-sale:
Less than one year		$	—				—
One to five years			—				—
Five to ten years			17,753				17,760
After ten years			184,817				189,541
Total		$	202,570				207,301
Securities held-to-maturity:
Less than one year		$	—				—
One to five years			970				989
Five to ten years			4,480				4,455
After ten years			18,804				20,466
Total		$	24,254				25,910

The contractual maturity dates of the securities were used for mortgage-backed securities and asset-backed securities. No estimates were made to anticipate principal repayments.

The following table summarizes the gross realized gains and losses from sales of investment securities available-for-sale for the periods indicated.

		For the Three Months								For the Six Months
		Ended June 30,								Ended June 30,
		2014				2013				2014				2013
		(In thousands)
Proceeds		$	18,753				40,104				28,561				45,842
Realized gains			204				360				520				376
Realized losses			(40	)			(422	)			(40	)			(422	)
Total investment securities gains, net		$	164				(62	)			480				(46	)

 

At June 30, 2014, the Company had pledged $11.3 million of securities for Federal Home Loan Bank (“FHLB”) advances.

The gross unrealized losses and fair value of the Company’s investments available-for-sale with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2014 are as follows:

		At June 30, 2014
		Less than 12 Months												12 Months or Greater												Total
		Amortized				Fair				Unrealized				Amortized				Fair				Unrealized				Amortized				Fair				Unrealized
		Cost				Value				Losses				Cost				Value				Losses				Cost				Value				Losses
		(In thousands)
Available-for-sale:
Municipal securities		$	10,513				10,353				(160	)			4,208				4,138				(70	)			14,721				14,491				(230	)
US government agencies			4,944				4,921				(23	)			—				—				—				4,944				4,921				(23	)
Collateralized loan obligations			4,708				4,696				(12	)			—				—				—				4,708				4,696				(12	)
Mortgage-backed securities:
Agency			3,639				3,600				(39	)			—				—				—				3,639				3,600				(39	)
Non-agency			9,239				8,998				(241	)			1,676				1,663				(13	)			10,915				10,661				(254	)
Total mortgage-backed securities			12,878				12,598				(280	)			1,676				1,663				(13	)			14,554				14,261				(293	)
Total		$	33,043				32,568				(475	)			5,884				5,801				(83	)			38,927				38,369				(558	)
Held-to-maturity:
Municipal securities		$	—				—				—				3,349				3,297				(52	)			3,349				3,297				(52	)
Asset-backed securities			—				—				—				6,481				4,512				(1,969	)			6,481				4,512				(1,969	)
Total		$	—				—				—				9,830				7,809				(2,021	)			9,830				7,809				(2,021	)

The gross unrealized losses and fair value of the Company’s investments available-for-sale with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2013 are as follows:

 

		At December 31, 2013
		Less than 12 Months												12 Months or Greater												Total
		Amortized				Fair				Unrealized				Amortized				Fair				Unrealized				Amortized				Fair				Unrealized
		Cost				Value				Losses				Cost				Value				Losses				Cost				Value				Losses
		(In thousands)
Available-for-sale:
Municipal securities		$	27,108				25,917				(1,191	)			3,157				2,958				(199	)			30,265				28,875				(1,390	)
US government agencies			5,199				5,175				(24	)			—				—				—				5,199				5,175				(24	)
Mortgage-backed securities:
Agency			27,140				26,823				(317	)			—				—				—				27,140				26,823				(317	)
Non-agency			15,006				14,951				(55	)			3,660				3,626				(34	)			18,666				18,577				(89	)
Total mortgage-backed securities			42,146				41,774				(372	)			3,660				3,626				(34	)			45,806				45,400				(406	)
Total		$	74,453				72,866				(1,587	)			6,817				6,584				(233	)			81,270				79,450				(1,820	)
Held-to-maturity:
Municipal securities		$	11,945				11,734				(211	)			2,177				2,047				(130	)			14,122				13,781				(341	)
Asset-backed  securities			—				—				—				7,398				4,595				(2,803	)			7,398				4,595				(2,803	)
Total		$	11,945				11,734				(211	)			9,575				6,642				(2,933	)			21,520				18,376				(3,144	)

The Company reviews its investment securities portfolio at least quarterly and more frequently when economic conditions warrant, assessing whether there is any indication of other-than-temporary impairment (“OTTI”). Factors considered in the review include estimated future cash flows, length of time and extent to which market value has been less than cost, the financial condition and near term prospect of the issuer, and our intent and ability to retain the security to allow for an anticipated recovery in market value. If the review determines that there is OTTI, then an impairment loss is recognized in earnings equal to the difference between the investment’s cost and its fair value at the balance sheet date of the reporting period for which the assessment is made, or a portion may be recognized in other comprehensive income. The fair value of investments on which OTTI is recognized then becomes the new cost basis of the investment.

At June 30, 2014 and December 31, 2013, the Company had 28 and 58, respectively, individual investments available-for-sale that were in an unrealized loss position. The unrealized losses on the Company’s investments in US government-sponsored agencies, municipal securities and mortgage-backed securities (agency and non-agency) summarized above were attributable primarily to changes in interest rates. Management has performed various analyses, including cash flows, and determined that no OTTI expense was necessary for the three months ended June 30, 2014.

At June 30, 2014 and December 31, 2013, the Company had four trust preferred securities within the held-to-maturity portfolio that were in an unrealized loss position. The asset-backed securities portfolio is collateralized with trust preferred securities issued by other financial institutions in pooled issuances.

To determine the fair value, cash flow models for trust preferred securities are provided by a third-party pricing service. Impairment testing is performed on a quarterly basis using a detailed cash flow analysis for each security. The major assumptions used during the impairment test are described in the subsequent paragraph.

In 2009, the Company adopted a four year “burst” scenario for its modeled default rates (2010 - 2013) that replicated the default rates for the banking industry from the four peak years of the savings and loan crisis, which then reduced to 0.25% annually. The elevated default rate ended in 2013, and the constant default rate used by the Company is now 0.25% annually. All issuers that were currently in deferral were presumed to be in default. Additionally, all defaults are assumed to have a 15% recovery after two years and 1% of the pool is presumed to prepay annually. If this analysis results in a present value of expected cash flows that is less than the book value of a security (that is, a credit loss exists), an OTTI is considered to have occurred. If there is no credit loss, any impairment is considered temporary. The cash flow analysis we performed used discount rates equal to the credit spread at the time of purchase for each security and then added the current three-month LIBOR forward interest rate curve. Based on the cash flow analysis performed at period end, management believes that there are no additional securities other-than-temporarily impaired at June 30, 2014.

There was no OTTI recognized for the three or six months ended June 30, 2014 or 2013.

The following table presents the cumulative credit related OTTI related to securities held-to-maturity taken as well as the activity at June 30, 2014 and December 31, 2013 for the trust preferred securities.

		At June 30,				At December 31,
		2014				2013
		(In thousands)
Balance at beginning of year		$	3,975				3,975
Additions for credit losses on securities  for which OTTI was not previously recognized			—				—
Additions for additional credit losses on securities for which OTTI was previously recognized			—				—
Balance at end of year		$	3,975				3,975

Management believes that there are no additional securities other-than-temporarily impaired at June 30, 2014. The Company does not intend to sell these securities and it is more likely than not that the Company will not be required to sell these securities before recovery of their amortized cost. Management continues to monitor these securities with a high degree of scrutiny. There can be no assurance that the Company will not conclude in future periods that conditions existing at that time indicate some or all of the securities may be sold or are other-than-temporarily impaired, which would require a charge to earnings in such periods.

NOTE 3 – DERIVATIVES

The derivative positions of the Company at June 30, 2014 and December 31, 2013 are as follows:

		At June 30,								At December 31,
		2014								2013
		Fair				Notional				Fair				Notional
		Value				Value				Value				Value
						(In thousands)
Derivative assets:
Mortgage loan interest rate lock commitments		$	1,672				159,113				—				—
Mortgage loan forward sales commitments			583				25,855				106				20,516
Mortgage-backed securities forward sales commitments			—				—				878				88,000
Interest rate swaps			—				—				428				20,000
		$	2,255				184,968				1,412				128,516
Derivative liabilities:
Mortgage-backed securities forward sales commitments		$	709				139,000				—				—
Mortgage loan interest rate lock commitments			—				—				55				103,614
Interest rate swaps			21				10,000				—				—
		$	730				149,000				55				103,614

The primary uses of derivative instruments are related to the mortgage banking activities of the Company. As such, the Company holds derivative instruments, which consist of rate lock agreements related to expected funding of fixed-rate mortgage loans to customers (interest rate lock commitments) and forward commitments to sell mortgage-backed securities and individual fixed-rate mortgage loans. The Company’s objective in obtaining the forward commitments is to mitigate the interest rate risk associated with the interest rate lock commitments and the mortgage loans that are held for sale. Derivatives related to these commitments are recorded as either a derivative asset or a derivative liability in the balance sheet and are measured at fair value. Both the interest rate lock commitments and the forward commitments are reported at fair value, with adjustments recorded in current period earnings in net gain on sale of loans held for sale within noninterest income in the consolidated statements of operations.

Derivative instruments not related to mortgage banking activities, including financial futures commitments and interest rate swap agreements that do not satisfy the hedge accounting requirements are recorded at fair value and are classified with resultant changes in fair value recorded in current period earnings in fair value adjustments on interest rate swaps within noninterest income in the consolidated statement of operations.

When using derivatives to hedge fair value and cash flow risks, the Company exposes itself to potential credit risk from the counterparty to the hedging instrument. This credit risk is normally a small percentage of the notional amount and fluctuates as interest rates change. The Company analyzes and approves credit risk for all potential derivative counterparties prior to execution of any derivative transaction. The Company seeks to minimize credit risk by dealing with highly rated counterparties and by obtaining collateralization for exposures above certain predetermined limits. If significant counterparty risk is determined, the Company would adjust the fair value of the derivative recorded to consider such risk.

NOTE 4 - LOANS RECEIVABLE, NET

Loans receivable, net at June 30, 2014 and December 31, 2013 are summarized by category as follows:

		At June 30,								At December 31,
		2014								2013
						% of Total								% of Total
		Amount				Loans				Amount				Loans
		(Dollars in thousands)
Loans secured by real estate:
One-to-four family		$	209,878				32.62	%			184,210				32.60	%
Home equity			23,529				3.66	%			23,661				4.19	%
Commercial real estate			264,911				41.18	%			253,035				44.79	%
Construction and development			77,629				12.07	%			67,056				11.87	%
Consumer loans			3,132				0.49	%			3,060				0.54	%
Commercial business loans			64,187				9.98	%			33,938				6.01	%
Total gross loans receivable			643,266				100.00	%			564,960				100.00	%
Less:
Undisbursed loans in process			29,053								21,550
Allowance for loan losses			8,662								8,091
Deferred fees, net			256								98
Total loans receivable, net		$	605,295								535,221

The composition of gross loans outstanding, net of undisbursed amounts, by rate type is as follows:

 

		At June 30,								At December 31,
		2014								2013
		(Dollars in thousands)
Variable rate loans		$	252,110				41.05	%			219,589				40.41	%
Fixed rate loans			362,103				58.95	%			323,821				59.59	%
Total loans outstanding		$	614,213				100.00	%			543,410				100.00	%

The following table presents activity in the allowance for loan losses for the period indicated. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

Allowance for loan losses:		For the Three Months Ended June 30, 2014
		Loans Secured by Real Estate
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Unallocated				Total
		(In thousands)
Balance at April 1, 2014		$	2,568				234				3,271				1,236				29				626				437				8,401
Provision for loan losses			(80	)			(27	)			(98	)			(13	)			(11	)			88				141				—
Charge-offs			(36	)			—				—				—				—				—				—				(36	)
Recoveries			52				—				—				2				10				233				—				297
Balance at June 30, 2014		$	2,504				207				3,173				1,225				28				947				578				8,662

Allowance for loan losses:		For the Three Months Ended June 30, 2013
		Loans Secured by Real Estate
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Unallocated				Total
		(In thousands)
Balance at April 1, 2013		$	3,010				229				3,234				1,823				87				835				420				9,638
Provision for loan losses			(706	)			49				(247	)			(342	)			(18	)			25				539				(700	)
Charge-offs			(48	)			(28	)			(110	)			(248	)			(1	)			(336	)			—				(771	)
Recoveries			18				—				21				72				8				117				—				236
Balance at June 30, 2013		$	2,274				250				2,898				1,305				76				641				959				8,403
Allowance for loan losses:		For the Six Months Ended June 30, 2014
		Loans Secured by Real Estate
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Unallocated				Total
		(In thousands)
Balance at January 1, 2014		$	2,472				231				2,855				1,418				42				339				734				8,091
Provision for loan losses			34				(24	)			346				(352	)			(51	)			203				(156	)			—
Charge-offs			(73	)			—				(28	)			(170	)			(13	)			—				—				(284	)
Recoveries			71				—				—				329				50				405				—				855
Balance at June 30, 2014		$	2,504				207				3,173				1,225				28				947				578				8,662
		For the Six Months Ended June 30, 2013
		Loans Secured by Real Estate
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Unallocated				Total
		(In thousands)
Balance at January 1, 2013		$	3,193				276				3,315				1,792				82				862				—				9,520
Provision for loan losses			(971	)			2				(380	)			(256	)			(4	)			(50	)			959				(700	)
Charge-offs			(81	)			(28	)			(110	)			(310	)			(34	)			(336	)			—				(899	)
Recoveries			133				—				73				79				32				165				—				482
Balance at June 30, 2013		$	2,274				250				2,898				1,305				76				641				959				8,403

The following table disaggregates our allowance for loan losses and recorded investment in loans by impairment methodology.

		Loans Secured by Real Estate
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Unallocated				Total
		(In thousands)
At June 30, 2014:
Allowance for loan losses ending balances:
Individually evaluated for impairment		$	304				—				30				90				4				3				—				431
Collectively evaluated for impairment			2,200				207				3,143				1,135				24				944				578				8,231
		$	2,504				207				3,173				1,225				28				947				578				8,662
Loans receivable ending balances:
Individually evaluated for impairment		$	6,301				—				16,054				671				24				2,231				—				25,281
Collectively evaluated for impairment			202,878				23,319				239,273				65,596				2,848				55,018				—				588,932
Total loans receivable		$	209,179				23,319				255,327				66,267				2,872				57,249				—				614,213
At December 31, 2013:
Allowance for loan losses ending balances:
Individually evaluated for impairment		$	103				—				55				165				20				6				—				349
Collectively evaluated for impairment			2,369				231				2,800				1,253				22				333				734				7,742
		$	2,472				231				2,855				1,418				42				339				734				8,091
Loans receivable ending balances:
Individually evaluated for impairment		$	6,220				125				17,008				1,493				40				2,560				—				27,446
Collectively evaluated for impairment			177,516				23,217				230,859				58,611				2,775				22,986				—				515,964
Total loans receivable		$	183,736				23,342				247,867				60,104				2,815				25,546				—				543,410

The following table presents impaired loans individually evaluated for impairment in the segmented portfolio categories and the corresponding allowance for loan losses as of June 30, 2014 and December 31, 2013. The recorded investment is defined as the original amount of the loan, net of any deferred costs and fees, less any principal reductions and direct charge-offs. Unpaid principal balance includes amounts previously included in charge-offs.

 

		At June 30, 2014												At December 31, 2013
						Unpaid												Unpaid
		Recorded				Principal				Related				Recorded				Principal				Related
		Investment				Balance				Allowance				Investment				Balance				Allowance
		(In thousands)
With no related allowance recorded:
Loans secured by real estate:
One-to-four family		$	5,162				7,304				—				5,713				7,682				—
Home equity			—				347				—				125				472				—
Commercial real estate			15,789				16,334				—				16,695				17,240				—
Construction and development			404				2,385				—				1,227				3,887				—
Consumer loans			20				546				—				20				404				—
Commercial business loans			2,228				3,804				—				2,554				3,599				—
			23,603				30,720				—				26,334				33,284				—
With an allowance recorded:
Loans secured by real estate:
One-to-four family			1,139				1,139				304				507				607				103
Home equity			—				—				—				—				—				—
Commercial real estate			265				265				30				313				313				55
Construction and development			267				267				90				266				266				165
Consumer loans			4				4				4				20				20				20
Commercial business loans			3				3				3				6				6				6
			1,678				1,678				431				1,112				1,212				349
Total:
Loans secured by real estate:
One-to-four family			6,301				8,443				304				6,220				8,289				103
Home equity			—				347				—				125				472				—
Commercial real estate			16,054				16,599				30				17,008				17,553				55
Construction and development			671				2,652				90				1,493				4,153				165
Consumer loans			24				550				4				40				424				20
Commercial business loans			2,231				3,807				3				2,560				3,605				6
		$	25,281				32,398				431				27,446				34,496				349

The following table presents the average recorded investment and interest income recognized on impaired loans individually evaluated for impairment in the segmented portfolio categories for the three and six months ended June 30, 2014 and 2013.

 

		For the Three Months Ended June 30,																For the Six Months Ended June 30,
		2014								2013								2014								2013
		Average				Interest				Average				Interest				Average				Interest				Average				Interest
		Recorded				Income				Recorded				Income				Recorded				Income				Recorded				Income
		Investment				Recognized				Investment				Recognized				Investment				Recognized				Investment				Recognized
		(In thousands)
With no related allowance recorded:
Loans secured by real estate:
One-to-four family		$	5,302				(9	)			4,724				73				5,431				44				7,253				100
Home equity			—				—				83				1				—				—				83				—
Commercial real estate			16,000				119				15,245				154				16,423				267				19,573				257
Construction and development			405				1				376				1				428				3				2,604				(5	)
Consumer loans			20				(3	)			37				1				22				—				37				—
Commercial business loans			2,264				(25	)			2,238				27				2,372				53				2,810				57
			23,991				83				22,703				257				24,676				367				32,360				409
With an allowance recorded:
Loans secured by real estate:
One-to-four family			841				(3	)			2,590				—				467				2				62				—
Home equity			—				—				—				—				—				—				—				—
Commercial real estate			266				4				4,372				1				269				9				44				—
Construction and development			200				1				2,228				—				100				1				—				—
Consumer loans			5				—				19				—				6				—				19				—
Commercial business loans			4				—				1,248				1				4				—				677				—
			1,316				2				10,457				2				846				12				802				—
Total:
Loans secured by real estate:
One-to-four family			6,143				(12	)			7,314				73				5,898				46				7,315				100
Home equity			—				—				83				1				—				—				83				—
Commercial real estate			16,266				123				19,617				155				16,692				276				19,617				257
Construction and development			605				2				2,604				1				528				4				2,604				(5	)
Consumer loans			25				(3	)			56				1				28				—				56				—
Commercial business loans			2,268				(25	)			3,486				28				2,376				53				3,487				57
		$	25,307				85				33,160				259				25,522				379				33,162				409

The Company was not committed to advance additional funds in connection with impaired loans as of June 30, 2014 and was committed to advance up to $230,000 in additional funds as of December 31, 2013.

A loan is considered past due if the required principal and interest payment has not been received as of the due date. The following schedule is an aging of past due loans receivable by portfolio segment as of June 30, 2014 and December 31, 2013.

 

		At June 30, 2014
		Real estate loans
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Total
		(In thousands)
30-59 days past due		$	2,626				207				265				168				—				—				3,266
60-89 days past due			700				—				191				—				5				—				896
90 days or more past due			4,116				—				4,285				660				4				168				9,233
Total past due			7,442				207				4,741				828				9				168				13,395
Current			201,737				23,112				250,586				65,439				2,863				57,081				600,818
Total loans receivable		$	209,179				23,319				255,327				66,267				2,872				57,249				614,213
		At December 31, 2013
		Real estate loans
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Total
		(In thousands)
30-59 days past due		$	231				—				273				53				—				—				557
60-89 days past due			1,034				—				—				—				—				—				1,034
90 days or more past due			3,440				125				5,074				1,477				7				431				10,554
Total past due			4,705				125				5,347				1,530				7				431				12,145
Current			179,031				23,217				242,520				58,574				2,808				25,115				531,265
Total loans receivable		$	183,736				23,342				247,867				60,104				2,815				25,546				543,410

Loans are generally placed in nonaccrual status when the collection of principal and interest is 90 days or more past due, unless the obligation is both well-secured and in the process of collection. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest payments received while the loan is on nonaccrual are applied to the principal balance. No interest income was recognized on impaired loans subsequent to the nonaccrual status designation. A loan is returned to accrual status when the borrower makes consistent payments according to contractual terms and future payments are reasonably assured. There were no loans past due 90 days or more and still accruing at June 30, 2014 or December 31, 2013.

The following is a schedule of loans receivable, by portfolio segment, on nonaccrual at June 30, 2014 and December 31, 2013.

		At June 30,				At December 31,
		2014				2013
Loans secured by real estate:		(In thousands)
One-to-four family		$	4,270				3,902
Home equity			—				125
Commercial real estate			4,285				5,114
Construction and development			661				1,481
Consumer loans			5				20
Commercial business loans			172				437
		$	9,393				11,079

 

The Company uses several metrics as credit quality indicators of current or potential risks as part of the ongoing monitoring of credit quality of its loan portfolio. The credit quality indicators are periodically reviewed and updated on a case-by-case basis. The Company uses the following definitions for the internal risk rating grades, listed from the least risk to the highest risk.

Pass: These loans range from minimal credit risk to average, however, still acceptable credit risk.

Special mention: A special mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or the institution’s credit position at some future date.

Substandard: A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness, or weaknesses, that may jeopardize the liquidation of the debt. A substandard loan is characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

Doubtful: A doubtful loan has all of the weaknesses inherent in one classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of the currently existing facts, conditions and values, highly questionable and improbable.

 

The Company uses the following definitions in the tables below:

 

Nonperforming: Loans on nonaccrual status plus loans greater than 90 days past due still accruing interest.

Performing: All current loans plus loans less than 90 days past due.

The following is a schedule of the credit quality of loans receivable, by portfolio segment, as of June 30, 2014 and December 31, 2013.

		At June 30, 2014
		Real estate loans
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Total
		(In thousands)
Internal Risk Rating Grades:
Pass		$	204,774				23,319				240,146				65,294				2,867				56,177				592,577
Special Mention			1,046				—				10,631				282				—				900				12,859
Substandard			3,359				—				4,550				691				5				172				8,777
Total loans receivable		$	209,179				23,319				255,327				66,267				2,872				57,249				614,213
Performing		$	204,909				23,319				251,042				65,606				2,867				57,077				604,820
Nonperforming:
90 days or more and still accruing			—				—				—				—				—				—				—
Nonaccrual			4,270				—				4,285				661				5				172				9,393
Total nonperforming			4,270				—				4,285				661				5				172				9,393
Total loans receivable		$	209,179				23,319				255,327				66,267				2,872				57,249				614,213
		At December 31, 2013
		Real estate loans
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Total
		(In thousands)
Internal Risk Rating Grades:
Pass		$	177,878				23,217				231,269				58,563				2,795				24,823				518,545
Special Mention			1,679				—				10,633				295				—				286				12,893
Substandard			4,179				125				5,965				1,246				20				437				11,972
Total loans receivable		$	183,736				23,342				247,867				60,104				2,815				25,546				543,410
Performing		$	179,834				23,217				242,753				58,623				2,795				25,109				532,331
Nonperforming:
90 days or more and still accruing			—				—				—				—				—				—				—
Nonaccrual			3,902				125				5,114				1,481				20				437				11,079
Total nonperforming			3,902				125				5,114				1,481				20				437				11,079
Total loans receivable		$	183,736				23,342				247,867				60,104				2,815				25,546				543,410

 

Troubled Debt Restructurings

 

At June 30, 2014, there were $22.0 million in loans designated as troubled debt restructurings of which $15.5 million were accruing. At December 31, 2013, there were $23.7 million in loans designated as troubled debt restructurings of which $16.4 million were accruing.

 

There were no loans designated as troubled debt restructings during the three or six months ended June 30, 2014 or 2013. No loans previously restructured in the twelve months prior to June 30, 2014 and 2013 went into default during the period ended June 30, 2014 and 2013.

 

The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

NOTE 5 – REAL ESTATE ACQUIRED THROUGH FORECLOSURE

The following presents summarized activity in other real estate owned for the periods ended June 30, 2014 and December 31, 2013:

		At June 30,				At December 31,
		2014				2013
		(In thousands)
Balance at beginning of period		$	6,273				6,284
Additions			1,232				4,140
Sales			(1,561	)			(3,302	)
Write downs			(289	)			(849	)
Balance at end of period		$	5,655				6,273

 

A summary of the composition of real estate acquired through foreclosure follows:

 

		At June 30,				At December 31,
		2014				2013
		(In thousands)
Real estate loans:
One-to-four family		$	521				959
Commercial real estate			1,498				1,781
Construction and development			3,636				3,533
		$	5,655				6,273

NOTE 6 - DEPOSITS

Deposits outstanding by type of account at June 30, 2014 and December 31, 2013 are summarized as follows:

		At June 30,				At December 31,
		2014				2013
		(In thousands)
Noninterest-bearing demand accounts		$	102,376				83,500
Interest-bearing demand accounts			128,431				92,067
Savings accounts			24,757				17,816
Money market accounts			208,658				220,915
Certificates of deposit:
Less than $100,000			211,277				195,239
$100,000 or more			104,037				88,044
Total certificates of deposit			315,314				283,283
Total deposits		$	779,536				697,581

The aggregate amount of brokered certificates of deposit was $83.0 million and $61.8 million at June 30, 2014 and December 31, 2013, respectively. Brokered certificates of deposit are included in the table above under certificates of deposit less than $100,000. The aggregate amount of institutional certificates of deposit was $47.0 million and $40.0 million at June 30, 2014 and December 31, 2013, respectively.

The following table summarizes the interest expense recorded on certificate of deposits greater than $100,000 for the periods indicated.

 

		For the Three Months								For the Six Months
		Ended June 30,								Ended June 30,
		2014				2013				2014				2013
		(In thousands)
Certificates of deposit:
$100,000 or more		$	216				170				395				328

NOTE 7 – ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS

Current accounting literature requires disclosures about the fair value of all financial instruments whether or not recognized in the balance sheet, for which it is practicable to estimate the value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized through immediate settlement of the instrument. Certain items are specifically excluded from disclosure requirements, including the Company’s stock, premises and equipment, accrued interest receivable and payable and other assets and liabilities.

The fair value of a financial instrument is an amount at which the asset or obligation could be exchanged in a current transaction between willing parties, other than in a forced sale. Fair values are estimated at a specific point in time based on relevant market information and information about the financial instruments. Because no market value exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors.

The Company has used management’s best estimate of fair value based on the above assumptions. Thus the fair values presented may not be the amounts that could be realized in an immediate sale or settlement of the instrument. In addition, any income taxes or other expenses that would be incurred in an actual sale or settlement are not taken into consideration in the fair values presented.

The Company determines the fair value of its financial instruments based on the fair value hierarchy established under ASC 820-10, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the financial instrument’s fair value measurement in its entirety. There are three levels of inputs that may be used to measure fair value. The three levels of inputs of the valuation hierarchy are defined below:

Level 1	Quoted prices (unadjusted) in active markets for identical assets and liabilities for the instrument or security to be valued. Level 1 assets include marketable equity securities as well as U.S. Treasury securities that are highly liquid and are actively traded in over-the-counter markets.
Level 2	Observable inputs other than Level 1 quoted prices, such as quoted prices for similar assets and liabilities in active markets, quoted prices in markets that are not active, or model-based valuation techniques for which all significant assumptions are derived principally from or corroborated by observable market data. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and derivative contracts whose value is determined by using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. U.S. Government sponsored agency securities, mortgage-backed securities issued by U.S. Government sponsored enterprises and agencies, obligations of states and municipalities, collateralized mortgage obligations issued by U.S. Government sponsored enterprises, and mortgage loans held-for-sale are generally included in this category. Certain private equity investments that invest in publicly traded companies are also considered Level 2 assets.

 

Level 3

Unobservable inputs that are supported by little, if any, market activity for the asset or liability. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow models and similar techniques, and may also include the use of market prices of assets or liabilities that are not directly comparable to the subject asset or liability. These methods of valuation may result in a significant portion of the fair value being derived from unobservable assumptions that reflect The Company’s own estimates for assumptions that market participants would use in pricing the asset or liability. This category primarily includes collateral-dependent impaired loans, other real estate, certain equity investments, and certain private equity investments.

Cash and due from banks - The carrying amounts of these financial instruments approximate fair value. All mature within 90 days and present no anticipated credit concerns.

Interest-bearing cash - The carrying amounts of these financial instruments approximate fair value.

Securities available-for-sale and securities held-to-maturity – Fair values for investment securities available-for-sale and securities held to maturity are based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.

FHLB stock and other non-marketable equity securities - The carrying amounts of these financial instruments approximate fair value.

Mortgage loans held for sale – Mortgage loans held for sale are recorded at either fair value, if elected, or the lower of cost or fair value on an individual loan basis. Origination fees and costs for loans held for sale recorded at lower of cost or market are capitalized in the basis of the loan and are included in the calculation of realized gains and losses upon sale. Origination fees and costs are recognized in earnings at the time of origination for loans held for sale that are recorded at fair value. Fair value is derived from observable current market prices, when available, and includes loan servicing value. When observable market prices are not available, the Company uses judgment and estimates fair value using internal models, in which the Company uses its best estimates of assumptions it believes would be used by market participants in estimating fair value. Mortgage loans held for sale are classified within Level 2 of the valuation hierarchy.

Loans receivable - For variable rate loans that reprice frequently and have no significant change in credit risk, estimated fair values are based on carrying values and are classified as Level 2. Estimated fair values for certain mortgage loans, credit card loans, and other consumer loans are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics and are classified as Level 2. Estimated fair values for commercial real estate and commercial loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality and are classified as Level 2. Estimated fair values on impaired loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable. Impaired loans not requiring a specific charge against the allowance represent loans for which the fair value of the expected repayments or collateral meet or exceed the recorded investment in the loan. Loans which are deemed to be impaired are primarily valued on a nonrecurring basis at the fair value of the underlying real estate collateral. Such fair values are obtained using independent appraisals, which the Company considers to be Level 3 inputs.

Mortgage servicing rights - The Company initially measures servicing assets and liabilities retained related to the sale of residential loans held for sale (“mortgage servicing rights”) at fair value, if practicable. For subsequent measurement purposes, the Company measures servicing assets and liabilities based on the lower of cost or market.

Deposits - The estimated fair value of demand deposits, savings accounts, and money market accounts is the amount payable on demand at the reporting date. The estimated fair value of fixed maturity certificates of deposits is estimated by discounting the future cash flows using rates currently offered for deposits of similar remaining maturities.

Bank-owned life insurance - The cash surrender value of bank owned life insurance policies held by the Bank approximates fair values of the policies.

 

Short-term borrowed funds - The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within 90 days approximate their fair values. Estimated fair values of other short-term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

 

Long-term debt - The estimated fair values of the Company’s long-term debt are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Derivative asset and liabilities – The primary use of derivative instruments are related to the mortgage banking activities of the Company. The Company’s wholesale mortgage banking subsidiary enters into interest rate lock commitments related to expected funding of residential mortgage loans at specified times in the future. Interest rate lock commitments that relate to the origination of mortgage loans that will be held-for-sale are considered derivative instruments under applicable accounting guidance. As such, the Company records its interest rate lock commitments and forward loan sales commitments at fair value, determined as the amount that would be required to settle each of these derivative financial instruments at the balance sheet date. In the normal course of business, the mortgage subsidiary enters into contractual interest rate lock commitments to extend credit, if approved, at a fixed interest rate and with fixed expiration dates. The commitments become effective when the borrowers “lock-in” a specified interest rate within the time frames established by the mortgage banking subsidiary. Market risk arises if interest rates move adversely between the time of the interest rate lock by the borrower and the sale date of the loan to an investor. To mitigate the effect of the interest rate risk inherent in providing interest rate lock commitments to borrowers, the mortgage banking subsidiary enters into best efforts forward sales contracts with third party investors. The forward sales contracts lock in a price for the sale of loans similar to the specific interest rate lock commitments. Both the interest rate lock commitments to the borrowers and the forward sales contracts to the investors that extend through to the date the loan may close are derivatives, and accordingly, are marked to fair value through earnings. In estimating the fair value of an interest rate lock commitment, the Company assigns a probability to the interest rate lock commitment based on an expectation that it will be exercised and the loan will be funded. The fair value of the interest rate lock commitment is derived from the fair value of related mortgage loans, which is based on observable market data and includes the expected net future cash flows related to servicing of the loans. The fair value of the interest rate lock commitment is also derived from inputs that include guarantee fees negotiated with the agencies and private investors, buy-up and buy-down values provided by the agencies and private investors, and interest rate spreads for the difference between retail and wholesale mortgage rates. Management also applies fall-out ratio assumptions for those interest rate lock commitments for which we do not close a mortgage loan. The fall-out ratio assumptions are based on the mortgage subsidiary’s historical experience, conversion ratios for similar loan commitments, and market conditions. While fall-out tendencies are not exact predictions of which loans will or will not close, historical performance review of loan-level data provides the basis for determining the appropriate fall out ratios. In addition, on a periodic basis, the mortgage banking subsidiary performs analysis of actual rate lock fall-out experience to determine the sensitivity of the mortgage pipeline to interest rate changes from the date of the commitment through loan origination, and then period end, using applicable published mortgage-backed investment security prices. The expected fall-out ratios (or conversely the “pull-through” percentages) are applied to the determined fair value of the unclosed mortgage pipeline in accordance with GAAP. Changes to the fair value of interest rate lock commitments are recognized based on interest rate changes, changes in the probability that the commitment will be exercised, and the passage of time. The fair value of the forward sales contracts to investors considers the market price movement of the same type of security between the trade date and the balance sheet date. These instruments are defined as Level 2 within the valuation hierarchy.

Derivative instruments not related to mortgage banking activities, including financial futures commitments and interest rate swap agreements that do not satisfy the hedge accounting requirements are recorded at fair value and are classified with resultant changes in fair value being recognized in noninterest income in the consolidated statement of operations. Fair values for these instruments are based on quoted market prices, when available. As such, the fair value adjustments for derivatives with fair values based on quoted market prices are recurring Level 1.

Commitments to extend credit – The carrying amounts of these commitments are considered to be a reasonable estimate of fair value because the commitments underlying interest rates are based upon current market rates.

Off-balance sheet financial instruments – Contract values and fair values for off-balance sheet, credit-related financial instruments are based on estimated fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and counterparties’ credit standing.

The carrying amount and estimated fair value of the Company’s financial instruments at June 30, 2014 and December 31, 2013 are as follows:

		At June 30, 2014
		Carrying				Fair Value
		Amount				Total				Level 1				Level 2				Level 3
Financial assets:		(In thousands)
Cash and due from banks		$	9,560				9,560				9,560				—				—
Interest-bearing cash			17,132				17,132				17,132				—				—
Securities available-for-sale			207,301				207,301				—				207,301				—
Securities held-to-maturity			24,254				25,910				—				15,954				9,956
Federal Home Loan Bank stock			4,730				4,730				—				—				4,730
Other investments			1,944				1,944				—				—				1,944
Derivative assets			2,255				2,255				—				2,255				—
Loans held for sale			47,859				48,442				—				48,442				—
Loans receivable, net			605,295				620,770				—				595,920				24,850
Mortgage servicing rights			9,843				15,238				—				15,238				—
Cash value life insurance			21,228				21,228				—				21,228				—
Financial liabilities:
Deposits			779,536				778,482				—				778,482				—
Short-term borrowed funds			35,300				35,300				—				35,300				—
Long-term debt			69,390				65,549				—				65,549				—
Derivative liabilities			730				730				21				709				—

 

		At December 31, 2013
		Carrying				Fair Value
		Amount				Total				Level 1				Level 2				Level 3
Financial assets:		(In thousands)
Cash and due from banks		$	4,489				4,489				4,489				—				—
Interest-bearing cash			34,176				34,176				34,176				—				—
Securities available-for-sale			167,535				167,535				—				167,535				—
Securities held-to-maturity			24,554				23,547				—				15,177				8,370
Federal Home Loan Bank stock			4,103				4,103				—				—				4,103
Other investments			1,858				1,858				—				—				1,858
Derivative assets			1,412				1,412				428				984				—
Loans held for sale			36,897				37,041				—				37,041				—
Loans receivable, net			535,221				524,142				—				497,045				27,097
Mortgage servicing rights			10,908				17,718				—				17,718				—
Cash value life insurance			20,910				20,910				—				20,910				—
Financial liabilities:
Deposits			697,581				696,674				—				696,674				—
Short-term borrowed funds			10,300				10,300				—				10,300				—
Long-term debt			74,540				71,462				—				71,462				—
Derivative liabilities			55				55				—				55				—

		At June 30, 2014								At December 31, 2013
		Notional				Estimated				Notional				Estimated
		Amount				Fair Value				Amount				Fair Value
Off-Balance Sheet Financial Instruments:		(In thousands)
Commitments to extend credit		$	46,788				—				38,595				—
Standby letters of credit			720				—				526				—
Derivative assets:
Mortgage loan interest rate lock commitments			159,113				1,672				—				—
Mortgage loan forward sales commitments			25,855				583				20,516				106
Mortgage-backed securities forward sales commitments			—				—				88,000				878
Interest rate swaps			—				—				20,000				428
Derivative liabilities:
Mortgage-backed securities forward sales commitments			139,000				709				—				—
Mortgage loan interest rate lock commitments			—				—				103,614				55
Interest rate swaps			10,000				21				—				—

In determining appropriate levels, the Company performs a detailed analysis of the assets and liabilities that are subject to fair value disclosures. At each reporting period, all assets and liabilities for which the fair value measurement is based on significant unobservable inputs are classified as Level 3.

Following is a description of valuation methodologies used for assets recorded at fair value on a recurring and non-recurring basis.

Investment Securities Available-for-Sale

Measurement is on a recurring basis upon quoted market prices, if available. If quoted market prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for prepayment assumptions, projected credit losses, and liquidity. At June 30, 2014 and December 31, 2013, the Company’s investment securities available-for-sale are recurring Level 2.

Mortgage Loans Held for Sale

Mortgage loans held for sale are recorded at either fair value, if elected, or the lower of cost or fair value on an individual loan basis. Origination fees and costs for loans held for sale recorded at lower of cost or market are capitalized in the basis of the loan and are included in the calculation of realized gains and losses upon sale. Origination fees and costs are recognized in earnings at the time of origination for loans held for sale that are recorded at fair value. Fair value is derived from observable current market prices, when available, and includes loan servicing value. When observable market prices are not available, the Company uses judgment and estimates fair value using internal models, in which the Company uses its best estimates of assumptions it believes would be used by market participants in estimating fair value. Mortgage loans held for sale are classified within Level 2 of the valuation hierarchy.

Derivative Assets and Liabilities

The primary use of derivative instruments is related to the mortgage banking activities of the Company. The Company’s wholesale mortgage banking subsidiary enters into interest rate lock commitments related to expected funding of residential mortgage loans at specified times in the future. Interest rate lock commitments that relate to the origination of mortgage loans that will be held-for-sale are considered derivative instruments under applicable accounting guidance. As such, the Company records its interest rate lock commitments and forward loan sales commitments at fair value, determined as the amount that would be required to settle each of these derivative financial instruments at the balance sheet date. In the normal course of business, the mortgage subsidiary enters into contractual interest rate lock commitments to extend credit, if approved, at a fixed interest rate and with fixed expiration dates. The commitments become effective when the borrowers “lock-in” a specified interest rate within the time frames established by the mortgage banking subsidiary. Market risk arises if interest rates move adversely between the time of the interest rate lock by the borrower and the sale date of the loan to an investor. To mitigate the effect of the interest rate risk inherent in providing interest rate lock commitments to borrowers, the mortgage banking subsidiary enters into best efforts forward sales contracts with third party investors. The forward sales contracts lock in a price for the sale of loans similar to the specific interest rate lock commitments. Both the interest rate lock commitments to the borrowers and the forward sales contracts to the investors that extend through to the date the loan may close are derivatives, and accordingly, are marked to fair value through earnings. In estimating the fair value of an interest rate lock commitment, the Company assigns a probability to the interest rate lock commitment based on an expectation that it will be exercised and the loan will be funded. The fair value of the interest rate lock commitment is derived from the fair value of related mortgage loans, which is based on observable market data and includes the expected net future cash flows related to servicing of the loans. The fair value of the interest rate lock commitment is also derived from inputs that include guarantee fees negotiated with the agencies and private investors, buy-up and buy-down values provided by the agencies and private investors, and interest rate spreads for the difference between retail and wholesale mortgage rates. Management also applies fall-out ratio assumptions for those interest rate lock commitments for which we do not close a mortgage loan. The fall-out ratio assumptions are based on the mortgage subsidiary’s historical experience, conversion ratios for similar loan commitments, and market conditions. While fall-out tendencies are not exact predictions of which loans will or will not close, historical performance review of loan-level data provides the basis for determining the appropriate fall-out ratios. In addition, on a periodic basis, the mortgage banking subsidiary performs analysis of actual rate lock fall-out experience to determine the sensitivity of the mortgage pipeline to interest rate changes from the date of the commitment through loan origination, and then period end, using applicable published mortgage-backed investment security prices. The expected fall-out ratios (or conversely the “pull-through” percentages) are applied to the determined fair value of the unclosed mortgage pipeline in accordance with GAAP. Changes to the fair value of interest rate lock commitments are recognized based on interest rate changes, changes in the probability that the commitment will be exercised, and the passage of time. The fair value of the forward sales contracts to investors considers the market price movement of the same type of security between the trade date and the balance sheet date. These instruments are defined as Level 2 within the valuation hierarchy.

Derivative instruments not related to mortgage banking activities, including financial futures commitments and interest rate swap agreements that do not satisfy the hedge accounting requirements are recorded at fair value and are classified with resultant changes in fair value being recognized in noninterest income in the consolidated statement of operations. Fair values for these instruments are based on quoted market prices, when available. As such, the fair value adjustments for derivatives with fair values based on quoted market prices in an active market are recurring Level 1.

Impaired Loans

Loans that are considered impaired are recorded at fair value on a nonrecurring basis. Once a loan is considered impaired, the fair value is measured using one of several methods, including collateral liquidation value, market value of similar debt and discounted cash flows. Those impaired loans not requiring a specific charge against the allowance represent loans for which the fair value of the expected repayments or collateral meet or exceed the recorded investment in the loan. Loans which are deemed to be impaired are primarily valued on a nonrecurring basis at the fair value of the underlying real estate collateral. Such fair values are obtained using independent appraisals, which the Company considers to be Level 3 inputs.

Other Real Estate Owned (“OREO”)

OREO is carried at the lower of carrying value or fair value on a nonrecurring basis.  Fair value is based upon independent appraisals or management’s estimation of the collateral and is considered a Level 3 measurement.  When the OREO value is based upon a current appraisal or when a current appraisal is not available or there is estimated further impairment, the measurement is considered a Level 3 measurement.

Brokered Deposits

Fair value accounting was elected for a brokered deposit entered into during 2013 as part of the Company’s interest rate risk management. Fair value of the brokered deposit is derived from quoted market prices. If quoted market prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for prepayment assumptions, projected credit losses, and liquidity.

Assets and liabilities measured at fair value on a recurring basis are as follows as of June 30, 2014 and December 31, 2013:

		Quoted market price				Significant other				Significant other
		in active markets				observable inputs				unobservable inputs
		(Level 1)				(Level 2)				(Level 3)
		(In thousands)
June 30, 2014
Available-for-sale investment securities:
Municipal securities		$	—				36,097				—
US government agencies			—				4,921				—
Collateralized loan obligations			—				9,696				—
Mortgage-backed securities:
Agency			—				104,142				—
Non-agency			—				52,445				—
Loans held for sale			—				48,442				—
Derivative assets:
Mortgage loan interest rate lock commitments			—				1,672				—
Mortgage loan forward sales commitments			—				583				—
Brokered deposits			—				4,957				—
Derivative liabilities:
Mortgage-backed securities forward sales commitments			—				709
Interest rate swaps			21				—				—
Total		$	21				263,664				—
December 31, 2013
Available-for-sale investment securities:
Municipal securities		$	—				38,499				—
US government agencies			—				5,175				—
Mortgage-backed securities:
Agency			—				69,929				—
Non-agency			—				53,932				—
Loans held for sale			—				37,041				—
Derivative assets:
Mortgage loan forward sales commitments			—				106				—
Mortgage-backed securities forward sales commitments			—				878				—
Interest rate swaps			428				—				—
Brokered deposits			—				4,948				—
Derivative liabilities:
Mortgage loan interest rate lock commitments			—				55				—
Total		$	428				210,563				—

Assets measured at fair value on a nonrecurring basis are as follows as of June 30, 2014 and December 31, 2013:

		Quoted market price				Significant other				Significant other
		in active markets				observable inputs				unobservable inputs
		(Level 1)				(Level 2)				(Level 3)
		(In thousands)
June 30, 2014
Impaired loans:
Loans secured by real estate:
One-to-four family		$	—				—				5,997
Commercial real estate			—				—				16,024
Construction and development			—				—				581
Consumer loans			—				—				20
Commercial business loans			—				—				2,228
Real estate owned:
One-to-four family			—				—				521
Commercial real estate			—				—				1,498
Construction and development			—				—				3,636
Total		$	—				—				30,505
December 31, 2013
Impaired loans:
Loans secured by real estate:
One-to-four family		$	—				—				6,117
Home equity			—				—				125
Commercial real estate			—				—				16,953
Construction and development			—				—				1,328
Consumer loans			—				—				20
Commercial business loans			—				—				2,554
Real estate owned:
One-to-four family			—				—				959
Commercial real estate			—				—				1,781
Construction and development			—				—				3,533
Total		$	—				—				33,370

 

For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of June 30, 2014 and December 31, 2013, the significant unobservable inputs used in the fair value measurements were as follows:

	June 30, 2014 and December 31, 2013
			Significant		Significant Unobservable
	Valuation Technique		Observable Inputs		Inputs
Impaired Loans	Appraisal Value		Appraisals and or sales of		Appraisals discounted 10% to 20% for
			comparable properties		sales commissions and other holding costs
Real estate owned	Appraisal Value/		Appraisals and or sales of		Appraisals discounted 10% to 20% for
	Comparison Sales/		comparable properties		sales commissions and other holding costs
	Other estimates

NOTE 8 - EARNINGS PER SHARE

Basic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding plus the weighted average number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. Diluted earnings per share include the effects of outstanding stock options and restricted stock issued by the Company, if dilutive. The number of additional shares is calculated by assuming that outstanding stock options were exercised and that the proceeds from such exercises and vesting were used to acquire shares of common stock at the average market price during the reporting period.

As stated in Note 1, on January 15, 2014, the Board of Directors of the Company declared a two-for-one stock split to stockholders of record dated February 10, 2014, payable on February 28, 2014. All share, earnings per share, and per share data have been retroactively adjusted to reflect this stock split for all periods presented in accordance with GAAP.

The following is a summary of the reconciliation of weighted average shares outstanding for the three and six months ended June 30, 2014 and 2013:

		For the Three Months Ended June 30,
		2014								2013
		Basic				Diluted				Basic				Diluted
Weighted average shares outstanding			3,881,115				3,881,115				3,832,043				3,832,043
Effect of dilutive securities			—				70,363				—				103,837
Weighted average shares outstanding			3,881,115				3,951,478				3,832,043				3,935,880

 

		For the Six Months Ended June 30,
		2014								2013
		Basic				Diluted				Basic				Diluted
Weighted average shares outstanding			3,866,353				3,866,353				3,829,130				3,829,130
Effect of dilutive securities			—				63,595				—				96,790
Weighted average shares outstanding			3,866,353				3,929,948				3,829,130				3,925,920

 

NOTE 9 – SUPPLEMENTAL SEGMENT INFORMATION

The Company has three reportable segments: community banking, wholesale mortgage banking (“mortgage banking”) and other. The community banking segment provides traditional banking services offered through CresCom Bank. The mortgage banking segment provides mortgage loan origination and servicing offered through Crescent Mortgage. The other segment provides managerial and operational support to the other business segments through Carolina Services and Carolina Financial.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on net income.

The Company accounts for intersegment revenues and expenses as if the revenue/expense transactions were generated to third parties, that is, at current market prices.

The Company’s reportable segments are strategic business units that offer different products and services. They are managed separately because each segment has different types and levels of credit and interest rate risk.

The following tables present selected financial information for the Company’s reportable business segments for the three months and six months ended June 30, 2014 and 2013:

		Community				Mortgage
For the Three Months Ended June 30, 2014		Banking				Banking				Other				Eliminations				Total
		(In thousands)
Interest income		$	8,429				274				4				36				8,743
Interest expense			1,286				—				135				—				1,421
Net interest income (expense)			7,143				274				(131	)			36				7,322
Provision for loan losses			(10	)			10				—				—				—
Noninterest income from external customers			958				4,482				9				—				5,449
Intersegment noninterest income			—				23				1,510				(1,533	)			—
Noninterest expense			4,267				3,553				1,671				—				9,491
Intersegment noninterest expense			1,270				240				—				(1,510	)			—
Income (loss) before income taxes			2,574				976				(283	)			13				3,280
Income tax expense (benefit)			766				365				(105	)			5				1,031
Net income (loss)		$	1,808				611				(178	)			8				2,249
		Community				Mortgage
For the Three Months Ended June 30, 2013		Banking				Banking				Other				Eliminations				Total
		(In thousands)
Interest income		$	7,874				383				5				19				8,281
Interest expense			1,252				33				186				(3	)			1,468
Net interest income (expense)			6,622				350				(181	)			22				6,813
Provision for loan losses			(700	)			—				—				—				(700	)
Noninterest income from external customers			908				11,877				20				—				12,805
Intersegment noninterest income			25				150				1,453				(1,628	)			—
Noninterest expense			4,035				6,131				1,439				—				11,605
Intersegment noninterest expense			1,213				265				—				(1,478	)			—
Income (loss) before income taxes			3,007				5,981				(147	)			(128	)			8,713
Income tax expense (benefit)			1,053				2,232				(61	)			(44	)			3,180
Net income (loss)		$	1,954				3,749				(86	)			(84	)			5,533

		Community				Mortgage
For the Six Months Ended June 30, 2014		Banking				Banking				Other				Eliminations				Total
		(In thousands)
Interest income		$	16,521				559				8				67				17,155
Interest expense			2,483				—				269				—				2,752
Net interest income (expense)			14,038				559				(261	)			67				14,403
Provision for loan losses			(10	)			10				—				—				—
Noninterest income from external customers			1,873				8,926				19				—				10,818
Intersegment noninterest income			—				95				3,020				(3,115	)			—
Noninterest expense			8,381				7,399				3,318				—				19,098
Intersegment noninterest expense			2,540				480				—				(3,020	)			—
Income (loss) before income taxes			5,000				1,691				(540	)			(28	)			6,123
Income tax expense (benefit)			1,501				639				(199	)			(11	)			1,930
Net income (loss)		$	3,499				1,052				(341	)			(17	)			4,193
		Community				Mortgage
For the Six Months Ended June 30, 2013		Banking				Banking				Other				Eliminations				Total
		(In thousands)
Interest income		$	15,690				776				9				35				16,510
Interest expense			2,527				80				367				(4	)			2,970
Net interest income (expense)			13,163				696				(358	)			39				13,540
Provision for loan losses			(700	)			—				—				—				(700	)
Noninterest income from external customers			1,613				24,532				43				—				26,188
Intersegment noninterest income			67				277				2,906				(3,250	)			—
Noninterest expense			9,428				12,454				2,746				—				24,628
Intersegment noninterest expense			2,426				547				—				(2,973	)			—
Income (loss) before income taxes			3,689				12,504				(155	)			(238	)			15,800
Income tax expense (benefit)			1,329				4,662				(65	)			(82	)			5,844
Net income (loss)		$	2,360				7,842				(90	)			(156	)			9,956

The following tables present selected financial information for the Company’s reportable business segments for June 30, 2014 and December 31, 2013:

		Community				Mortgage
At June 30, 2014		Banking				Banking				Other				Eliminations				Total
		(In thousands)
Assets		$	978,629				66,123				105,836				(162,176	)			988,412
Loans receivable, net			606,732				4,380				—				(5,817	)			605,295
Loans held for sale			3,119				44,740				—				—				47,859
Deposits			780,473				—				—				(937	)			779,536
Borrowed funds			89,226				5,020				15,465				(5,021	)			104,690
		Community				Mortgage
At December 31, 2013		Banking				Banking				Other				Eliminations				Total
		(In thousands)
Assets		$	873,104				61,846				101,497				(154,863	)			881,584
Loans receivable, net			532,616				3,374				—				(769	)			535,221
Loans held for sale			753				36,144				—				—				36,897
Deposits			701,110				—				—				(3,529	)			697,581
Borrowed funds			69,376				—				15,465				(1	)			84,840

NOTE 10 – SUBSEQUENT EVENT

 

On August 6, 2014, the Bank entered into a definitive agreement with First Community Bank, Bluefield, Virginia, to acquire 13 branches with total deposits of approximately $230 million and approximately $67 million in loans. Three of the offices are in South Carolina and operate under the name “People’s Community Bank” and 10 are in southeastern North Carolina. The deposit premium will be approximately 3.11% of deposits acquired. The transaction, which is subject to regulatory approval and other customary conditions, is expected to close in late 2014 or early 2015.

 

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

The following discussion reviews our results of operations for the three and six months ended June 30, 2014 as compared to the three and six months ended June 30, 2013 and assesses our financial condition as of June 30, 2014 as compared to December 31, 2013. You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements and the related notes and the consolidated financial statements and the related notes for the year ended December 31, 2013 included in our Form 10 for that period. Results for the three and six months ended June 30, 2014 are not necessarily indicative of the results for the year ending December 31, 2014 or any future period.

 

Cautionary Warning Regarding Forward-Looking Statements

 

This report, including information included or incorporated by reference in this report, contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may relate to our financial condition, results of operation, plans, objectives, or future performance. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “believe,” “continue,” “assume,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties that could cause our actual results to differ from those anticipated in any forward-looking statements include, but are not limited to, the following:

	●	our ability to maintain appropriate levels of capital and to comply with our capital ratio requirements;
	●	examinations by our regulatory authorities, including the possibility that the regulatory authorities may, among other things, require us to increase our allowance for loan losses or write-down assets or otherwise impose restrictions or conditions on our operations, including, but not limited to, our ability to acquire or be acquired;
	●	changes in economic conditions, either nationally or regionally and especially in our primary service areas, resulting in, among other things, a deterioration in credit quality;
	●	an increase in interest rates, resulting in a decline in our mortgage production and a decrease in the profitability of our mortgage banking operations;
	●	credit losses as a result of declining real estate values, increasing interest rates, increasing unemployment, changes in payment behavior or other factors;
	●	credit losses because our loans are concentrated by loan type, industry segment, borrower type, or location of the borrower or collateral;
	●	changes in the amount of our loan portfolio collateralized by real estate and weaknesses in the South Carolina and national real estate markets;
	●	the rate of delinquencies and amount of loans charged-off;
	●	the adequacy of the level of our allowance for loan losses and the amount of loan loss provisions required in future periods;
	●	the rate of loan growth in recent or future years;
	●	our ability to attract and retain key personnel;
	●	our ability to retain our existing customers, including our deposit relationships;
	●	significant increases in competitive pressure in the banking and financial services industries;
	●	adverse changes in asset quality and resulting credit risk-related losses and expenses;

	●	changes in the interest rate environment which could reduce anticipated or actual margins;
	●	changes in political conditions or the legislative or regulatory environment, including, but not limited to, the Dodd-Frank Wall Street Reform and Consumer Protection Act and regulations adopted thereunder, changes in federal or state tax laws or interpretations thereof by taxing authorities and other governmental initiatives affecting the banking and financial service industries;
	●	inflation;
	●	increased funding costs due to market illiquidity, increased competition for funding, or increased regulatory requirements with regard to funding;
	●	our business continuity plans or data security systems could prove to be inadequate, resulting in a material interruption in, or disruption to, business and a negative impact on results of operations;
	●	changes in deposit flows;
	●	changes in technology;
	●	changes in monetary and tax policies;
	●	changes in accounting policies, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board and the Financial Accounting Standards Board;
	●	loss of consumer confidence and economic disruptions resulting from terrorist activities or other military actions;
	●	our expectations regarding our operating revenues, expenses, effective tax rates and other results of operations;
	●	the general decline in the real estate and lending markets;
	●	our anticipated capital expenditures and our estimates regarding our capital requirements;
	●	our liquidity and working capital requirements;
	●	competitive pressures among depository and other financial institutions;
	●	the growth rates of the markets in which we compete;
	●	our anticipated strategies for growth and sources of new operating revenues;
	●	our current and future products, services, applications and functionality and plans to promote them;
	●	our ability to retain and hire necessary employees and to staff our operations appropriately;
	●	management compensation and the methodology for its determination;
	●	our ability to compete in our industry and innovation by our competitors;
	●	our ability to stay abreast of new or modified laws and regulations that currently apply or become applicable to our business;
	●	increased cybersecurity risk, including potential business disruptions or financial losses; and
	●	estimates and estimate methodologies used in preparing our consolidated financial statements and determining option exercise prices.

 

If any of these risks or uncertainties materialize, or if any of the assumptions underlying such forward-looking statements proves to be incorrect, our results could differ materially from those expressed, implied or projected by us in such forward-looking statements. For information with respect to factors that could cause actual results to differ from the expectations stated in the forward-looking statements, see “Risk Factors” under Part I, Item 1A of the Form 10. We urge investors to consider all of these factors carefully in evaluating the forward-looking statements contained in this Quarterly Report on Form 10-Q. We make these forward-looking statements as of the date of this document and we do not intend, and assume no obligation, to update the forward-looking statements or to update the reasons why actual results could differ from those expressed, implied or projected by us in the forward-looking statements.

Overview

 

Carolina Financial Corporation is a Delaware corporation and bank holding company that was incorporated in 1996 and began operations in 1997. It operates principally through CresCom Bank, a South Carolina state-chartered bank. Unless the context indicates otherwise, all references in this report to “we,” “us,” and “our” refer to Carolina Financial Corporation and our wholly owned subsidiary, CresCom Bank, except that in the discussion of our capital stock and related matters, these terms refer solely to Carolina Financial Corporation and not to the Bank. All references to the “Bank” refer to CresCom Bank only.

Our subsidiaries provide a full range of financial services designed to meet the financial needs of our customers, including:

	●	Commercial and retail banking;
	●	Mortgage banking; and
	●	Cash management

Through the Bank, the Company currently conducts business through 13 bank branches located in the following counties in South Carolina: Charleston (4), Dorchester (3), Berkeley (1) Georgetown (1), and Horry (4). Effective July 31, 2011, the Company merged its wholly-owned subsidiary bank, Community FirstBank of Charleston, with and into its other wholly-owned subsidiary bank, Crescent Bank. In conjunction with this internal reorganization, Crescent Bank’s name was changed to CresCom Bank, and Crescent Mortgage Company, formerly a wholly-owned subsidiary of Community FirstBank of Charleston, became a wholly-owned subsidiary of CresCom Bank. Crescent Mortgage Company is located in Atlanta, Georgia, and is qualified to originate loans in 46 states.

At June 30, 2014, we had total assets of $988.4 million, an increase of $106.8 million, from total assets of $881.6 million at December 31, 2013. The largest components of our total assets are loans receivable and securities which were $605.3 million and $231.6 million, respectively at June 30, 2014. Comparatively, our loans receivable and securities totaled $535.2 million and $192.1 million, respectively, at December 31, 2013. At June 30, 2014 loans held for sale were $47.9 million compared to $36.9 million as of December 31, 2013. Our liabilities and stockholders’ equity at June 30, 2014 totaled $899.1 million and $89.3 million, respectively, compared to liabilities of $799.4 million and stockholders’ equity of $82.2 million at December 31, 2013. The principal components of our liabilities are deposits, which were $779.5 million and $697.6 million at June 30, 2014 and December 31, 2013, respectively.

Like most community banks, we derive a significant portion of our income from interest we receive on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, both interest-bearing and noninterest-bearing. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits and borrowed funds. In order to maximize our net interest income, we must not only manage the volume of these balance sheet items, but also the yields that we earn on our interest-earning assets and the rates that we pay on interest-bearing liabilities.

Of course, there are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible. We establish and maintain this allowance by charging a provision for loan losses against our operating earnings.

In addition to earning interest on our loans and investments, we derive a substantial portion of our income from Crescent Mortgage Company through net gain on sale of loans held for sale as well as servicing income. We also earn income through fees that we charge to our customers. Likewise, we incur other operating expenses as well. We describe the various components of this noninterest income, as well as our noninterest expense, within the “Results of Operations” within the MD&A.

Economic conditions, competition, and the monetary and fiscal policies of the federal government significantly affect most financial institutions, including the Bank. Lending and deposit activities and fee income generation are influenced by levels of business spending and investment, consumer income, consumer spending and savings, capital market activities, and competition among financial institutions as well as client preferences, interest rate conditions and prevailing market rates on competing products in our market areas.

Recent Events

 

On January 15, 2014, the Board of Directors of the Company declared a two-for-one stock split to stockholders of record as of February 10, 2014, payable on February 28, 2014. All share, earnings per share, and per share data have been retroactively adjusted in the consolidated balance sheets, earnings per share, and stockholders’ equity disclosures to reflect the stock split for all periods presented in accordance with GAAP.

 

On June 16, 2014, the Company declared a $0.05 per share dividend to stockholders of record on September 17, 2014, payable October 8, 2014.

On August 6, 2014, the Bank entered into a definitive agreement with First Community Bank, Bluefield, Virginia to acquire 13 branches with total deposits of approximately $230 million and approximately $67 million in loans. Three of the offices are in South Carolina and operate under the name “People’s Community Bank” and 10 are in southeastern North Carolina. The deposit premium will be approximately 3.11% of deposits acquired. The transaction, which is subject to regulatory approval and other customary conditions, is expected to close in late 2014 or early 2015.

Critical Accounting Policies

We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in the notes to our consolidated financial statements in this report.

Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.

We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgment and estimates used in preparation of our consolidated financial statements. Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses, the impact of current events, and conditions, and other factors impacting the level of probable inherent losses. Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

The evaluation and recognition of other-than-temporary impairment, or OTTI, on certain investments including our private label mortgage-backed securities and trust preferred securities requires significant judgment and estimates. Some of the more critical judgments supporting the evaluation of OTTI include projected cash flows including prepayment assumptions, default rates and severities of losses on the underlying collateral within the security. Under different conditions or utilizing different assumptions, the actual OTTI realized by us may be different from the actual amounts recognized in our consolidated financial statements.

The determination of fair value related to derivatives of the Company requires significant judgment and estimates. The primary uses of derivative instruments are related to the mortgage banking activities of the Company. As such, the Company holds derivative instruments, which consist of rate lock agreements related to expected funding of fixed-rate mortgage loans to customers (“interest rate lock commitments”) and forward commitments to sell mortgage-backed securities and individual fixed-rate mortgage loans (“forward commitments”). The Company’s objective in obtaining the forward commitments is to mitigate the interest rate risk associated with the interest rate lock commitments and the mortgage loans that are held for sale. Derivatives related to these commitments are recorded as either a derivative asset or a derivative liability in the balance sheet and are measured at fair value. Both the interest rate lock commitments and the forward commitments are reported at fair value, with adjustments recorded in current period earnings in net gain on sale of loans held for sale within the noninterest income section of the consolidated statements of operations.

Derivative instruments not related to mortgage banking activities, including interest rate swap agreements, that do not satisfy the hedge accounting requirements, are recorded at fair value and changes in fair value are recognized in noninterest income in the consolidated statements of operations.

The establishment of the mortgage repurchases reserves related to various representations and warranties that reflect management’s estimate of losses require significant judgment and estimates. Some of the more critical factors that are incorporated into the estimation of the mortgage repurchase reserve include the defects on internal quality assurance, default expectations, historical investor repurchase demand and appeals success rates, reimbursement by correspondent and other third party originators, changes in regulatory framework regarding representations and warranties and projected loss severity. The Company establishes a reserve at the time loans are sold and continually updates the reserve estimate during the estimated loan life. To the extent that economic conditions and the housing market do not recover or future investor repurchase demand and appeals success rates differ from past experience, the Company could continue to have increased demands and increased loss severities on repurchases, causing future additions to the repurchase reserve. Refer to the “Mortgage Operations” within the MD&A for additional discussion.

Results of Operations

Summary

For the three months ended June 30, 2014, net income available to common stockholders was approximately $2.2 million, or $0.57 per diluted share, compared to net income available to common stockolders of $5.5 million, or $1.40 per diluted share, for the three months ended June 30, 2013. The $3.3 million decrease in net income from quarter to quarter resulted primarily from a $3.2 million decrease in income derived from our wholesale mortgage banking subsidiary.

For the six months ended June 30, 2014, net income available to common stockholders was approximately $4.2 million, or $1.07 per share diluted, compared to net income available to common stockholders of $10.0 million, or $2.53 per share diluted, for the six months ended June 30, 2013. The $5.8 million decrease in net income from period to period resulted primarily from a $6.8 million decrease in income derived from our wholesale mortgage banking subsidiary.

During the third quarter of 2013, mortgage interest rates began to rise and, as a result, mortgage loan production began to slow down. Rising interest rates significantly slowed the mortgage refinance activity in 2013 and has continued into 2014. As the overall mortgage originations volumes declined, there was a corresponding reduction in margins earned due to competitive pressures. For additional information regarding the effects of the wholesale mortgage banking subsidiary on net income, refer to Note 9 under Item 1 “Financial Statements”.

 

Net Interest Income and Margin

Net interest income is a significant component of our net income. Net interest income is the difference between income earned on interest-earning assets and interest paid on interest-bearing liabilities. Net interest income is determined by the yields earned on interest-earning assets, rates paid on interest-bearing liabilities, the relative balances of interest-earning assets and interest-bearing liabilities, the degree of mismatch, and the maturity and repricing characteristics of interest-earning assets and interest-bearing liabilities.

Net interest income increased to $7.3 million for the three months ended June 30, 2014 from $6.8 million for the three months ended June 30, 2013. During the six months ended June 30, 2014, net interest income increased to $14.4 million compared to $13.5 million for the six months ended June 30, 2013. The increase in net interest income for the three and six months ended June 30, 2014 as compared to the three and six months ended June 30, 2013 is a result of the increase in average earning assets as well as a decrease in rates paid on interest-bearing liabilities and a shift to lower cost funding sources.

The Company is focused on continuing to improve the utilization of its capital. To accomplish this, the Bank has incorporated various strategies to increase high quality loan portfolios. Accordingly, the increase in average earnings assets for the three and six months ended June 30, 2014 is primarily the result of increased balances of loans receivable. The growth in average loan balances were primarily the result of the following:

●

Residential mortgage – during the third quarter of 2013 continuing into 2014, the Company has hired several retail residential mortgage loan officers in its Charleston and Myrtle Beach markets of South Carolina. In addition to selling a portion of its production, the Company has retained a portion of the mortgage production. Due to the emphasis, gross loans receivable within the one-to-four family portfolio have increased $16.7 million, excluding loans acquired in the St. George branch acquisition described below, since December 31, 2013.

●

Commercial lending – during 2014, the Company expanded its commercial lending team by hiring additional loan officers in its Charleston and Myrtle Beach markets of South Carolina. As a result, gross loans receivable within the commercial real estate and construction and development portfolios have grown $11.8 million and $10.6 million, respectively, since December 31, 2013.

●

Syndicated loans – the Charleston and Myrtle Beach markets of South Carolina have provided limited opportunities for the Bank to develop a Commercial and Industrial (“C&I”) loan portfolio. The Company’s primary markets are generally concentrated in real estate lending. However, in order to diversify our lending portfolio, the Company began a syndicated loan program in 2014 to purchase C&I loans to retain in the loan portfolio. These loans typically have terms of seven years and are tied to a floating rate index such as libor or prime. To effectively manage this new line of lending, the Company hired an experienced senior lending executive with relevant experience to lead and manage this area of the loan portfolio and engaged a consulting firm that specializes in syndicated loans. The Company expects to continue to grow this portion of the loan portfolio throughout 2014. As of June 30, 2014, the syndicated loan portfolio was $29.1 million and is grouped within commercial business loans. As of June 30, 2014, the Moody’s weighted average credit facility rating of the syndicated loan portfolio was Ba3, with no credit rated less than B2.

●

Acquisition of St. George branch – The Bank acquired $11.2 million in loans related to this first quarter branch acquisition. Approximately $ 9.2 million of these loans were one-to-four family secured loans with the remaining loans consisting of consumer and commercial real estate loans.

Partially offsetting the increase in average earning assets is the decrease in average balance of loans held for sale as the Company experienced a significant decrease in the level of mortgage originations during the latter half of 2013 continuing into 2014. For the six months ended June 30, 2014, mortgage originations were $449.8 million, a decrease of 54.8%, as compared to originations of $995.8 million for the six months ended June 30, 2013.

The decrease in rates paid on interest-bearing liabilities is based on the continued historically low interest rates that have positively impacted our ability to reduce funding cost while the shift to lower cost funding sources relates to the sustained efforts of the Company to grow checking, savings, and money market accounts. During the first half of 2014, the Company experienced significant growth in checking, savings, and money market accounts which typically yield less than other forms of interest-bearing liabilities. Specifically, checking, savings and money market balances increased $26.6 million during the second quarter of 2014 and $23.3 million during the first quarter of 2014 for year to date growth of $49.9 million. This growth includes $11.3 million of deposits acquired in the St. George branch acquisition during the first quarter of 2014. In addition to the aforementioned growth, the Company established a deposit relationship with its mortgage subservicing provider during the third quarter of 2013 whereby the subservicer deposited impound escrow funds with the Company. The impound escrow funds had average balances of $41.8 million and $38.6 million for the three and six months ended June 30, 2014, respectively, and are included in interest-bearing demand accounts within the yield rate tables below. As this relationship was established during the third quarter of 2013, there were no funds outstanding for the three or six months ended June 30, 2013.

The following table sets forth information related to our average balance sheet, average yields on assets, and average costs of liabilities for the periods indicated (dollars in thousands). We derived these yields or costs by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. During the same periods, we had no securities purchased with agreements to resell. All investments were owned at an original maturity of over one year. Nonaccrual loans are included in earning assets in the following tables. Loan yields reflect the negative impact on our earnings of loans on nonaccrual status. The net of capitalized loan costs and fees, which are considered immaterial, are amortized into interest income on loans.

		For The Three Months Ended June 30,
		2014												2013
						Interest				Average								Interest				Average
		Average				Paid/				Yield/				Average				Paid/				Yield/
		Balance				Earned				Rate				Balance				Earned				Rate
Interest-earning assets:
Loans held for sale		$	28,466				251				3.45	%			89,042				754				3.31	%
Loans receivable, net (1)			581,267				6,906				4.71	%			499,181				6,251				4.97	%
Interest-bearing cash			24,063				14				0.23	%			44,289				29				0.26	%
Securities available for sale			199,634				1,352				2.69	%			166,587				1,122				2.67	%
Securities held to maturity			24,238				174				2.85	%			9,169				83				3.59	%
Federal Home Loan Bank stock			3,625				35				3.86	%			4,106				31				3.02	%
Other investments			1,925				11				2.27	%			1,731				11				2.52	%
Total interest-earning assets			863,218				8,743				4.02	%			814,105				8,281				4.04	%
Non-earning assets			84,949												73,932
Total assets		$	948,167												888,037
Interest-bearing liabilities:
Demand accounts			104,140				46				0.18	%			44,525				22				0.20	%
Money market accounts			213,576				132				0.25	%			210,519				231				0.44	%
Savings accounts			24,812				11				0.18	%			13,206				12				0.36	%
Certificates of deposit			312,809				709				0.90	%			315,046				577				0.73	%
Short-term borrowed funds			11,523				11				0.38	%			20,812				80				1.53	%
Long-term debt			69,571				512				2.92	%			79,762				546				2.72	%
Total interest-bearing liabilities			736,431				1,421				0.77	%			683,870				1,468				0.85	%
Noninterest-bearing deposits			112,021												107,475
Other liabilities			12,587												21,781
Stockholders’ equity			87,128												74,911
Total liabilities and
Stockholders’ equity		$	948,167												888,037
Net interest spread											3.25	%											3.19	%
Net interest margin			3.37	%											3.32	%
Net interest margin (tax equivalent) (2)			3.45	%											3.37	%
Net interest income							7,322												6,813

 

(1) Average balances of loans include nonaccrual loans.

(2) The tax equivalent net interest margin reflects tax-exempt income on a tax-equivalent basis.

 

Our net interest margin was 3.37%, or 3.45% on a tax equivalent basis, for the three month period ended June 30, 2014 compared to 3.32%, or 3.37% on a tax equivalent basis, for the three month period ended June 30, 2013. The increase in our net margin primarily resulted from a decrease in the rate paid on interest-bearing liabilities, an increase in average non-interest bearing depoists, as well as the shift to lower cost deposits.

Our net interest spread was 3.25% for the three months ended June 30, 2014 as compared to 3.19% for the same period in 2013. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The six basis point increase in net interest spread is a result of the 8 basis point reduction in rate paid on our interest-bearing liabilities offset by a two basis point reduction in yield on interest-earning assets.

		For The Six Months Ended June,
		2014												2013
						Interest				Average								Interest				Average
		Average				Paid/				Yield/				Average				Paid/				Yield/
		Balance				Earned				Rate				Balance				Earned				Rate
Interest-earning assets:
Loans held for sale		$	27,062				517				3.80	%			97,985				1,672				3.39	%
Loans receivable, net (1)			567,379				13,473				4.79	%			500,940				12,412				5.00	%
Interest-bearing cash			22,536				28				0.25	%			28,775				47				0.33	%
Securities available for sale			190,852				2,705				2.86	%			163,592				2,183				2.69	%
Securities held to maturity			24,282				342				2.84	%			9,120				125				2.76	%
Federal Home Loan Bank stock			3,699				69				7.46	%			4,786				60				5.01	%
Other investments			1,911				21				2.22	%			1,730				11				1.28	%
Total interest-earning assets			837,721				17,155				4.13	%			806,928				16,510				4.13	%
Non-earning assets			83,729												73,997
Total assets		$	921,450												880,925
Interest-bearing liabilities:
Demand accounts			94,131				86				0.18	%			44,137				49				0.22	%
Money market accounts			215,722				268				0.25	%			209,842				500				0.48	%
Savings accounts			22,784				21				0.19	%			12,299				23				0.38	%
Certificates of deposit			302,585				1,338				0.89	%			306,681				1,136				0.75	%
Short-term borrowed funds			8,086				16				0.40	%			26,519				194				1.48	%
Long-term debt			71,436				1,023				2.89	%			87,505				1,068				2.46	%
Total interest-bearing liabilities			714,744				2,752				0.78	%			686,983				2,970				0.87	%
Noninterest-bearing deposits			107,814												99,687
Other liabilities			13,563												20,676
Stockholders’ equity			85,329												73,579
Total liabilities and
Stockholders’ equity		$	921,450												880,925
Net interest spread											3.35	%											3.26	%
Net interest margin			3.47	%											3.38	%
Net interest margin (tax equivalent) (2)			3.56	%											3.42	%
Net interest income							14,403												13,540

 

(1) Average balances of loans include nonaccrual loans.

(2) The tax equivalent net interest margin reflects tax-exempt income on a tax-equivalent basis.

 

Our net interest margin was 3.47%, or 3.56% on a tax equivalent basis, for the six months ended June 30, 2014 compared to 3.38%, or 3.42% on a tax equivalent basis, for the six months ended June 30, 2013. The increase in our net margin primarily resulted from a decrease in the rate paid on interest-bearing liabilities, an increase in average non-interest bearing depoists, as well as the shift to lower cost deposits.

Our net interest spread was 3.35% for the six months ended June 30, 2014 as compared to 3.26% for the same period in 2013. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The nine basis point increase in net interest spread is a result of the nine basis point reduction in rate paid on our interest-bearing liabilities.

Provision for Loan Loss

We have established an allowance for loan losses through a provision for loan losses charged as an expense on our consolidated statements of operations. We review our loan portfolio periodically to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses. Please see the discussion below under “Allowance for Loan Losses” for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.

Following is a summary of the activity in the allowance for loan losses during the periods ended June 30, 2014 and 2013.

		For the Three Months								For the Six Months
		Ended June 30,								Ended June 30,
		2014				2013				2014				2013
		(Dollars in thousands)
Balance, beginning of period		$	8,401				9,638				8,091				9,520
Provision for loan losses			—				(700	)			—				(700	)
Loan charge-offs			(36	)			(771	)			(284	)			(899	)
Loan recoveries			297				236				855				482
Balance, end of period		$	8,662				8,403				8,662				8,403

 

During the three and six months ended June 30, 2014, there was no provision for loan loss recorded. During the three months and six months ended June 30, 2013, a negative provision of $700,000 was recorded. The negative provision was recorded during 2013 was primarily related to the removal of a specific reserve on an impaired loan relationship. The specific reserve was removed during the quarterly impairment analysis performed where it was determined that the net realizable value of the collateral was greater than the amortized cost of the loan; therefore, no specific reserve was warranted.

Provision expense is recorded based on our assessment of general loan loss risk as well as asset quality and is driven by the determination of the allowance for loan losses. The allowance for loan losses is management’s estimate of probable credit losses inherent in the loan portfolio at the balance sheet date. Management determines the allowance based on an ongoing evaluation. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on non-impaired loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. For further discussion regarding the calculation of the allowance, see the “Allowance for Loan Losses” discussion below.

Noninterest Income and Expense

 

Noninterest income provides us with additional revenues that are significant sources of income. The major components of noninterest income for the three and six months ended June 30, 2014 and 2013 are presented below:

 

		For the Three Months								For the Six Months
		Ended June 30,								Ended June 30,
		2014				2013				2014				2013
		(In thousands)
Noninterest income:
Net gain on sale of loans held for sale		$	3,426				10,199				5,880				21,549
Deposit service charges			517				371				948				689
Net loss on extinguishment of debt			(31	)			(19	)			(31	)			(19	)
Net gain (loss) on sale of securities			164				(62	)			480				(46	)
Fair value adjustments on interest rate swaps			(263	)			263				(518	)			263
Net gain on sale of servicing assets			—				—				775				—
Net increase in cash value life insurance			187				—				373				1
Mortgage loan servicing income			1,254				1,836				2,531				3,328
Other			195				217				380				423
Total noninterest income		$	5,449				12,805				10,818				26,188

Noninterest income decreased $7.4 million to $5.4 million for the three months ended June 30, 2014 from $12.8 million for the three months ended June 30, 2013. For the six months ended June 30, 2014, noninterest income decreased $15.4 million to $10.8 million from $26.2 million for the six months ended June 30, 2013. The decrease in noninterest income for the three and six months ended June 30, 2014 as compared to the three and six months ended June 30, 2013 primarily relates to the decrease in the gain on sale of loans sold from our mortgage banking subsidiary. During the third quarter of 2013, mortgage interest rates began to rise and, as a result, mortgage loan production began to slow down. Rising interest rates significantly slowed the mortgage refinancing activity, and, as the overall mortgage originations volumes declined, there was a corresponding reduction in margins earned due to competitive pressures. Mortgage loan originations decreased 54.8% to $449.8 million for the six months ended June 30, 2014 compared to originations of $995.8 million for the six months ended June 30, 2013.

Partially offsetting the overall decrease in noninterest income was an increase in the net gain on sale of servicing asset. During the first quarter of 2014, the Company sold $147.7 million in unpaid principal balance of mortgage servicing rights for a net gain of $776,000. There were no servicing rights sold during three or six months ended June 30, 2013. The sale of mortgage servicing rights during the first quarter of 2014 as well as a sale of servicing rights during the second half of 2013 of $972.9 million of unpaid principal balance of mortgage servicing rights resulted in a corresponding decrease of mortgage loan servicing income for the three and six months ended June 30, 2014 as compared to the prior periods.

During the three and six months ended June 30, 2014, the Company recognized net gains on sale of available-for-sale securities of $164,000 and $480,000, respectively, compared to losses on sale of securities during the three and six months ended June 30, 2013 of $62,000 and $46,000, respectively. The fair value adjustment on interest rate swaps was a reduction of noninterest income of $263,000 and $518,000 for the three and six months ended, June 30, 2014, respectively, compared to an increase of noninterest income of $263,000 for the three and six months ended June 30, 2013. The change in fair value adjustment on interest rate swaps relate to the change in interest rates from period to period.

Net increase in cash value of life insurance was $187,000 and $0 for the three months ended June 30, 2014 and 2013, respectively. Net increase in the cash value of life insurance was $373,000 and $1,000 for the six months ended June 30, 2014 and 2013, respectively. The increase in cash surrender value relates to the increase of $20.1 million in cash value life insurance that was purchased at the end of the first quarter in 2013 and was outstanding for all of the three and six month periods ended June 30, 2014. During 2013, the Company purchased and invested in bank owned life insurance policies on certain employees with an initial cash surrender value of $20.0 million through two insurance carriers. As of June 30, 2014, cash value of life insurance was $21.2 million compared to $20.9 million at December 31, 2013.

 

The following table sets forth for the periods indicated the primary components of noninterest expense:

		For the Three Months								For the Six Months
		Ended June 30,								Ended June 30,
		2014				2013				2014				2013
		(In thousands)
Noninterest expense:
Salaries and employee benefits		$	5,515				6,248				10,859				12,708
Occupancy and equipment			1,051				847				2,035				1,661
Marketing and public relations			297				263				571				498
FDIC insurance			136				157				263				413
Legal expense			191				290				361				440
Other real estate expense, net			60				335				307				411
Mortgage subservicing expense			326				469				689				935
Amortization of mortgage servicing rights			441				738				913				1,331
Settlement of employment agreements			—				119				—				1,902
Other			1,474				2,139				3,100				4,329
Total noninterest expense		$	9,491				11,605				19,098				24,628

 

Noninterest expense represents the largest expense category for the Company. Noninterest expense decreased $2.1 million to $9.5 for the three months ended June 30, 2014 from $11.6 million for the three months ended June 30, 2013. For the six months ended June 30, 2014, noninterest expense decreased $5.5 million to $19.1 million from $24.6 million for the six months ended June 30, 2013. The decrease in noninterest expense for the three and six months ended June 30, 2014 compared to the prior periods are primarily a result of the decrease in salaries and employee benefits, a reduction in mortgage subservicing and amortization expense, the reduction in settlement of employment agreements and other.

The decrease in salaries and benefits and noninterest expense – other is a result of the reduced mortgage loan originations during the three and six months ended June 30, 2014 as compared to the prior periods, and the related compensation paid on and expenses releated to those originations. As previously discussed, mortgage loan originations decreased 54.8% to $449.8 million for the six months ended June 30, 2014 compared to originations of $995.8 million for the six months ended June 30, 2013.

Mortgage subservicing expense and amortization of mortgage subservicing rights decreased during the three and six months ended June 30, 2014 as compared to the three and six months ended June 30, 2013 due to the sale of $147.7 million in unpaid principal balance of mortgage servicing rights during the first quarter of 2014 and the sale of $972.9 million in unpaid principal balance of mortgage servicing rights during the second half of 2013.

The decrease in expense in settlement of employment agreements related to the Company settling employment agreements with two former retired executive officers during 2013. All amounts related to the settlement of these agreements were expensed during 2013. As such, there were no additional expenses related to these contracts during the three or six months ended June 30, 2014.

Income Tax Expense

Our effective tax rate decreased to 31.4% for three month period ended June 30, 2014, compared to 36.5% for the three month period ended June 30, 2013. For the six months ended June 30, 2014, our effective tax rate decreased to 31.5% compared to 37.0% for the six months ended June 30, 2013. The lower effective tax rate in 2014 is primarily attributable to the increase in balances of tax-exempt municipal securities as well as the increase in average balances of bank-owned life insurance during the second half of 2013 and into 2014.

Balance Sheet Review

 

Investment Securities

Our primary objective in managing the investment portfolio is to maintain a portfolio of high quality, highly liquid investments yielding competitive returns. We are required under federal regulations to maintain adequate liquidity to ensure safe and sound operations. We maintain investment balances based on a continuing assessment of cash flows, the level of current and expected loan production, current interest rate risk strategies and the assessment of the potential future direction of market interest rate changes. Investment securities differ in terms of default, interest rate, liquidity and expected rate of return risk.

At June 30, 2014, the $231.5 million in our investment securities portfolio, excluding FHLB stock and other investments, represented approximately 23.4% of our assets. Our available-for-sale investment portfolio included US agency securities, municipal securities, collateralized loan obligations and mortgage-backed securities (agency and non-agency) with a fair value of $207.3 million and an amortized cost of $202.6 million for a net unrealized gain of $4.7 million. Our held-to-maturity portfolio included municipal securities and asset-backed securities, made up of pooled trust preferred securities, with a fair value of $25.9 million and a cost of $24.3 million for a net unrealized gain of $1.6 million.

As securities are purchased, they are designated as held-to-maturity or available-for-sale based upon our intent, which incorporates liquidity needs, interest rate expectations, asset/liability management strategies, and capital requirements. We do not currently hold, nor have we ever held, any securities that are designated as trading securities.

The following table summarizes issuer concentrations of agency mortgage-backed securities for which aggregate fair values exceed 10% of stockholders’ equity at June 30, 2014:

		Aggregate				Aggregate				Fair Value
		Amortized				Fair				as a % of
Issuer		Cost				Value				Stockholders’ Equity
		(Dollars in thousands)
GNMA		$	30,410				31,337				35.10	%
FNMA			45,599				46,841				52.47	%
FHLMC			25,071				25,964				29.08	%
		$	101,080				104,142				116.65	%

 

See Note 2 “Securities” in the “Notes to Consolidated Financial Statements” herein for additional disclosures related to the Company’s evaluation of securities for OTTI.

Loans by Type

 

Since loans typically provide higher interest yields than other types of interest-earning assets, a substantial percentage of our earning assets are invested in our loan portfolio. Before allowance for loan losses, loans outstanding at June 30, 2014 and December 2013 were $614.0 million and $543.3 million, respectively.

Our loan portfolio consists primarily of loans secured by real estate mortgages. As of June 30, 2014, our loan portfolio included $554.1 million, or 90.2%, of loans secured by real estate before allowance for loan losses. As of December 31, 2013, our loan portfolio included $515.1 million, or 94.8%, of loans secured by real estate before allowance for loan losses. Most of our real estate loans are secured by residential or commercial property. We obtain a security interest in real estate, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans to coincide with the appropriate regulatory guidelines. The Bank’s primary markets are generally concentrated in real estate lending. In order to diversify our lending portfolio, the Bank began a syndicated loan program during 2014 with balances of $29.1 million as of June 30, 2014 and are grouped within commercial business loans in the table below. As of June 30, 2014, the Moody’s weighted average credit facility rating of the syndicated loan portfolio was Ba3, with no credit rated less than B2. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral and business types.

As shown in the table below, loans prior to the allowance for loan losses increased $70.7 million to $614.0 million at June 30, 2014 from $543.3 million at December 31, 2013. The increase in loans receivable primarily relates to the Bank’s focus on growing residential mortgage, commercial lending, and syndicated loans, as well as $11.2 million of loans acquired related to the acquisition of the St. George branch. See additional discussion in “Results of Operations – Net Interest Income and Margin”.

The following table summarizes loans by type and percent of total at the end of the periods indicated:

		At June 30,								At December 31,
		2014								2013
						% of Total								% of Total
		Amount				Loans				Amount				Loans
		(Dollars in thousands)
Loans secured by real estate:
One-to-four family		$	209,878				32.62	%			184,210				32.60	%
Home equity			23,529				3.66	%			23,661				4.19	%
Commercial real estate			264,911				41.18	%			253,035				44.79	%
Construction and development			77,629				12.07	%			67,056				11.87	%
Consumer loans			3,132				0.49	%			3,060				0.54	%
Commercial business loans			64,187				9.98	%			33,938				6.01	%
Total gross loans receivable			643,266				100.00	%			564,960				100.00	%
Less:
Undisbursed loans in process			29,053								21,550
Allowance for loan losses			8,662								8,091
Deferred fees, net			256								98
Total loans receivable, net		$	605,295								535,221

Maturities and Sensitivity of Loans to Changes in Interest Rates

The information in the following table is based on the contractual maturities of individual loans, including loans which may be subject to renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity. Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties.

The following table summarizes the loan maturity distribution by type and related interest rate characteristics.

		At June 30, 2014
						After one
		One Year				but within				After five
		or Less				five years				years				Total
		(In thousands)
Loans secured by real estate:
One-to-four family		$	41,223				62,698				105,957				209,878
Home equity			6,347				1,222				15,960				23,529
Commercial real estate			32,764				97,537				134,610				264,911
Construction and development			10,795				21,852				44,982				77,629
Consumer loans			549				1,226				1,357				3,132
Commercial business loans			2,779				18,217				43,191				64,187
Total gross loans receivable			94,457				202,752				346,057				643,266
Less:
Undisbursed loans in process			2,210				13,791				13,052				29,053
Deferred fees, net			33				74				149				256
Total loans receivable		$	92,214				188,887				332,856				613,957
Loans maturing - after one year
Variable rate loans														$	310,505
Fixed rate loans															211,238
														$	521,743

Nonperforming and Problem Assets

Nonperforming assets include loans on which interest is not being accrued, accruing loans that are 90 days or more delinquent and foreclosed property. Foreclosed property consists of real estate and other assets acquired as a result of a borrower’s loan default. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when we believe, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction of principal when received. In general, a nonaccrual loan may be placed back onto accruing status once the borrower has made a minimum of six consecutive payments in accordance with the loan terms. Further, the borrower must show capacity to continue performing into the future prior to restoration of accrual status. As of June 30, 2014 and December 31 2013, we had no loans 90 days past due and still accruing.

Troubled Debt Restructurings (“TDRs”)

The Company designates loan modifications as TDRs when, for economic or legal reasons related to the borrower’s financial difficulties, it grants a concession to the borrower that it would not otherwise consider. Loans on nonaccrual status at the date of modification are initially classified as nonaccrual TDRs. Loans on accruing status at the date of modification are initially classified as accruing TDRs at the date of modification, if the note is reasonably assured of repayment and performance is in accordance with its modified terms. Such loans may be designated as nonaccrual loans subsequent to the modification date if reasonable doubt exists as to the collection of interest or principal under the restructuring agreement. Nonaccrual TDRs are returned to accrual status when there is economic substance to the restructuring, there is well documented credit evaluation of the borrower’s financial condition, the remaining balance is reasonably assured of repayment in accordance with its modified terms, and the borrower has demonstrated repayment performance in accordance with the modified terms for a reasonable period of time, generally a minimum of six months.

The following table summarizes nonperforming and problem assets at the end of the periods indicated.

		At June 30,				At December 31,
		2014				2013
		(In thousands)
Loans receivable:
Nonaccrual loans-renegotiated loans		$	6,537				7,641
Nonaccrual loans-other			2,856				3,438
Accruing loans 90 days or more delinquent			—				—
Real estate acquired through foreclosure, net			5,655				6,273
Total Non-Performing Assets		$	15,048				17,352
Problem Assets not included in Non-Performing Assets-
Accruing renegotiated loans outstanding		$	15,488				16,367

At June 30, 2014, nonperforming assets were $15.0 million, or 1.52% of total assets. Comparatively, nonperforming assets were $17.4 million, or 2.0% of total assets, at December 31, 2013. Nonperforming loans were 1.53% and 2.0% of loans outstanding at June 30, 2014 and December 31, 2013, respectively. Nonaccrual loans decreased $1.7 million to $9.4 million at June 30, 2014 from $11.1 million at December 31, 2013.

Potential problem loans, which are not included in nonperforming loans, amounted to approximately $15.5 million, or 2.5% of loans outstanding prior to the allowance for loan losses, at June 30, 2014, compared to $16.4 million, or 3.0% of loans outstanding prior to the allowance for loan losses, at December 31, 2013. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms.

Substantially all of the nonaccrual loans, accruing loans 90 days or more delinquent and accruing renegotiated loans at June 30, 2014 and December 31, 2013 are collateralized by real estate. The Bank utilizes third party appraisers to determine the fair value of collateral dependent loans. Our current loan and appraisal policies require the Bank to obtain updated appraisals on an annual basis, either through a new external appraisal or an internal appraisal evaluation. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment. We typically charge-off a portion or create a specific reserve for impaired loans when we do not expect repayment to occur as agreed upon under the original terms of the loan agreement. Management believes based on information known and available currently, the probable losses related to problem assets are adequately reserved in the allowance for loan losses.

Although nonperforming assets remain at a historically elevated level, credit quality indicators generally showed improvement during 2013 and continuing into 2014 as the Company experienced reduced loan migrations to nonaccrual status, lower loss severity on individual problem assets and a reduction in nonperforming assets. The Company believes this general trend in reduced loans migrating into nonaccrual status is an indication of improving credit quality in the Company’s overall loan portfolio and a leading indicator of reduced credit losses going forward. Nevertheless, the Company can make no assurances that nonperforming assets will continue to improve in future periods. The Company continues to monitor the loan portfolio and foreclosed assets and is continually working to reduce its problem assets.

Allowance for Loan Losses

The allowance for loan losses is management’s estimate of probable credit losses inherent in the loan portfolio at the balance sheet date. Management determines the allowance based on an ongoing evaluation. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on non-impaired loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The allowance consists of specific and general components.

The general component covers nonimpaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by major loan category and is based on the actual loss history trends for the previous 12 quarters. The actual loss experience is supplemented with internal and external qualitative factors as considered necessary at each period and given the facts at the time. These qualitative factors adjust the 12 quarter historical loss rate to recognize the most recent loss results and changes in the economic conditions to ensure the estimated losses in the portfolio are recognized in the period incurred and that the allowance at each balance sheet date is adequate and appropriate in accordance with GAAP. Qualitative factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries for the most recent twelve quarters; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations.

The specific component relates to loans that are individually classified as impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. Impaired loans are evaluated for impairment using the discounted cash flow methodology or based on the net realizable value of the underlying collateral. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment. See additional discussion in section “Nonperforming and Problem Assets” of the MD&A.

While management uses the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the valuations or, if required by regulators, based upon information available to them at the time of their examinations. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels may vary from previous estimates. To the extent actual outcomes differ from management’s estimates, additional provisions for loan losses could be required that could adversely affect the Bank’s earnings or financial position in future periods.

At June 30, 2014 and December 31, 2013, the allowance for loan losses was $8.7 million and $8.1 million, respectively, or 1.41% and 1.49% of outstanding loans, respectively. There was no provision recorded for the three or six months ended June 30, 2014. During the three and six months ended June 30, 2013, the Company recorded a negative provision of $700,000 primarily due to the removal of a specific reserve on an impaired loan relationship. The specific reserve was removed during the quarterly impairment analysis performed where it was determined that the net realizable value of the collateral was greater than the amortized cost of the loan; therefore, management determined the reserve previously placed against this loan relationship should be reversed through a negative provision.

The following table summarizes the activity related to our allowance for loan losses for the three and six months ended June 30, 2014 and June 30, 2013.

		For the Three Months								For the Six Months
		Ended June 30,								Ended June 30,
		2014				2013				2014				2013
		(Dollars in thousands)
Balance, beginning of period		$	8,401				9,638				8,091				9,520
Provision for loan losses			—				(700	)			—				(700	)
Loan charge-offs:
Loans secured by real estate:
One-to-four family			(36	)			(48	)			(73	)			(81	)
Home equity			—				(28	)			—				(28	)
Commercial real estate			—				(110	)			(28	)			(110	)
Construction and development			—				(248	)			(170	)			(310	)
Consumer loans			—				(1	)			(13	)			(34	)
Commercial business loans			—				(336	)			—				(336	)
Total loan charge-offs			(36	)			(771	)			(284	)			(899	)
Loan recoveries:
Loans secured by real estate:
One-to-four family			52				18				71				133
Home equity			—				—				—				—
Commercial real estate			—				21				—				73
Construction and development			2				72				329				79
Consumer loans			10				8				50				32
Commercial business loans			233				117				405				165
Total loan recoveries			297				236				855				482
Net loan (charge-offs) recoveries			261				(535	)			571				(417	)
Balance, end of period		$	8,662				8,403				8,662				8,403
Allowance for loan losses as a percentage of loans receivable, net (end of period)			1.41	%			1.64	%			1.41	%			1.64	%
Net charge-offs (recoveries) to average loans receivable (annualized)			-0.16	%			0.43	%			-0.20	%			0.17	%

Mortgage Operations

Mortgage Activities and Servicing

Our wholesale mortgage banking operations are conducted through our mortgage origination subsidiary, Crescent Mortgage Company. Mortgage activities involve the purchase of mortgage loans and table funded originations for the purpose of generating gains on sales of loans and fee income on the origination of loans. While the Company originates residential one-to-four family loans that are held in its loan portfolio, the majority of new loans are generally sold pursuant to secondary market guidelines through Crescent Mortgage Company. Generally, residential mortgage loans are sold and, depending on the pricing in the marketplace, servicing rights are either sold or retained. The level of loan sale activity and its contribution to the Company’s profitability depends on maintaining a sufficient volume of loan originations and margin. Changes in the level of interest rates and the local economy affect the volume of loans originated by the Company and the amount of loan sales and loan fees earned. Discussion related to the impact and changes within the mortgage operations are provided in “Results of Operations”. Additional segment information is provided in Note 9 “Supplemental Segment Information” to the consolidated financial statements.

Loan Servicing

We retain the rights to service a portion of the loans we sell on the secondary market, as part of our mortgage banking activities, for which we receive service fee income. These rights are known as mortgage servicing rights, or MSRs, where the owner of the MSR acts on behalf of the mortgage loan owner and has the contractual right to receive a stream of cash flows in exchange for performing specified mortgage servicing functions. These duties typically include, but are not limited to, performing loan administration, collection, and default activities, including the collection and remittance of loan payments, responding to customer inquiries, accounting for principal and interest, holding custodial (impound) funds for the payment of property taxes and insurance premiums, counseling delinquent mortgagors, modifying loans and supervising foreclosures and property dispositions. We subservice the duties and responsibilities obligated to the owner of the MSR to a third party provider for which we pay a fee.

At June 30, 2014, the Company was servicing $1.8 billion of loans for others, a decrease of $200 million from $2.0 billion at December 31, 2013. The decrease in loans serviced in the current year primarily relates to principal payments and a loan servicing sale where the Company sold $147.7 million in unpaid principal balance of mortgage servicing rights for a net gain of $775,000.

We recognize the rights to service mortgage loans for others as an asset. We initially record the MSR at fair value and subsequently account for the asset at lower of cost or market using the amortization method. Servicing assets are amortized in proportion to, and over the period of, the estimated net servicing income and are carried at amortized cost. A valuation is performed by an independent third party on a quarterly basis to assess the servicing assets for impairment based on the fair value at each reporting date. The fair value of servicing assets is determined by calculating the present value of the estimated net future cash flows consistent with contractually specified servicing fees. This valuation is performed on a disaggregated basis, based on loan type and year of production. Generally, loan servicing becomes more valuable when interest rates rise (as prepayments typically decrease) and less valuable when interest rates decline (as prepayments typically increase). As discussed in detail in notes to the consolidated financial statements, we use an appropriate weighted average constant prepayment rate, discount rate, and other defined assumptions to model the respective cash flows and determine the fair value of the servicing asset at each reporting date.

In the aggregate, the net servicing asset had a balance of $9.8 million and $10.9 million at June 30, 2014 and December 31, 2013, respectively. The economic estimated fair value of the mortgage servicing rights was $15.2 million and $17.7 million at June 30, 2014 and December 31, 2013, respectively. The amortization expense related to the mortgage servicing rights were $441,000 and $738,000 during the three months ended June 30, 2014 and 2013, respectively. For the six months ended June 30, 2014 and 2013, the amortization expense recorded was $913,000 and $1.3 million, respectively.

Below is a roll-forward of activity in the balance of the servicing assets for the three and six months ended June 30, 2014 and June 30, 2013.

		For the Three Months								For the Six Months
		Ended June 30,								Ended June 30,
		2014				2013				2014				2013
		(In thousands)
MSR beginning balance		$	10,003				14,564				10,908				12,039
Amount capitalized			281				1,662				648				4,780
Amount sold			—				—				(800	)			—
Amount amortized			(441	)			(738	)			(913	)			(1,331	)
MSR ending balance		$	9,843				15,488				9,843				15,488

Losses on Mortgage Loans Previously Sold

Loans held for sale have primarily been fixed-rate single-family residential mortgage loans under contracts to be sold in the secondary market. In most cases, loans in this category are sold within 30 days of closing. Buyers generally have recourse to return a purchased loan to the Company under limited circumstances. Repurchases and losses on mortgage loans previously sold are recorded when the Company indemnifies or repurchases mortgage loans previously sold.  The representations and warranties in our loan sale agreements provide that we repurchase or indemnify the investors for losses or costs on loans we sell under certain limited conditions.  Some of these conditions include underwriting errors or omissions, fraud or material misstatements by the borrower in the loan application or invalid market value on the collateral property due to deficiencies in the appraisal.  In addition to these representations and warranties, our loan sale contracts define a condition in which the borrower defaults during a short period of time, typically 120 days to one year, as an early payment default, or EPD.  In the event of an EPD, we are required to return the premium paid by the investor for the loan as well as certain administrative fees, and in some cases repurchase the loan or indemnify the investor.  Because the level of mortgage loan repurchase losses depends upon economic factors, investor demand strategies and other external conditions that may change over the life of the underlying loans, the level of the liability for mortgage loan repurchase losses is difficult to estimate and requires considerable management judgment.

The following table demonstrates the activity for the mortgage repurchase reserve for the three and six months ended June 30, 2014 and June 30, 2013.

		For the Three Months								For the Six Months
		Ended June,								Ended June,
		2014				2013				2014				2013
		(In thousands)
Beginning Balance		$	5,871				5,443				6,108				4,882
Losses paid			(95	)			(210	)			(354	)			(341	)
Recoveries			7				—				29				—
Provision for buyback			(250	)			460				(250	)			1,152
Ending balance		$	5,533				5,693				5,533				5,693

For the three and six months ended June 30, 2014, the Company recorded a negative provision for mortgage repurchase reserve of $250,000. This compares to provision expense for mortgage repurchase reserve of $460,000 and $1.1 million for the three and six months ended June 30, 2013, respectively. The decline in the provision for mortgage loan repurchase losses is related to several factors. The Company sells mortgage loans to various third parties, including government-sponsored entities (“GSEs”), under contractual provisions that include various representations and warranties as previously stated. The Company establishes the reserve for mortgage loan repurchase losses based on a combination of factors, including estimated levels of defects on internal quality assurance, default expectations, historical investor repurchase demand and appeals success rates, reimbursement by correspondent and other third party originators, and projected loss severity. Prior to 2012, there was no expiration date related to representations and warranties as long as the loan sold to the investor was outstanding. As a result, the Company received loan repurchase requests years after the loan was originated and sold to various third parties. In the latter part of 2012, the regulatory framework for certain GSEs changed where, under certain circumstances, the loan repurchase risk was limited for production beginning in January 2013. In addition, in May 2014, additional regulatory changes further limited loan repurchase risk. As a result, the Company performed an analysis of its reserve for mortgage loan repurchase losses and, based on management’s judgment and interpretation of such regulatory changes, reduced the reserve by $250,000. Management will continue to monitor how the GSEs implement the regulatory changes and trends. If such trends continue to be favorable, there is a possibility that additional reductions in this reserve could occur in future periods.

Deposits

We provide a range of deposit services, including noninterest-bearing demand accounts, interest-bearing demand and savings accounts, money market accounts and time deposits. These accounts generally pay interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. Deposits continue to be our primary funding source. At June 30, 2014 deposits totaled $779.5 million, an increase of $82.0 million, or 11.7%, from deposits of $697.6 million at December 31, 2013. The increase in deposits is primarily related to $24.5 million of deposits acquired related to the acquisition of the St. George branch during the first quarter of 2014 as well as an increase in the number of deposit accounts and seasonality of our customer balances during the summer months.

Our retail deposits represented $649.5 million, or 83.3% of total deposits at June 30, 2014, while our out-of-market, or brokered deposits and institutional deposits, represented $130.0 million, or 16.7% of our total deposits. Our retail deposits represented $595.7 million, or 85.4% of total deposits at December 31, 2013, while our out-of-market, or brokered deposits and institutional deposits, represented $101.9 million, or 14.6% of our total deposits.

The following table shows the average balance amounts and the average rates paid on deposits held by us.

		For the Six Months
		Ended June,
		2014								2013
						Average								Average
		Average				Yield/				Average				Yield/
		Balance				Rate				Balance				Rate
		(In thousands)
Interest-bearing demand accounts		$	94,131				0.18	%			44,137				0.22	%
Money market accounts			215,722				0.25	%			209,842				0.48	%
Savings accounts			22,784				0.19	%			12,299				0.38	%
Certificates of deposit less than $100,000			207,069				0.92	%			213,279				0.77	%
Certificates of deposit of $100,000 or more			95,516				0.83	%			93,402				0.70	%
Total interest-bearing average deposits			635,222								572,959
Noninterest-bearing deposits			107,814								99,687
Total average deposits		$	743,036								672,646

 

The maturity distribution of our time deposits of $100,000 or more is as follows:

 

		At June 30,
		2014
		(In thousands)
Three months or less		$	20,862
Over three through six months			18,270
Over six through twelve months			5,925
Over twelve months			58,980
Total certificates of deposits		$	104,037

Liquidity

 

Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities. Liquidity management involves monitoring our sources and uses of funds in order to meet our day-to-day cash flow requirements while maximizing profits. Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control at the time investment decisions are made. However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control.

The Company utilizes borrowing facilities in order to maintain adequate liquidity including: the FHLB of Atlanta advance window, the Federal Reserve Bank (“FRB”), and federal funds purchased. The Company also uses wholesale deposit products, including brokered deposits as well as national certificate of deposit services. Additionally, the Company has certain investment securities classified as available-for-sale that are carried at market value with changes in market value, net of tax, recorded through stockholders’ equity.

Lines of credit with the FHLB of Atlanta are based upon FHLB-approved percentages of Bank assets, but must be supported by appropriate collateral to be available. The Company has pledged first lien residential mortgage, second lien residential mortgage, residential home equity line of credit, commercial mortgage and multifamily mortgage portfolios under blanket lien agreements. At June 30, 2014, the Company had FHLB advances of $87.5 million outstanding with excess collateral pledged to the FHLB during those periods that would support additional borrowings of approximately $52.0 million.

Lines of credit with the FRB are based on collateral pledged. At June 30, 2014, the Company had lines available with the FRB for $60.3 million. At June 30, 2014, the Company had no FRB advances outstanding.

Capital Resources

The Company and the Bank are subject to numerous regulatory capital requirements administered by federal banking agencies. If these capital requirements are not met, regulators can initiate certain mandatory – and possibly additional discretionary – actions that, if undertaken, could affect operations. Under capital adequacy guidelines and the regulatory framework for corrective action, the Company and the Bank must meet certain capital guidelines, which involve quantitative measures of the Company’s and the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company’s and the Bank’s capital amounts and classification are subject to qualitative judgments by the regulators about components, risk weightings and certain other factors.

Quantitative measures set up by regulation to guarantee capital adequacy require the Company and the Bank to sustain minimum amounts and ratios of Tier 1 capital and total risk-based capital to risk-weighted assets and Tier 1 capital to total average assets. The Company and the Bank are required to maintain minimum Tier 1 capital and total risk-based capital to risk-weighted assets, and Tier 1 capital to total average assets of 4%, 8%, and 4%, respectively. To be considered “well capitalized”, the Company and the Bank must maintain at least Tier 1 capital and total risk-based capital to risk-weighted assets, and Tier 1 capital to total average assets of 6%, 10%, and 5%, respectively. As of June 30, 2014, the Company and the Bank are considered “well capitalized” under regulatory capital adequacy guidelines.

The actual capital amounts and ratios as well as minimum amounts for each regulatory defined category for the Company and the Bank at June 30, 2014 and December 31, 2013 are as follows:

										Required to be
										Categorized								Required to be
										Adequately								Categorized
		Actual								Capitalized								Well Capitalized
		Amount				Ratio				Amount				Ratio				Amount				Ratio
										(Dollars in thousands)
June 30, 2014
Carolina Financial Corporation
Tier 1 capital (to risk weighted assets)		$	103,744				14.80	%			28,045				4.00	%			N/A				N/A
Total risk based capital (to risk weighted assets)			113,231				16.15	%			56,089				8.00	%			N/A				N/A
Tier 1 capital (to total average assets)			103,744				10.92	%			37,995				4.00	%			N/A				N/A
CresCom Bank
Tier 1 capital (to risk weighted assets)			102,168				14.61	%			27,973				4.00	%			41,960				6.00	%
Total risk based capital (to risk weighted assets)			111,655				15.97	%			55,946				8.00	%			69,933				10.00	%
Tier 1 capital (to total average assets)			102,168				10.78	%			37,914				4.00	%			47,392				5.00	%
December 31, 2013
Carolina Financial Corporation
Tier 1 capital (to risk weighted assets)		$	99,602				15.42	%			25,834				4.00	%			N/A				N/A
Total risk based capital (to risk weighted assets)			108,650				16.82	%			51,668				8.00	%			N/A				N/A
Tier 1 capital (to total average assets)			99,602				11.15	%			35,732				4.00	%			N/A				N/A
CresCom Bank
Tier 1 capital (to risk weighted assets)			98,301				15.26	%			25,763				4.00	%			38,645				6.00	%
Total risk based capital (to risk weighted assets)			107,327				16.66	%			51,526				8.00	%			64,408				10.00	%
Tier 1 capital (to total average assets)			98,301				11.01	%			35,706				4.00	%			44,632				5.00	%

In December 2010, the Basel Committee on Banking Supervision, or BCBS, an international forum for cooperation on banking supervisory matters, announced the “Basel III” capital standards, which substantially revised the existing capital requirements for banking organizations. Modest revisions were made in June 2011. The Basel III standards operate in conjunction with portions of standards previously released by the BCBS and commonly known as “Basel II” and “Basel 2.5.” On June 7, 2012, the Federal Reserve, the OCC, and the FDIC requested comment on these proposed rules that, taken together, would implement the Basel regulatory capital reforms through what we refer to herein as the “Basel III capital framework.”

On July 2, 2013, the Federal Reserve adopted a final rule for the Basel III capital framework and, on July 9, 2013, the OCC also adopted a final rule and the FDIC adopted the same provisions in the form of an “interim” final rule. The rule will apply to all national and state banks and savings associations and most bank holding companies and savings and loan holding companies, which we collectively refer to herein as “covered” banking organizations. Bank holding companies with less than $500 million in total consolidated assets are not subject to the final rule, nor are savings and loan holding companies substantially engaged in commercial activities or insurance underwriting. In certain respects, the rule imposes more stringent requirements on “advanced approaches” banking organizations—those organizations with $250 billion or more in total consolidated assets, $10 billion or more in total foreign exposures, or that have opted in to the Basel II capital regime. The requirements in the rule will begin to phase on January 1, 2014, for advanced approaches banking organizations, and on January 1, 2015, for other covered banking organizations. The requirements in the rule will be fully phased in by January 1, 2019. Management expects to comply with the final rules when issued and effective.

Market Risk Management and Interest Rate Risk

The effective management of market risk is essential to achieving the Company’s objectives. As a financial institution, the Company’s most significant market risk exposure is interest rate risk. The primary objective of managing interest rate risk is to minimize the effect that changes in interest rates have on net income. This is accomplished through active asset and liability management, which requires the strategic pricing of asset and liability accounts and management of appropriate maturity mixes of assets and liabilities. The expected result of these strategies is the development of appropriate maturity and re-pricing opportunities in those accounts to produce consistent net income during periods of changing interest rates. The Bank’s asset/liability management committee, or ALCO, monitors loan, investment and liability portfolios to ensure comprehensive management of interest rate risk. These portfolios are analyzed for proper fixed-rate and variable-rate mixes under various interest rate scenarios. The asset/liability management process is designed to achieve relatively stable net interest margins and assure liquidity by coordinating the volumes, maturities or re-pricing opportunities of interest-earning assets, deposits and borrowed funds. It is the responsibility of the ALCO to determine and achieve the most appropriate volume and mix of interest-earning assets and interest-bearing liabilities, as well as ensure an adequate level of liquidity and capital, within the context of corporate performance goals. The ALCO meets regularly to review the Company’s interest rate risk and liquidity positions in relation to present and prospective market and business conditions, and adopts funding and balance sheet management strategies that are intended to ensure that the potential impact on earnings and liquidity as a result of fluctuations in interest rates is within acceptable standards. The Board of Directors also sets policy guidelines and establishes long-term strategies with respect to interest rate risk exposure and liquidity.

The Company uses interest rate sensitivity analysis to measure the sensitivity of projected net interest income to changes in interest rates. Management monitors the Company’s interest sensitivity by means of a computer model that incorporates current volumes, average rates earned and paid, and scheduled maturities, payments of asset and liability portfolios, together with multiple scenarios of prepayments, repricing opportunities and anticipated volume growth. Interest rate sensitivity analysis shows the effect that the indicated changes in interest rates would have on net interest income as projected for the next 12 months under the current interest rate environment. The resulting change in net interest income reflects the level of sensitivity that net interest income has in relation to changing interest rates.

As of June 30, 2014, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward movements in interest rates of 100, 200, and 300 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates. Downward movements do not appear to be applicable due to the low interest rate environment experienced since 2013. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the Consolidated Financial Statements. Therefore, management’s assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. In addition, this analysis does not consider any strategic changes to our balance sheet which management may consider as a result of changes in market conditions.

				Annualized Hypothetical
Interest Rate Scenario				Percentage Change in
Change		PrimeRate		Net Interest Income
0.00%		3.25%		0.00%
1.00%		4.25%		2.10%
2.00%		5.25%		4.00%
3.00%		6.25%		4.80%

The primary uses of derivative instruments are related to the mortgage banking activities of the Company. As such, the Company holds derivative instruments, which consist of rate lock agreements related to expected funding of fixed-rate mortgage loans to customers (interest rate lock commitments) and forward commitments to sell mortgage-backed securities and individual fixed-rate mortgage loans. The Company’s objective in obtaining the forward commitments is to mitigate the interest rate risk associated with the interest rate lock commitments and the mortgage loans that are held for sale. Derivatives related to these commitments are recorded as either a derivative asset or a derivative liability in the balance sheet and are measured at fair value. Both the interest rate lock commitments and the forward commitments are reported at fair value, with adjustments recorded in current period earnings within the noninterest income of the consolidated statements of operations.

Derivative instruments not related to mortgage banking activities, including financial futures commitments and interest rate swap agreements that do not satisfy the hedge accounting requirements, are recorded at fair value and are classified with resultant changes in fair value being recognized in noninterest income in the consolidated statement of operations.

When using derivatives to hedge fair value and cash flow risks, the Company exposes itself to potential credit risk from the counterparty to the hedging instrument. This credit risk is normally a small percentage of the notional amount and fluctuates as interest rates change. The Company analyzes and approves credit risk for all potential derivative counterparties prior to execution of any derivative transaction. The Company seeks to minimize credit risk by dealing with highly rated counterparties and by obtaining collateralization for exposures above certain predetermined limits. If significant counterparty risk is determined, the Company would adjust the fair value of the derivative recorded asset balance to consider such risk.

Accounting, Reporting, and Regulatory Matters

Information regarding recent authoritative pronouncements that could impact the accounting, reporting, and/or disclosure of the financial information by the Company are included in Note 1 of the consolidated financial statements.

Effect of Inflation and Changing Prices

The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements. Rather, our financial statements have been prepared on an historical cost basis in accordance with GAAP.

Unlike most industrial companies, our assets and liabilities are primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on our performance than the effect of changing prices and inflation in general. In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude. As discussed previously, we seek to manage the relationships between interest sensitive assets and liabilities in order to protect against wide rate fluctuations, including those resulting from inflation.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

See Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Market Risk Management and Interest Rate Risk, and – Liquidity.

 

Item 4. CONTROLS AND PROCEDURES.

 

Evaluation of Disclosure Controls and Procedures

 

Management, including our President and Chief Executive Officer and Executive Vice President and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report. Based upon that evaluation, our President and Chief Executive Officer and Executive Vice President and Chief Financial Officer concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Exchange Act is (i) recorded, processed, summarized and reported as and when required and (ii) accumulated and communicated to our management, including our President and Chief Executive Officer and Executive Vice President and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

 

Changes in Internal Control over Financial Reporting

 

There has been no change in the Company’s internal control over financial reporting during the three or six months ended June 30, 2014, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

Item 1. LEGAL PROCEEDINGS.

 

We are a party to claims and lawsuits arising in the ordinary course of business. Management is not aware of any material pending legal proceedings against the Company which, if determined adversely, would have a material adverse impact on the Company’s financial position, results of operations or cash flows.

 

Item 1A RISK FACTORS.

 

Not applicable

 

Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

 

(a) (i)	Pursuant to its 2013 Equity Incentive Plan (the “Plan”), the Company issued to certain of its employees, including an employee of Crescent Mortgage Company, 18,723 shares of restricted common stock and granted options to purchase 2,740 shares of common stock, exercise price of $10.00 per share. 8,723 shares of restricted stock were issued as part of Crescent Mortgage Company’s 2013 bonus compensation plan and vested immediately on the grant date, January 9, 2014. 8,000 shares of the restricted stock are subject to incremental vesting over a four-year period (25% of the award to vest annually on the first four anniversaries of the grant date), and 2,000 shares of the restricted stock cliff vests on the fifth anniversary of the grant date. The options to purchase 2,740 shares of common stock vest incrementally over a two-year period (50% of the award to vest annually on the first two anniversaries of the grant date). The shares of restricted stock subject to vesting and the options to purchase common stock were granted on April 23, 2014.
(ii)	Pursuant to the Plan, on July 7, 2014, the Company granted 7,408 shares of common stock to certain of its employees. The grants included 2,908 shares under Crescent Mortgage Company’s 2013 bonus compensation plan that vested immediately on the grant date, 4,000 shares of restricted stock that are subject to incremental vesting over a four-year period (25% of the award to vest annually on the first four anniversaries of the grant date), and 500 shares of restricted stock that cliff vest on the fifth anniversary of the grant date.

 

The issuance of such securities was exempt from the registration requirements of the Securities Act pursuant to Section 3(b) and Rule 701 promulgated thereunder and the consideration was services rendered.

 

(b)

The following stock repurchases were made during the period covered by this report in connection with the Company’s administration of the 2013 Equity Incentive Plan.

 

Period				Total Number of Shares Purchased				Average Price Paid per Share				Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs				Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
	April 1, 2014 – April 30, 2014				—			$	—				—				—
	May 1, 2014 - May 31, 2014				687			$	20.48				—				—
	June 1, 2014 – June 30, 2014				—			$	—				—				—
					687								—				—

 

Item 3. DEFAULTS UPON SENIOR SECURITIES.

 

Not applicable

 

Item 4. MINE SAFETY DISCLOSURES.

 

Not applicable

 

Item 5. OTHER INFORMATION.

 

Not applicable

 

Item 6. EXHIBITS.

 

The exhibits required to be filed as part of this Quarterly Report on Form 10-Q are listed in the Index to Exhibits attached hereto and are incorporated herein by reference.

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

		CAROLINA FINANCIAL CORPORATION
		Registrant
Date: August 11th, 2014		/s/ Jerold L. Rexroad
		Jerold L. Rexroad
		President and Chief Executive Officer
		(Principal Executive Officer)
Date: August 11th, 2014		/s/ William A. Gehman, III
		William A. Gehman III
		Executive Vice President and Chief Financial Officer
		(Principal Financial and Accounting Officer)

INDEX TO EXHIBITS

Exhibit Number		Description
3.1		Certificate of Amendment to the Amended and Restated Certificate of Incorporation of Carolina Financial Corporation filed on May 8, 2014.(1)
3.2		Certificate of Amendment to the Amended and Restated Certificate of Incorporation filed on June 11, 2010.(2)
3.3		Amended and Restated Certificate of Incorporation filed on April 2, 1997.(2)
31.1		Rule 13a-14(a) Certification of the Principal Executive Officer.
31.2		Rule 13a-14(a) Certification of the Principal Financial Officer.
32		Section 1350 Certifications.
101		The following materials from the Quarterly Report on Form 10-Q of Carolina Financial Corporation for the quarter ended June 30, 2014, formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statement of Changes in Stockholders’ Equity, (v) Consolidated Statements of Cash Flows and (vi) Notes to Unaudited Consolidated Financial Statements.

(1)

Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014.

(2)

Incorporated by reference from the Company’s Registration on Form 10 filed on February 26, 2014. 1

 

¹ When the articles are amended during a quarter, there is a requirement to file the complete articles, as amended. See Item 601(b)(3)(i) of Regulation S-K.