SOUTHCOAST FINANCIAL CORP - FORM 10-Q

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EXCEL - IDEA: XBRL DOCUMENT - SOUTHCOAST FINANCIAL CORP	Financial_Report.xls
EX-31 - EXHIBIT 31.1 - SOUTHCOAST FINANCIAL CORP	ex31-1.htm
EX-32 - EXHIBIT 32 - SOUTHCOAST FINANCIAL CORP	ex32.htm
EX-31 - EXHIBIT 31.2 - SOUTHCOAST FINANCIAL CORP	ex31-2.htm

U.S. 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 September 30, 2014

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

For the Transition Period from _________to_________

Commission File No.

0-25933

SOUTHCOAST FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

South Carolina		57-1079460
(State or other jurisdiction		(I.R.S. Employer
of incorporation or organization)		Identification No.)

530 Johnnie Dodds Boulevard

Mt. Pleasant, South Carolina 29464

(Address of principal executive offices)

843-884-0504

(Registrant's telephone number, including area code)

________________________________________________

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

YES [ X ] NO [ ]

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [ X ] No [ ]

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 the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer [ ]		Accelerated filer [ ]
Non-accelerated filer [ ] (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 [ ] NO [ X ]

State the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date.

7,096,574 shares of common stock, no par value, as of October 31, 2014

SOUTHCOAST FINANCIAL CORPORATION

INDEX

		Page No.
PART I - FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets – September 30, 2014 and December 31, 2013		2

Condensed Consolidated Statements of Income – Nine months ended September 30, 2014 and 2013		3

Condensed Consolidated Statements of Income – Three months ended September 30, 2014 and 2013		4

Condensed Consolidated Statements of Comprehensive Income – Nine months ended September 30, 2014 and 2013		5

Condensed Consolidated Statements of Comprehensive Income – Three months ended September 30, 2014 and 2013		5

Condensed Consolidated Statements of Changes in Shareholders' Equity – Nine months ended September 30, 2014 and 2013		6

Condensed Consolidated Statements of Cash Flows - Nine months ended September 30, 2014 and 2013		7

Notes to Condensed Consolidated Financial Statements		8-32

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	33-45

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	45

Item 4.	Controls and Procedures	45

PART II - OTHER INFORMATION

Item 6.	Exhibits	46

Signatures		46

Exhibit Index		47

SOUTHCOAST FINANCIAL CORPORATION

PART I - FINANCIAL INFORMATION

Item 1 - Financial Statements

Condensed Consolidated Balance Sheets

(Dollars in thousands)

	September 30,			December 31,
	2014			2013
	(Unaudited)
Assets
Cash and due from banks	$	29,529		$	28,460

Investment securities
Available for sale		35,530			39,822
Federal Home Loan Bank Stock, at cost		3,550			3,629

Loans held for sale		257			271

Loans, net of allowance of $5,938 and $6,041		349,000			325,865

Premises and equipment, net		20,605			21,150
Other real estate owned, net		4,060			5,249
Company owned life insurance		12,903			12,658
Deferred tax asset, net		6,196			7,516
Other assets		2,803			2,764

Total assets	$	464,433		$	447,384

Liabilities
Deposits
Noninterest-bearing	$	52,213		$	41,295
Interest-bearing		271,666			274,533

Total deposits		323,879			315,828

Federal funds purchased		7,970			3,115
Securities sold under agreements to repurchase		1,694			1,703
Federal Home Loan Bank borrowings		70,000			69,000
Junior subordinated debentures		10,310			10,310
Other liabilities		4,918			4,859

Total liabilities		418,771			404,815

Shareholders’ Equity
Common stock (no par value; 20,000,000 shares authorized; 7,093,132 shares issued and outstanding at September 30, 2014 and 7,082,062 at December 31, 2013)		54,619			54,544
Accumulated deficit		(7,552	)		(9,937	)
Accumulated other comprehensive loss		(1,405	)		(2,038	)

Total shareholders’ equity		45,662			42,569

Total liabilities and shareholders’ equity	$	464,433		$	447,384

See Notes to Condensed Consolidated Financial Statements

-2-

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Income

(Unaudited)

(Dollars in thousands)

	For the Nine Months Ended
	September 30,
	2014			2013
Interest income
Loans, including fees	$	12,703		$	12,468
Taxable securities		725			677
Tax exempt securities		113			132
Cash and federal funds sold		24			24

Total interest income		13,565			13,301

Interest expense
Deposits and borrowings		2,706			2,911

Net interest income		10,859			10,390
Provision for loan losses		-			-

Net interest income after provision for loan losses		10,859			10,390

Noninterest income
Service fees on deposit accounts		1,118			1,127
Gains on loans held for sale		27			203
Gain on sales of available for sale securities		109			105
Company owned life insurance earnings		245			268
Other		131			137
Total noninterest income		1,630			1,840

Noninterest expenses
Salaries and employment benefits		4,880			5,260
Occupancy		870			980
Furniture and equipment		1,267			1,241
Software		54			151
Insurance		457			593
Professional fees		547			620
Telephone, postage, and supplies		245			261
Gain on sale of other real estate owned		(340	)		(314	)
Other real estate owned rental income, impairment provision, and other expenses		112			133
Other operating expenses		891			933

Total noninterest expenses		8,983			9,858

Income before income taxes		3,506			2,372
Income tax expense (benefit)		1,121			(6,363	)

Net income	$	2,385		$	8,735

Basic net income per common share	$	.34		$	1.23

Diluted net income per common share	$	.34		$	1.23

Weighted average shares outstanding
Basic		7,089,630			7,074,183
Diluted		7,089,630			7,074,183

See Notes to Condensed Consolidated Financial Statements

-3-

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Income

(Unaudited)

(Dollars in thousands)

	For the Three Months Ended
	September 30,
	2014			2013
Interest income
Loans, including fees	$	4,286		$	4,106
Taxable securities		222			280
Tax exempt securities		37			38
Cash and federal funds sold		8			11

Total interest income		4,553			4,435

Interest expense
Deposits and borrowings		897			951

Net interest income		3,656			3,484
Provision for loan losses		-			-

Net interest income after provision for loan losses		3,656			3,484

Noninterest income
Service fees on deposit accounts		380			377
Gains on mortgage loans held for sale		6			32
Company owned life insurance earnings		82			91
Other		44			60
Total noninterest income		512			560

Noninterest expenses
Salaries and employment benefits		1,431			1,705
Occupancy		285			314
Furniture and equipment		424			449
Software		11			19
Insurance		157			198
Professional fees		171			204
Telephone, postage, and supplies		77			79
Gain on sale of other real estate owned		(184	)		-
Other real estate owned rental income, impairment provision, and other expenses		51			55
Other operating expenses		315			327

Total noninterest expenses		2,738			3,350

Income before income taxes		1,430			694
Income tax expense (benefit)		397			-

Net income	$	1,033		$	694

Basic net income per common share	$	.15		$	.10

Diluted net income per common share	$	.15		$	.10

Weighted average shares outstanding
Basic		7,093,132			7,077,878

Diluted		7,093,132			7,077,878

See Notes to Condensed Consolidated Financial Statements

-4-

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Comprehensive Income

(Unaudited)

(Dollars in thousands)

	For the Nine Months Ended
	September 30,
	2014			2013
Net income	$	2,385		$	8,735

Other comprehensive income (loss):
Unrealized gains/losses on available for sale securities		1,097			(1,226	)
Tax effect		(394	)		483
Reclassification of gains included in net income		(109	)		(105	)
Tax effect		39			38
Total other comprehensive income (loss)		633			(810	)

Comprehensive income	$	3,018		$	7,925

	For the Three Months Ended
	September 30,
	2014			2013
Net income	$	1,033		$	694

Other comprehensive income (loss):
Unrealized gains/losses on available for sale securities		(12	)		227
Tax effect		5			(80	)
Total other comprehensive income (loss)		(7	)		147

Comprehensive income	$	1,026		$	841

See Notes to Condensed Consolidated Financial Statements

-5-

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Changes in Shareholders' Equity

For the nine months ended September 30, 2014 and 2013

(Unaudited)

(Dollars in thousands)

					Accumulated Deficit			Accumulated Other
	Common Stock							Comprehensive			Total
	Shares		Amount					Loss

Balance, January 1, 2013		7,065,515	$	54,437	$	(19,002	)	$	(1,171	)	$	34,264

Comprehensive income						8,735			(810	)		7,925

Employee stock purchase plan		12,363		83		.-			-			83

Balance, September 30, 2013		7,077,878	$	54,520	$	(10,267	)	$	(1,981	)	$	42,272

Balance, January 1, 2014		7,082,062	$	54,544	$	(9,937	)	$	(2,038	)	$	42,569

Comprehensive income						2,385			633			3,018

Employee stock purchase plan		11,070		75		.-			-			75

Balance, September 30, 2014		7,093,132	$	54,619	$	(7,552	)	$	(1,405	)	$	45,662

See Notes to Condensed Consolidated Financial Statements

-6-

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(Amounts in thousands)	For the Nine Months Ended
	September 30,
	2014			2013
Operating activities
Net income	$	2,385		$	8,735
Adjustments to reconcile net income to net cash provided by operating activities
(Increase) decrease in deferred income taxes		964			(6,785	)
Depreciation and amortization		642			629
Discount accretion and premium amortization		102			240
Gain on sales of available for sale securities		(109	)		(105	)
Gain on sales of other real estate owned		(340	)		(314	)
Gain on sales of premises and equipment		-			(9	)
Change in deferred gain on sale of other real estate owned		95			(63	)
Impairment charges on other real estate owned		6			4
Originations of loans held for sale		(1,254	)		(14,662	)
Proceeds from sales of loans held for sale		1,295			15,729
Gain on sales of mortgage loans held for sale		(27	)		(203	)
Company owned life insurance earnings		(245	)		(268	)
Decrease(increase) in other assets		(39	)		201
Increase in other liabilities		58			480
Net cash provided by operating activities		3,533			3,609

Investing activities
Calls, maturities, and paydowns of investment securities available-for-sale		5,060			6,906
Purchases of investment securities available-for-sale		(3,000	)		(12,485	)
Sales of investment securities available-for-sale		3,229			8,310
Purchases of Federal Home Loan Bank stock		(878	)		(178	)
Sales of Federal Home Loan Bank stock		957			382
Net increase in loans		(22,837	)		(837	)
Proceeds from sales of premises and equipment		-			9
Purchases of premises and equipment		(97	)		(300	)
Proceeds from sales of other real estate owned		1,144			2,908
Capital expenditures related to other real estate owned		(14	)		(99	)
Net cash provided (used) by investing activities		(16,436	)		4,616

Financing activities
Net increase (decrease) in deposits		8,051			(6,390	)
Increase in federal funds purchased		4,855			1,992
Increase (decrease) in securities sold under agreements to repurchase		(9	)		892
Proceeds from Federal Home Loan Bank Borrowings		29,000			75,500
Paydowns of Federal Home Loan Bank Borrowings		(28,000	)		(77,500	)
Net proceeds from issuances of stock		75			83
Net cash provided (used) by financing activities		13,972			(5,423	)

Increase in cash and cash equivalents		1,069			2,802
Cash and cash equivalents, beginning of period		28,460			21,984
Cash and cash equivalents, end of period	$	29,529		$	24,786
Cash paid for:
Interest	$	2,911		$	2,996
Income taxes		133			351
Supplemental noncash investing and financing activities:
Real estate acquired in settlement of loans	$	747		$	317
Change in unrealized losses on available-for-sale securities		(988	)		1,331
Loans to finance sales of other real estate owned		1,045			2,086

See Notes to Condensed Consolidated Financial Statements

-7-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 1 - Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Regulation S-X of the Securities and Exchange Commission. Accordingly they do not include all information and notes required by generally accepted accounting principles for complete financial statements. However, in the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.

Note 2 - Organization

Southcoast Financial Corporation (the “Company”) is a South Carolina corporation organized in 1999 for the purpose of being a holding company for Southcoast Community Bank (the “Bank”). On April 29, 1999, pursuant to a Plan of Exchange approved by the shareholders, all of the outstanding shares of capital stock of the Bank were exchanged for shares of common stock of the Company. The Company presently engages in no business other than that of owning the Bank and another subsidiary, Southcoast Investment Corporation.

Note 3 - Net Income Per Share

Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. Earnings and dividends per share are restated for all stock splits and stock dividends through the date of issuance of the financial statements, if any. The Company had no potentially dilutive shares during the periods presented in this report.

Note 4 – Recently Issued Accounting Standards

The following is a summary of recent authoritative pronouncements that may affect accounting, reporting, and disclosure of financial information by the Company:

In May 2014, the FASB issued ASU 2014-09 – Revenue from Contracts with Customers (“ASU 2019-09”). ASU 2014-09 provides guidance that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 is effective prospectively, for annual and interim periods, beginning after December 15, 2016. The Company is currently evaluating the impact this standard will have on the Company’s results of operations, financial position or disclosures.

-8-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 5 – Investment Securities

The amortized cost and fair value of investment securities are as follows:

(Amounts in thousands)	September 30, 2014
	Amortized		Gross Unrealized				Estimated
Available for sale	Cost		Gains		Losses		Fair Value
Mortgage backed
Government sponsored enterprises	$	25,597	$	-	$	412	$	25,185
Municipal securities		3,923		270		-		4,193
Other		8,206		7		2,061		6,152

Total	$	37,726	$	277	$	2,473	$	35,530

	December 31, 2013
	Amortized		Gross Unrealized				Estimated
Available for sale	Cost		Gains		Losses		Fair Value
Mortgage backed
Government sponsored enterprises	$	30,889	$	80	$	1,100	$	29,869
Municipal securities		3,918		150		-		4,068
Other		8,199		-		2,314		5,885

Total	$	43,006	$	230	$	3,414	$	39,822

The following tables show gross unrealized losses and fair value, aggregated by investment category, and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2014 and December 31, 2013.

Available for Sale

(Amounts in thousands)	September 30, 2014
	Less than				Twelve Months
	Twelve Months				or More				Total
			Unrealized				Unrealized				Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses

Mortgage backed	$	5,451	$	10	$	19,734	$	402	$	25,185	$	412
Other		-		-		1,645		2,061		1,645		2,061

Total	$	5,451	$	10	$	21,379	$	2,463	$	26,830	$	2,473

	December 31, 2013
	Less than				Twelve Months
	Twelve Months				or More				Total
			Unrealized				Unrealized				Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses

Mortgage backed	$	26,394	$	1,100	$	-	$	-	$	26,394	$	1,100
Other		3,948		52		1,437		2,262		5,385		2,314

Total	$	30,342	$	1,152	$	1,437	$	2,262	$	31,779	$	3,414

-9-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 5 – Investment Securities – (continued)

Securities classified as available-for-sale are recorded at fair market value. Unrealized losses on securities in a continuous loss position for twelve months or more totaled $2,463,000, or 99% of unrealized losses, and $2,262,000, or 66% of unrealized losses, at September 30, 2014 and December 31, 2013, respectively. These unrealized losses for both periods were comprised of three securities. 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.

The unrealized loss attributable to “Other” securities primarily relates to valuations on two individual collateralized debt obligations. The Company believes, based on industry analyst reports, credit ratings, and third party other-than-temporary loss impairment evaluations, that the deterioration in the value of these securities is attributable to a combination of the lack of liquidity in both of these securities and credit quality concerns for one of the two securities. These securities are considered Level 3 securities in the fair value hierarchy as they both trade in less than liquid markets.

One of the Company’s collateralized debt obligations with an amortized cost of approximately $1,820,000 and fair value of approximately $1,084,000 is receiving contractual interest payments, while the other with an amortized cost of approximately $1,736,000 and fair value of approximately $459,000 is receiving payment-in-kind interest in lieu of cash interest payments. Due to the over-collateralized credit position of the security currently receiving interest payments, no other-than-temporary impairment was recognized on this security. Payment-in-kind interest consists of capitalization of interest amounts due on a security. In accordance with terms outlined in its offering circular, the security not currently paying interest has its deferred interest capitalized and added to the principal balance of the security. Future interest payments are accrued on these larger principal balances. The Company has discontinued the accrual of interest on this security due to its payment-in-kind status.

Payment-in-kind interest was triggered on this security due to deferrals of interest payments by individual issuers within the pool of issuers. Individual issuers are allowed to defer their interest payments for a period of up to five years. The security is divided into several tranches, with the A tranche securities being the most senior in terms of payment priority and Income Notes being the least senior. The Company owns notes in the C tranche of the security. Each tranche must pass an overcollateralization test in order for note holders in subordinate tranches to receive their contractual interest payments. The overcollateralization test is based on total performing collateral in the pool divided by total outstanding debt within the tranche. The senior most pool failing its overcollateralization test will receive principal paydowns on its outstanding notes in addition to contractual interest payments in order to cure its failure. These additional payments will be diverted from note holders in subordinate tranches who will instead receive payment-in-kind interest. At September 30, 2014, there was $225,234,000 of performing collateral in the pool. The table below summarizes balance and overcollateralization data for the individual tranches at September 30, 2014.

(Amounts in thousands)
Tranche	Current Balance		Required Overcollateralization %			Current Overcollateralization %
A	$	175,963		128.00	%		128.81	%
B		38,965		115.00	%		105.45	%
C		47,821		106.20	%		86.26	%
D		27,969		100.30	%		77.96	%
Income Notes		18,000	N/A			N/A

As shown above, tranches B and below currently fail their overcollateralization test. According to the structured payment terms as described in the offering circular for this security, interest payments are currently being diverted from tranches subordinate to B to pay down total principal balances in the B tranche. If and when these payments reduce the principal balance in the B tranche by enough to pass its overcollateralization requirement, the C tranche securities will begin to receive contractual interest payments, and additional payments will be diverted from subordinate tranches in order to meet its overcollateralization requirement. This payment structure, known as a waterfall, is designed to continue until all tranches meet their overcollateralization requirement. However, this outcome is dependent on the level of future interest deferrals and defaults by individual issuers. Any shortfalls to contractual principal and interest payments due will be borne in reverse order of payment priority, with the most subordinate tranche having the largest loss and the senior most tranche having the smallest loss. As a note holder in the C tranche of this structure, the Company’s principal and interest claims are subordinate to the principal and interest claims of note holders in the A and B tranches. More specifically, the Company and other C note holders would stand to lose 100% of their principal and interest before note holders in the B tranche lost their first dollar, and B note holders would lose 100% of their investment before A note holders experienced any loss.

-10-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 5 – Investment Securities – (continued)

The Company engaged a firm specializing in security valuations to evaluate the security receiving payment-in-kind interest for other-than- temporary impairment (“OTTI”). This firm uses the OTTI evaluation model to compare the present value of expected cash flows to the previous estimate to measure whether there are any adverse changes in cash flows during the quarter. The OTTI model considers the structure and term of the collateralized debt obligation and the financial condition of the underlying issuers. Specifically, the model details interest rates, principal balances of note classes and issuers, the timing and amount of interest and principal payments of the underlying issuers, and the allocation of the payments to the note classes. The allocation of payments to the note classes follows the payment priority hierarchy for the individual tranches. The OTTI evaluation prepared as of September 30, 2014 predicts the Company will resume receipt of its contractual principal and interest payments sometime during 2015, which is when the B tranche is projected to pass its overcollateralization test. These projections are based on assumptions developed from current financial data for the underlying issuers and may change in subsequent periods based on future financial data which could alter the assumptions.

The current estimate of expected cash flows is based on the most recent trustee reports and any other relevant information including announcements of interest payment deferrals or defaults of underlying issuers. The OTTI evaluation model assumes no recoveries on defaults. The result of the firm’s analysis indicated approximately $176,000 of credit loss as of March 31, 2011, which was recognized as an other-than-temporary loss in the first quarter of 2011 and reported in noninterest income. No credit losses had been recognized on these securities prior to 2011, and there have been no changes to credit losses recognized in earnings for any subsequent periods. Due to the credit loss recognized on this security, the Company has not accrued into interest income any of the payment-in-kind interest due on the security. Consequently, the security’s payment-in-kind interest is not reflected in the book value of the security. Total other-than-temporary impairment in accumulated other comprehensive income was $817,000 for the security (Security B in the table below) at September 30, 2014.

The following table provides certain relevant details on each of our collateralized debt obligations as of September 30, 2014, including the book value, fair value, and unrealized losses on the securities, as well as certain information about the overall pools and the current status of their underlying issuers. “Excess Subordination” is a measure of the excess performing collateral in the pool beyond the total level of debt outstanding in the pool with an equal or greater level of preference in the payment structure. It is expressed in the tables below as a percentage of performing collateral. It represents the percentage reduction in performing collateral that would precede an inability of the security to make contractually required payments to the Company.

September 30, 2014
(Amounts in thousands)
	Security A			Security B

Book Value	$	1,820		$	1,736
Fair Value	$	1,084		$	459
Unrealized Loss	$	736		$	1,277
Number of underlying financial institution issuers		47			40
Number of deferrals and defaults		10			14
Additional expected deferrals/ defaults*	N/A			0/0
Excess Subordination as a percentage of performing collateral^		25.52	%	N/A

* No assessment of these numbers was made for Security A as it was not modeled for cash flows due to its current payment status and its excess subordination. For Security B, this includes issuers for which there is an estimated probability of deferral or default of 50% or greater. None of the remaining performing collateral was projected as a future deferral or default, due to low Texas ratios; two deferring issuers were projected to default.

^Security B is in a support tranche and has no excess subordination.

The credit quality of the collateralized debt obligations is directly related to the financial strength and ability to make contractual interest payments of the underlying issuers in these securities, most of which are banks or bank holding companies. As such, these securities may show additional OTTI in future periods if the financial condition of the underlying issuers further deteriorates.

-11-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 5 – Investment Securities – (continued)

The amortized costs and fair values of investment securities available for sale at September 30, 2014 by contractual maturity are shown in the following table. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

(Amounts in thousands)	Amortized		Fair
	Cost		Value
Due after five but within ten years	$	2,329	$	2,470
Due after ten years		5,650		3,766
Mortgage backed		25,597		25,185
Equity securities with no maturity		4,150		4,109

Total investment securities available-for-sale	$	37,726	$	35,530

Investment securities with an aggregate amortized cost of $23,392,000 and estimated fair value of $23,041,000 at September 30, 2014, were pledged to secure public deposits and for other purposes, as required or permitted by law. Investment securities with an aggregate amortized cost of $19,321,000 and estimated fair value of $18,852,000 at December 31, 2013, were pledged to secure public deposits and for other purposes, as required or permitted by law.

Investment securities with an aggregate amortized cost of $2,652,000 and estimated fair value of $2,610,000 at September 30, 2014, were pledged to secure securities sold under agreements to repurchase. Investment securities with an aggregate amortized cost of $2,827,000 and estimated fair value of $2,716,000 at December 31, 2013, were pledged to secure securities sold under agreements to repurchase.

-12-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 - Loans

The composition of loans by major loan category is presented below:

(Dollars in thousands)	September 30,			December 31,
	2014			2013
Real estate secured loans:
Residential 1-4 Family	$	209,937		$	188,406
Multifamily		6,075			4,828
Commercial		90,354			79,963
Construction and land development		26,143			34,232

Total real estate secured loans		332,509			307,429
Commercial and industrial		20,044			22,208
Consumer		2,052			1,960
Other		333			309

Total gross loans		354,938			331,906
Allowance for loan losses		(5,938	)		(6,041	)
	$	349,000		$	325,865

The Company uses a numerical grading system from 1 to 9 to assess the credit risk inherent in its loan portfolio, with Grade 1 loans having the lowest credit risk and Grade 9 loans having the highest credit risk. Loans with credit grades from 1 to 5 are considered passing grade, or acceptable, loans. Loans with grades from 6 to 9 are considered to have less than acceptable credit quality. Generally, impaired loans have credit grades of 7 or higher. Following is a listing and brief description of the various risk grades. The grading of individual loans may involve the use of estimates.

Credit Grade		Description
1		Loans secured by cash collateral.
2		Loans secured by readily marketable collateral.
3		Top quality loans with excellent repayment sources and no significant identifiable risk of collection.
4		Acceptable loans with adequate repayment sources and little identifiable risk of collection.
5		Acceptable loans with signs of weakness as to repayment or collateral, but with mitigating factors that minimize the risk of loss.
6		Watch List or Special Mention loans with underwriting tolerances and/or exceptions with no mitigating factors that may, due to economic or other factors, increase the risk of loss.
7		Classified substandard loans inadequately protected by the paying capacity or net worth of the obligor, or of the collateral with weaknesses that jeopardize the liquidation of the debt.
8		Classified doubtful loans in which collection or liquidation in full is highly improbable.
9		Classified loss loans that are uncollectible and of such little value that continuance as an asset is not warranted.

-13-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

The following tables provide a summary of our credit risk profile by loan categories as of September 30, 2014 and December 31, 2013 (including nonaccrual loans).

(Dollars in thousands)

Credit Risk Profile by Creditworthiness Category

As of September 30, 2014 and December 31, 2013

	Real Estate Secured
	Residential 1-4 Family				Multi Family				Commercial				Construction and Land Development
	2014		2013		2014		2013		2014		2013		2014		2013
Grade
1	$	-	$	-	$	-	$	-	$	-	$	-	$	-	$	-
2		-		-		-		-		-		-		-		-
3		101,174		80,732		737		592		14,757		13,356		11,587		10,238
4		55,241		49,414		1,779		2,017		31,051		27,956		7,217		9,159
5		46,318		49,204		2,328		884		33,426		27,981		6,060		11,156
6		1,229		925		-		-		1,752		1,842		550		676
7		5,354		7,387		1,231		1,335		9,368		8,128		729		2,312
8		621		744		-		-		-		700		-		691
9		-		-		-		-		-		-		-		-

Total	$	209,937	$	188,406	$	6,075	$	4,828	$	90,354	$	79,963	$	26,143	$	34,232

	Non-Real Estate Secured
	Commercial				Consumer				Other				Total
	2014		2013		2014		2013		2014		2013		2014		2013
Grade
1	$	449	$	1,971	$	415	$	426	$	-	$	60	$	864	$	2,457
2		-		-		-		-		-		-		-		-
3		2,392		1,228		409		269		95		-		131,151		106,415
4		5,430		6,680		169		224		181		204		101,068		95,654
5		10,398		9,777		970		954		57		45		99,557		100,001
6		20		860		-		-		-		-		3,551		4,303
7		1,355		1,692		89		87		-		-		18,126		20,941
8		-		-		-		-		-		-		621		2,135
9		-		-		-		-		-		-		-		-

Total	$	20,044	$	22,208	$	2,052	$	1,960	$	333	$	309	$	354,938	$	331,906

-14-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

The following tables provide a summary of past due loans by loan category as of September 30, 2014 and December 31, 2013.

(Dollars in thousands)

Past Due Loans

For the Periods Ended September 30, 2014 and December 31, 2013

September 30, 2014	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans Receivable		Recorded Investment > 90 Days and Accruing
Real Estate Secured
1-4 Family Residential	$	2,233	$	1,068	$	2,060	$	5,361	$	204,576	$	209,937	$	-
Multifamily Residential		-		348		883		1,231		4,844		6,075		-
Commercial Real Estate		794		327		1,107		2,228		88,126		90,354		-
Construction and Land Development		53		-		10		63		26,080		26,143		-
Non Real Estate Secured														-
Commercial and Industrial		110		95		158		363		19,681		20,044		-
Consumer and Other		11		11		68		90		2,295		2,385		-

Total	$	3,201	$	1,849	$	4,286	$	9,336	$	345,602	$	354,938	$	-

December 31, 2013	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans Receivable		Recorded Investment > 90 Days and Accruing
Real Estate Secured
1-4 Family Residential	$	736	$	538	$	2,310	$	3,584	$	184,822	$	188,406	$	-
Multifamily Residential		349		-		986		1,335		3,493		4,828		-
Commercial Real Estate		1,330		-		877		2,207		77,756		79,963		-
Construction and Land Development		-		21		859		880		33,352		34,232		-
Non Real Estate Secured														-
Commercial and Industrial		461		-		171		632		21,576		22,208		-
Consumer and Other		53		12		19		84		2,185		2,269		-

Total	$	2,929	$	571	$	5,222	$	8,722	$	323,184	$	331,906	$	-

-15-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

The following table provides a summary of nonaccrual loans as of September 30, 2014 and December 31, 2013.

(Dollars in thousands)

	September 30,		December 31,
	2014		2013

1-4 Family Residential	$	3,392	$	4,624
Multifamily Residential		883		986
Commercial Real Estate		2,736		2,590
Construction and Land Development		10		860
Commercial and Industrial		890		775
Consumer and Other		105		19

Total	$	8,016	$	9,854

At September 30, 2014 and December 31, 2013, nonaccrual loans totaled $8 million and $9.9 million, respectively. The gross interest income which would have been recorded under the original terms of nonaccrual loans amounted to approximately $685,000 and $618,000 at September 30, 2014 and December 31, 2013, respectively. At September 30, 2014 and December 31, 2013, impaired loans (which include nonaccrual loans and troubled debt restructurings (TDRs)) totaled $8.2 million and $10.3 million, respectively. The recorded investment in impaired loans individually evaluated for impairment, which include nonaccrual loans over $250,000 and TDRs, totaled $6.7 million and $7.9 million at September 30, 2014 and December 31, 2013, respectively. At September 30, 2014 and December 31, 2013, there were no loans over ninety days past due and still accruing interest.

At September 30, 2014 and December 31, 2013, all TDRs, including those on nonaccrual status, totaled $4.1 million and $4.6 million, respectively. The gross interest income that would have been recognized on TDRs according to the original loan terms did not differ materially from the interest income recognized as a result of the modified terms. The gross interest income that would have been recognized on TDRs according to the original loan terms during the year ended December 31, 2013 totaled approximately $27,000; actual interest income recognized on these loans according to the restructured terms totaled approximately $27,000. During the quarter ended September 30, 2014, two loans totaling $830,000 had their original loan terms restructured, and no loans that had previously had their original terms restructured went into nonaccrual. During the same period, there were no loans that had their original terms restructured that paid off, and no amounts related to TDRs were charged off. During the quarter ended September 30, 2014, there were two TDR’s initiated in the preceding twelve months which have subsequently defaulted. The first of these TDR’s is a 1-4 Family Residential loan with an impaired balance totaling $78,000 at September 30, 2014. The second is secured by commercial and industrial property and had an impaired balance of $108,000 at September 30, 2014. The Company defines subsequent defaults on TDRs to be TDRs with delinquencies of thirty or more days that occurred subsequent to the date of the restructure. TDRs did not have a material effect on the allowance for loan losses as of September 30, 2014 or December 31, 2013. Additionally, the Company had no commitments to extend additional credit on its TDRs at September 30, 2014 or December 31, 2013.

The following tables provide a year to date analysis of activity within the allowance for loan losses.

(Dollars in thousands)	September 30,			September 30,
	2014			2013

Balance, beginning of year	$	6,041		$	8,159
Provision for loan losses		-			-
Net (charge offs) recoveries		(103	)		(732	)
Balance, end of quarter	$	5,938		$	7,427

-16-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

	For the Nine Months Ended September 30, 2014
	Beginning Balance		Charge Offs			Recoveries		Provisions			Ending Allowance for Loan Losses
(Dollars in thousands)											General Reserves		Specific Reserves		Total

Real Estate Secured
1-4 Family Residential	$	1,829	$	(52	)	$	46	$	(231	)	$	1,524	$	68	$	1,592
Multifamily Residential		58		(113	)		-		153			98		-		98
Commercial Real Estate		1,031		(106	)		1		594			1,520		-		1,520
Construction and Land Development		585		(114	)		19		(201	)		289		-		289
Non Real Estate Secured
Commercial and Industrial		690		(42	)		213		(286	)		575		-		575
Consumer and Other		24		(1	)		46		(36	)		33		-		33
Other
Other General Reserves		1,339		-			-		14			1,353		-		1,353
Unallocated		485		-			-		(7	)		478		-		478
Total	$	6,041	$	(428	)	$	325	$	-		$	5,870	$	68	$	5,938

	For the Nine Months Ended September 30, 2013
	Beginning Balance		Charge Offs			Recoveries		Provisions			Ending Allowance for Loan Losses
(Dollars in thousands)											General Reserves		Specific Reserves		Total

Real Estate Secured
1-4 Family Residential	$	2,312	$	(297	)	$	499	$	(860	)	$	1,522	$	132	$	1,654
Multifamily Residential		39		-			-		(14	)		25		-		25
Commercial Real Estate		1,264		(423	)		3		168			1,012		-		1,012
Construction and Land Development		606		(845	)		5		1,555			671		650		1,321
Non Real Estate Secured
Commercial and Industrial		1,324		(483	)		9		(61	)		789		-		789
Consumer and Other		55		(44	)		66		(55	)		22		-		22
Other
Other General Reserves		1,939		-			-		(573	)		1,366		-		1,366
Unallocated		620		-			-		(160	)		460		-		460
Total	$	8,159	$	(2,092	)	$	582	$	-		$	5,867	$	782	$	6,649

-17-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

	For the Three Months Ended September 30, 2014
	Beginning Balance		Charge Offs			Recoveries		Provisions			Ending Allowance for Loan Losses
(Dollars in thousands)											General Reserves		Specific Reserves		Total

Real Estate Secured
1-4 Family Residential	$	1,280	$	-		$	37	$	275		$	1,524	$	68	$	1,592
Multifamily Residential		197		(113	)		-		14			98		-		98
Commercial Real Estate		1,096		-			1		423			1,520		-		1,520
Construction and Land Development		633		(58	)		1		(287	)		289		-		289
Non Real Estate Secured
Commercial and Industrial		713		-			32		(170	)		575		-		575
Consumer and Other		21		-			1		11			33		-		33
Other
Other General Reserves		1,451		-			-		(98	)		1,353		-		1,353
Unallocated		646		-			-		(168	)		478		-		478
Total	$	6,037	$	(171	)	$	72	$	-		$	5,870	$	68	$	5,938

	For the Three Months Ended September 30, 2013
	Beginning Balance		Charge Offs			Recoveries		Provisions			Ending Allowance for Loan Losses
(Dollars in thousands)											General Reserves		Specific Reserves		Total

Real Estate Secured
1-4 Family Residential	$	2,049	$	(35	)	$	286	$	(646	)	$	1,522	$	132	$	1,654
Multifamily Residential		64		-			-		(39	)		25		-		25
Commercial Real Estate		1,179		(423	)		3		253			1,012		-		1,012
Construction and Land Development		1,191		(312	)		2		440			671		650		1,321
Non Real Estate Secured
Commercial and Industrial		834		(302	)		3		254			789		-		789
Consumer and Other		22		-			-		-			22		-		22
Other
Other General Reserves		1,421		-			-		(55	)		1,366		-		1,366
Unallocated		667		-			-		(207	)		460		-		460
Total	$	7,427	$	(1,072	)	$	294	$	-		$	5,867	$	782	$	6,649

-18-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

	For the Year Ended December 31, 2013
	Beginning Balance		Charge Offs			Recoveries		Provisions			Ending Allowance for Loan Losses
											General Reserves		Specific Reserves		Total
Real Estate Secured
1-4 Family Residential	$	2,312	$	(388	)	$	499	$	(594	)	$	1,630	$	199	$	1,829
Multi Family Residential		39		-			1		18			49		9		58
Commercial Real Estate		1,264		(423	)		3		187			1,031		-		1,031
Construction and Land Development		606		(972	)		32		919			577		8		585
Non Real Estate Secured
Commercial and Industrial		1,324		(1,263	)		13		616			690		-		690
Consumer and Other		55		(86	)		66		(11	)		24		-		24
Other
Other General Reserves		1,939		-			-		(600	)		1,339		-		1,339
Unallocated		620		-			-		(135	)		485		-		485
Total	$	8,159	$	(3,132	)	$	614	$	400		$	5,825	$	216	$	6,041

Impaired loans with a balance of $250,000 or more are evaluated individually for impairment. All other loans are collectively evaluated for impairment. The following tables provide summaries and totals of loans individually and collectively evaluated for impairment as of September 30, 2014 and December 31, 2013.

Loans Receivable:	As of September 30, 2014
(Dollars in thousands)	Individually evaluated for impairment		Collectively evaluated for impairment		Total
Real Estate Secured
1-4 Family Residential	$	2,381	$	207,556	$	209,937
Multifamily Residential		884		5,191		6,075
Commercial Real Estate		2,848		87,506		90,354
Construction and Land Development		-		26,143		26,143
Non Real Estate Secured
Commercial and Industrial		560		19,484		20,044
Consumer and Other		-		2,385		2,385
Total	$	6,673	$	348,265	$	354,938

Loans Receivable:	As of December 31, 2013
(Dollars in thousands)	Individually evaluated for impairment		Collectively evaluated for impairment		Total
Real Estate Secured
1-4 Family Residential	$	3,196	$	185,210	$	188,406
Multifamily Residential		986		3,842		4,828
Commercial Real Estate		2,585		77,378		79,963
Construction and Land Development		691		33,541		34,232
Non Real Estate Secured
Commercial and Industrial		479		21,729		22,208
Consumer and Other		-		2,269		2,269
Total	$	7,937	$	323,969	$	331,906

-19-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

Impaired Loans

For the Nine Months ended September 30, 2014

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized

With no related allowance recorded
1-4 Family Residential	$	1,820	$	1,734	$	-	$	86	$	1,758	$	-
Multifamily Residential		997		884		-		113		960		-
Commercial Real Estate		2,848		2,848		-		-		2,906		8
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		560		560		-		-		578		-
Consumer and Other		-		-		-		-		-		-

With an allowance recorded
1-4 Family Residential	$	682	$	647	$	68	$	35	$	667	$	-
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		-		-		-		-		-		-
Consumer and Other		-		-		-		-		-		-

Total
1-4 Family Residential	$	2,502	$	2,381	$	68	$	121	$	2,425	$	-
Multifamily Residential		997		884		-		113		960		-
Commercial Real Estate		2,848		2,848		-		-		2,906		8
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		560		560		-		-		578		-
Consumer and Other		-		-		-		-		-		-

Total	$	6,907	$	6,673	$	68	$	234	$	6,869	$	8

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

-20-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

(dollars in thousands)

Impaired Loans

For the Nine Months ended September 30, 2013

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized

With no related allowance recorded:
1-4 Family Residential	$	1,910	$	1,755	$	-	$	155	$	1,822	$	11
Multifamily Residential		366		366		-		-		372		-
Commercial Real Estate		3,399		2,975		-		424		3,230		80
Construction and Land Development		2,152		1,313		-		839		1,784		-
Commercial and Industrial		485		485		-		-		539		11
Consumer and Other		-		-		-		-		-		-

With an allowance recorded:
1-4 Family Residential	$	1,605	$	1,605	$	132	$	-	$	1,577	$	-
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		650		650		650		-		658		-
Consumer and Other		-		-		-		-		-		-

Total:
1-4 Family Residential	$	3,515	$	3,360	$	132	$	155	$	3,399	$	11
Multifamily Residential		366		366		-		-		372		-
Commercial Real Estate		3,399		2,975		-		424		3,230		80
Construction and Land Development		2,152		1,313		-		839		1,784		-
Commercial and Industrial		1,135		1,135		650		-		1,197		11
Consumer and Other		-		-		-		-		-		-

Total:	$	10,567	$	9,149	$	782	$	1,418	$	9,982	$	102

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

-21-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

Impaired Loans

For the Three Months Ended September 30, 2014

(Dollars in thousands)

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized

With no related allowance recorded
1-4 Family Residential	$	1,820	$	1,734	$	-	$	86	$	1,743	$	-
Multifamily Residential		997		884		-		113		935		-
Commercial Real Estate		2,848		2,848		-		-		2,865		3
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		560		560		-		-		565		-
Consumer and Other		-		-		-		-		-		-

With an allowance recorded
1-4 Family Residential	$	682	$	647	$	68	$	35	$	658	$	-
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		-		-		-		-		-		-
Consumer and Other		-		-		-		-		-		-

Total
1-4 Family Residential	$	2,502	$	2,381	$	68	$	121	$	2,401	$	-
Multifamily Residential		997		884		-		113		935		-
Commercial Real Estate		2,848		2,848		-		-		2,865		3
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		560		560		-		-		565		-
Consumer and Other		-		-		-		-		-		-

Total	$	6,907	$	6,673	$	68	$	234	$	6,766	$	3

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

-22-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 - Loans – (continued)

(Dollars in thousands)

Impaired Loans

For the Three Months ended September 30, 2013

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized

With no related allowance recorded:
1-4 Family Residential	$	1,910	$	1,755	$	-	$	155	$	1,785	$	4
Multifamily Residential		366		366		-		-		369		-
Commercial Real Estate		3,399		2,975		-		424		3,201		13
Construction and Land Development		2,152		1,313		-		839		1,474		-
Commercial and Industrial		485		485		-		-		498		3
Consumer and Other		-		-		-		-		-		-

With an allowance recorded:
1-4 Family Residential	$	1,605	$	1,605	$	132	$	-	$	1,576	$	-
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		650		650		650		-		650		-
Consumer and Other		-		-		-		-		-		-

Total:
1-4 Family Residential	$	3,515	$	3,360	$	132	$	155	$	3,361	$	4
Multifamily Residential		366		366		-		-		369		-
Commercial Real Estate		3,399		2,975		-		424		3,201		13
Construction and Land Development		2,152		1,313		-		839		1,474		-
Commercial and Industrial		1,135		1,135		650		-		1,148		3
Consumer and Other		-		-		-		-		-		-

Total:	$	10,567	$	9,149	$	782	$	1,418	$	9,553	$	20

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

-23-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 - Loans – (continued)

(Dollars in thousands)

Impaired Loans

For the Year Ended December 31, 2013

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized

With no related allowance recorded
1-4 Family Residential	$	1,367	$	1,165	$	-	$	202	$	1,242	$	16
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		3,008		2,584		-		423		2,833		9
Construction and Land Development		692		159		-		533		434		-
Commercial and Industrial		480		480		-		-		536		-
Consumer and Other		-		-		-		-		-		-

With an allowance recorded
1-4 Family Residential	$	2,066	$	2,031	$	199	$	35	$	2,033	$	-
Multifamily Residential		986		986		9		-		990		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		833		532		8		302		680		-
Commercial and Industrial		-		-		-		-		-		-
Consumer and Other		-		-		-		-		-		-

Total
1-4 Family Residential	$	3,433	$	3,196	$	199	$	237	$	3,275	$	16
Multifamily Residential		986		986		9		-		990		-
Commercial Real Estate		3,007		2,584		-		423		2,833		9
Construction and Land Development		1,526		691		8		835		1,114		-
Commercial and Industrial		480		480		-		-		536		-
Consumer and Other		-		-		-		-		-		-

Total	$	9,432	$	7,937	$	216	$	1,495	$	8,748	$	25

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

-24-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 7 – Deferred Taxes

Two years after establishing a full valuation allowance against its deferred tax assets, the Company reversed most of its valuation allowance on its deferred tax assets, which resulted in a tax benefit totaling approximately $6.4 million for the six month and three month periods ending June 30, 2013. The decision to reverse the valuation allowance was due to a change in management’s assessment of the near term realizability of the deferred tax assets. This change in assessment was the result of improved operating results, most notably six consecutive quarters of profitability beginning with the three months ended March 31, 2012. The profitability during these periods included core earnings. These improved results provided positive evidence of the Company’s potential to generate the future profits necessary to realize the benefits provided by its deferred tax assets in future periods. The Company maintained a valuation allowance of $200,000 related to its holding company net operating loss carryforward for state income taxes. Throughout the Company’s history, the holding company has consistently produced operating losses on a stand alone basis, and the realizability of this loss carryforward continues to remain in doubt. As of September 30, 2014, the gross deferred tax assets totaled approximately $6.4 million, while the deferred tax assets net of the remaining valuation allowance totaled approximately $6.2 million.

During the nine months and three months ended September 30, 2014, the Company recognized $1,121,000 and $397,000, respectively, of income tax expense. Of these amounts, $1,012,000 and $355,000, respectively, were for Federal income taxes, and represented a direct reduction to the Company’s deferred tax asset related to its net operating loss carryforward. The deferred tax asset attributable to the Company’s net operating loss carryforward totaled approximately $3.2 million at December 31, 2013. Also during the nine months ended September 30, 2014, the Company’s gross unrealized losses on securities available for sale declined by $1,097,000, which decreased the related deferred tax asset by approximately $394,000. During the three months ended September 30, 2014, the Company’s gross unrealized losses increased by $12,000, which increased the related deferred tax asset by $5,000.

Note 8 – Fair Value Measurements

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Generally accepted accounting principles also establish a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1 - Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as U.S. Treasuries, and money market funds.

Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments, mortgage backed securities, municipal bonds, corporate debt securities, and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.

Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, real estate appraisals, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. For example, this category generally includes certain private equity investments, asset- backed securities in less liquid markets, retained residual interests in securitizations, residential mortgage servicing rights, and other real estate owned when adjusting for selling costs, and impaired loans.

-25-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

The Company used the following methods and assumptions to estimate fair value:

Available for Sale Investment Securities

Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available (Leve1 1). If quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Securities classified as Level 3 include asset-backed securities in less liquid markets. The fair values of Level 3 available for sale investment securities are determined by a third party pricing service and reviewed by the Company’s Chief Financial Officer for reasonableness. The fair value of the trust preferred securities is computed based upon discounted cash flows estimated using interest rates, principal balances of note classes and underlying issuers, the timing and amount of interest and principal payments of the underlying issuers, and the allocation to the note classes. Current estimates of expected cash flows are based on the most recent trustee reports and any other relevant market information, including announcements of interest payment deferrals or defaults of underlying issuers. The payment, default and recovery assumptions are believed to reflect the assumptions of market participants. Cash flows are discounted at appropriate market rates, including consideration of credit spreads and illiquidity discounts.

Loans Held for Sale

Mortgage loans held for sale are carried at the lower of cost or market value. The fair value of mortgage loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, the Company categorizes loans subjected to nonrecurring fair value adjustments as Level 2. There were no fair value adjustments to mortgage loans held for sale as of September 30, 2014 and December 31, 2013.

Impaired Loans

Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Impaired loans are carried at the lesser of their principal balance or their fair value. The Company considers problem loans with principal balances of $250,000 or greater individually for impairment. The fair value of loans individually evaluated for impairment is estimated using one of several methods, including the present value of expected cash flows, market price of the loan, if available, or fair value of the underlying collateral less estimated costs to sell. At September 30, 2014, all impaired loans deemed collateral dependent were evaluated based on the fair value of the collateral less estimated costs to sell. Those impaired loans not requiring a specific allowance for loan losses allocation represent loans with fair values equal to or exceeding their recorded investments. Impaired loans for which a specific allowance is established based on the fair value of collateral require classification in the fair value hierarchy. If the fair value of an impaired loan is based on an observable market price of the loan the Company records the impaired loan as nonrecurring Level 2. When the fair value of an impaired loan is based on discounted cash flows or the fair value of the underlying collateral less estimated costs to sell the Company records the impaired loan as nonrecurring Level 3.

Other real estate owned

Assets acquired through or instead of loan foreclosure are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals.

For both collateral dependent impaired loans and other real estate owned the Company uses appraisals prepared by certified appraisal professionals whose qualifications and licenses have been reviewed and verified by the Company. These appraisals may utilize a single valuation approach or a combination of approaches, including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically lead to a Level 3 classification of the inputs for determining fair value. Once the Company receives an appraisal on an impaired loan, the Chief Credit Officer and Chief Financial Officer review the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics, as well as the Company’s own loss experience. For appraisals received on other real estate owned, the Chief Financial Officer and Chief Operating Officer use a similar approach. The Company may take additional discounts against the appraisals based on the circumstances surrounding individual properties.

-26-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

Assets measured at fair value on a recurring basis are as follows as of September 30, 2014 and December 31, 2013 (amounts in thousands):

	September 30, 2014
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Available-for-sale investment securities
Mortgage backed Government sponsored enterprises	$	-	$	25,185	$	-	$	25,185
Municipals		-		4,193		-		4,193
Other		-		4,109		2,043		6,152

Total assets at fair value	$	-	$	33,487	$	2,043	$	35,530

	December 31, 2013
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Available-for-sale investment securities
Mortgage backed Government sponsored enterprises	$	-	$	29,869	$	-	$	29,869
Municipals		-		4,068		-		4,068
Other		-		4,049		1,836		5,885

Total assets at fair value	$	-	$	37,986	$	1,836	$	39,822

Investments in collateralized debt obligations and a single-issue trust preferred security comprise the Company’s Level 3 assets as shown above. Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.

There were no transfers between Level 1 and Level 2 during 2014 or 2013.

The Company has no liabilities carried at fair value or measured at fair value on a recurring basis.

-27-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

The following table reconciles the changes in recurring Level 3 financial instruments for the nine months ended

September 30, 2014 and 2013 (amounts in thousands):

	September 30,		September 30,
	2014		2013

Beginning of Year Balance	$	1,836	$	1,401
Discount Accretion		7		6
Reduction in Unrealized Loss		200		306
Ending Balance	$	2,043	$	1,713

The following table presents quantitative information about Level 3 fair value measurements at September 30, 2014 (amounts in thousands):

Security Type	Fair Value		Valuation Technique	Unobservable Input	Rates

Collateralized Debt Obligations	$	1,543	Discounted cash flows	Discount rate	Approximately 10%
				Weighted default probability for deferring issuers	Approximately 60%
				Recovery rate on deferring issuers	10% - 15%
				Default probability for current issuers	0.33% - 20.00%
Trust Preferred Security	$	500	Discounted cash flows	Discount rate	Approximately 4%

The significant unobservable inputs used in the fair value measurement of the Company’s collateralized debt obligations investments are prepayment rates, probability of default, and loss severity in the event of default. Significant increases/(decreases) in any of those inputs in isolation would result in a significantly lower/(higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.

In addition to the collateralized debt obligations included in the table above, the Company owns a trust preferred security backed by a single issuer for which meaningful pricing data is not readily available. The security’s book value of $500,000 is assumed to equal its fair value. The discount rate shown for the security in the table above approximates the security’s yield at September 30, 2014.

There were no changes in unrealized gains and losses for Level 3 asssets which were recorded in earnings for either of the nine month periods ended September 30, 2014 or September 30, 2013.

-28-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

Assets measured at fair value on a nonrecurring basis are as follows as of September 30, 2014 and December 31, 2013 (amounts in thousands):

	September 30, 2014
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Impaired Loans
1 - 4 Family Residential	$	-	$	-	$	1,512	$	1,512
Multifamily		-		-		950		950
Commercial Real Estate		-		-		1,136		1,136
Construction and Land Development		-		-		742		742
Commercial & Industrial		-		-		108		108
Other Real Estate Owned
1 - 4 Family Residential		-		-		334		334
Construction and Land Development		-		-		54		54

Total assets at fair value	$	-	$	-	$	4,836	$	4,836

	December 31, 2013
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Impaired Loans
1 - 4 Family Residential	$	-	$	-	$	2,574	$	2,574
Multifamily		-		-		1,050		1,050
Commercial Real Estate		-		-		753		753
Construction and Land Development		-		-		735		735
Other Real Estate Owned
Commercial Real Estate		-		-		585		585
Construction and Land Development		-		-		254		254

Total assets at fair value	$	-	$	-	$	5,951	$	5,951

Impaired loans that are measured at fair value had a recorded investment of $3,700,000 with a valuation allowance of $68,000 at September 30, 2014, resulting in an additional provision for loan losses of $113,000 for the nine months ended September 30, 2014. The additional provision included $21,000 for 1 – 4 Family Residential loans and $92,000 for Multifamily loans. During the three months ended September 30, 2014, the Company charged down its impaired Multifamily loans, thereby eliminating the related valuation allowance. The additional provision for loan losses for the three months ended September 30, 2014 totaled $21,000 and was attributable to 1- 4 Family Residential loans.

Impaired loans that are measured for impairment using the fair value of the collateral had a recorded investment of $4,970,000 with a valuation allowance of $ 216,000 at December 31, 2013, resulting in an additional provision for loan losses of $149,000 for the year ended December 31, 2013. These additional provisions included: $8,000 for Construction and Land Development loans, $132,000 for 1 – 4 Family Residential loans, and $9,000 for Multifamily loans.

Impaired loans that are measured for impairment using the fair value of the collateral had a recorded investment of $2,255,000 with a valuation allowance of $782,000 at September 30, 2013, resulting in an additional provision for loan losses of $650,000 for the nine months and three months ended September 30, 2013. The additional provision related entirely to a single Commercial & Industrial loan that had a carrying amount at September 30, 2013 of zero.

-29-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

Other real estate owned measured at fair value less estimated costs to sell had a net carrying amount of $361,000, which is made up of the outstanding balance of $482,000, net of a valuation allowance of $121,000 at September 30, 2014. This valuation allowance included an impairment provision of $6,000 made during the nine months ended September 30, 2014, all of which related to 1 – 4 Family Residential property. There was no impairment provision made for the three months ending September 30, 2014. Other real estate owned measured at fair value less costs to sell had a net carrying amount of $780,000, which is made up of the outstanding balance of $1,014,000, net of a valuation allowance of $234,000, at December 31, 2013. This valuation allowance included $75,000 of impairment made during the year ended December 31, 2013. The breakdown of this impairment was as follows: $14,000 for Construction and Land Development loans, and $61,000 for 1-4 Family Residential loans.

Other real estate owned measured at fair value less estimated costs to sell had a net carrying amount of $952,000, which is made up of the outstanding balance of $1,187,000, net of a valuation allowance of $235,000 at September 30, 2013. A $4,000 valuation allowance was made during the nine months ended September 30, 2013, which related to 1-4 Family Residential property. No valuation allowance was made during the three months ended September 30, 2013.

The Company has no liabilities carried at fair value or measured at fair value on a nonrecurring basis.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at September 30, 2014:

	Valuation Techniques	Unobservable Inputs	Range
Impaired Loans

1 - 4 Family Residential	Sales comparison approach	Bank Owned Discount		10%-20	%
Multifamily Residential
Construction and Land Development

Commercial Real Estate	Sales comparison approach	Bank Owned Discount		10%-20	%
	Income approach	Capitalization Rate		8% - 12	%

Other Real Estate Owned

Commercial Office Properties	Sales comparison approach	Bank Owned Discount		10%-20	%
	Income approach	Capitalization Rate		8% - 12	%

Commercial Lots	Sales comparison approach	Bank Owned Discount		10%-20	%
Residential 1 – 4 Family Lots
Residential 1 – 4 Family Homes
Residential 1 – 4 Under Construction
Multifamily Residential

-30-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

The estimated fair values of the Company’s financial instruments are as follows (amounts in thousands):

	Fair Value Measurements at September 30, 2014 Using:
	Carrying
	Amount		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	29,529	$	29,529	$	-	$	-	$	29,529
Available for sale investment securities		35,530		-		33,487		2,043		35,530
Federal Home Loan Bank Stock		3,550		N/A		N/A		N/A		N/A
Loans, net		349,000		-		-		345,578		345,578
Accrued interest receivable		1,183		-		101		1,082		1,183

Financial liabilities
Deposits		323,879		-		297,200		-		297,200
Short term borrowings		9,664		-		9,664		-		9,664
Advances from Federal Home Loan Bank		70,000		-		73,112		-		73,112
Junior subordinated debentures		10,310		-		-		4,944		4,944
Accrued interest payable		934		-		933		1		934

	Fair Value Measurements at December 31, 2013 Using:
	Carrying
	Amount		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	28,460	$	28,460	$	-	$	-	$	28,460
Available for sale investment securities		39,822		-		37,986		1,836		39,822
Federal Home Loan Bank Stock		3,629		N/A		N/A		N/A		N/A
Loans held for sale		271		-		271		-		271
Loans, net		325,865		-		-		315,917		315,917
Accrued interest receivable		1,122		-		113		1,009		1,122

Financial liabilities
Deposits		315,828		-		303,851		-		303,851
Short term borrowings		4,818		-		4,818		-		4,818
Advances from Federal Home Loan Bank		69,000		-		72,158		-		72,158
Junior subordinated debentures		10,310		-		-		4,826		4,826
Accrued interest payable		1,049		-		599		450		1,049

Valuation Methodologies – Assets and Liabilities not recorded at Fair Value

The following is a description of the valuation methodologies used for assets and liabilities that are not recorded at fair value, but whose fair value must be estimated and disclosed:

Cash and Cash Equivalents

The carrying amounts of cash and short-term instruments approximate fair values and are classified Level 1.

FHLB Stock

It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

-31-

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

Loans

Fair values of loans, excluding loans held for sale, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values, resulting in a Level 3 classification. Fair values for other 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, resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors, resulting in a Level 2 classification.

Deposits

The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are derived based on applying discount rates to their expected lives, resulting in a Level 2 classification. The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date, resulting in a Level 2 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits, resulting in a Level 2 classification.

Short-term Borrowings

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings, generally maturing within ninety days, approximate their fair values, resulting in a Level 2 classification.

Other Borrowings

The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements, resulting in a Level 2 classification.

The fair values of the Company’s Subordinated Debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements, resulting in a Level 3 classification.

Accrued Interest Receivable/Payable

The carrying amounts of accrued interest are assigned Levels 1, 2, or 3 classifications commensurate with the assets or liabilities to which they are associated.

Off-balance Sheet Instruments

Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material.

-32-

SOUTHCOAST FINANCIAL CORPORATION

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

The following discussion and analysis should be read in conjunction with the financial statements and related notes appearing herein and in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2013. Results of operations for the period ending September 30, 2014 are not necessarily indicative of the results to be attained for any other period.

This Report on Form 10-Q may contain forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products and similar matters. All statements that are not historical facts are "forward-looking statements." The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with terms of the safe harbor, the Company notes that a variety of factors could cause the Company's actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. Forward-looking statements include statements with respect to management's beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond the Company's control, and which may cause actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. All statements other than statements of historical fact are statements that could be forward-looking statements. These forward-looking statements can be identified through use of words such as "may," "will," "anticipate," "assume," "should," "indicate," "would," "believe," "contemplate," "expect," "seek," "estimate," "continue," "plan," "point to," "project," “projection,” "predict," "could," "intend," "target," "potential," and other similar words and expressions of the future. These forward-looking statements may not be realized due to a variety of factors, including, without limitation:

	o	future economic and business conditions;
	o	lack of sustained growth and disruptions in the economy of the Greater Charleston area, including, but not limited to, falling real estate values and increasing levels of unemployment;
	o	government monetary and fiscal policies;
	o	the effects of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values of loan collateral, securities, and interest sensitive assets and liabilities;
	o	the effects of competition from a wide variety of local, regional, national and other providers of financial, investment, and insurance services, as well as competitors that offer banking products and services by mail, telephone, computer and/or the Internet;
	o	the effects of credit rating downgrades on the value of investment securities issued or guaranteed by various governments and government agencies, including the United States of America;
	o	credit risks;
	o	higher than anticipated levels of defaults on loans;
	o	perceptions by depositors about the safety of their deposits;
	o	the failure of assumptions underlying the establishment of the allowance for loan losses and other estimates, including the value of collateral securing loans;
	o	changes in assumptions underlying allowances on deferred tax assets;
	o	changes in assumptions underlying, or accuracy of, analysis relating to other-than-temporary impairment of assets;
	o	accuracy of fair value measurements and the methods and assumptions used to estimate fair value;
	o	the risks of opening new offices, including, without limitation, the related costs and time of building customer relationships and integrating operations as part of these endeavors and the failure to achieve expected gains, revenue growth and/or expense savings from such endeavors;
	o	changes in laws and regulations, including tax, banking and securities laws and regulations and deposit insurance assessments;
	o	the effect of agreements with regulatory authorities, which restrict various activities and impose additional administrative requirements without commensurate benefits;
	o	changes in the requirements of regulatory agencies;
	o	changes in accounting policies, rules and practices;
	o	changes in technology or products may be more difficult or costly, or less effective than anticipated;
	o	cybersecurity risk related to our dependence on internal security systems and the technology of outside service providers, as well as the potential impacts of third party security breaches;
	o	the effects of war or other conflicts, acts of terrorism or other catastrophic events that may affect general economic conditions and economic confidence;
	o	loss of consumer or investor confidence; and
	o	other factors and information described in any of the reports that we file with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

-33-

SOUTHCOAST FINANCIAL CORPORATION

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

All forward-looking statements are expressly qualified in their entirety by this cautionary notice. The Company has no obligation, and does not undertake, to update, revise or correct any of the forward-looking statements after the date of this report. The Company has expressed its expectations, beliefs, and projections in good faith and believes they have a reasonable basis. However, there is no assurance that these expectations, beliefs or projections will result or be achieved or accomplished.

Results of Operations

The Company’s net income for the nine months ended September 30, 2014 was $2,385,000 or $0.34 per basic share, compared to net income of $8,735,000, or $1.23 per basic share, for the nine months ended September 30, 2013. The net income for the nine months ended September 30, 2013 included a tax benefit of $6,363,000 resulting from a reversal of the valuation allowance on the Company’s deferred tax asset. The average number of basic shares outstanding for the nine months ended September 30, 2014 was 7,089,630 compared to 7,074,183 for the nine months ended September 30, 2013.

The Company’s net income for the three months ended September 30, 2014 was approximately $1,033,000 or $0.15 per basic share, compared to net income of approximately $694,000, or $0.10 per basic share, for the three months ended September 30, 2013. The average number of basic shares outstanding for the three months ended September 30, 2014 was 7,093,132 compared to 7,077,878 for the three months ended September 30, 2013.

Net Interest Income

Net interest income is the difference between the interest earned on interest earning assets and the interest paid for funds acquired to support those assets, and is the principal source of the Company’s earnings. Net interest income was $10.9 million for the nine months ended September 30, 2014, compared to $10.4 million for the nine months ended September 30, 2013. Net interest income was $3.7 million for the three months ended September 30, 2014, compared to $3.5 million for the three months ended September 30, 2013.

Changes that affect net interest income include changes in the average rate earned on interest earning assets, changes in the average rate paid on interest bearing liabilities, and changes in the volumes of interest earning assets and interest bearing liabilities. The increase in the Company’s net interest income for the nine months and three months ended September 30, 2014 compared to the same periods of 2013 was due to increased interest income and decreased interest expense between the two periods. The increase in interest income primarily related to interest income on loans. Interest income on loans increased between the two periods due to increases in volume which outpaced declines due to lower average rates. The decrease in interest expense was primarily driven by lower interest expense on time deposits. Interest expense on time deposits decreased between the two periods due to changes in both volume and rate, as the Company was able to lower its cost of funds on time deposits while changing its funding mix towards deposits with lower funding costs.

Average earning assets for the nine months ended September 30, 2014 increased 3.3 percent to $392.9 million from the $380.3 million reported for the nine months ended September 30, 2013. The increase was primarily attributable to an increase of $15.6 million in average loans. The increase in average loans between the two periods was primarily due to the Company’s retaining a greater percentage of residential 1-4 family mortgage loans in its loan portfolio in 2014.

Average interest bearing liabilities for the nine months ended September 30, 2014 increased 1.6 percent to $349.4 million from the $343.9 million reported for the nine months ended September 30, 2013. The increase was attributable to increases of $17.5 million and $1.1 million in average savings and transaction accounts and other borrowings, respectively, partially offset by a decrease of $13.1 million in average time deposits. The decrease in average time deposits was attributable to a $16.2 million decrease in retail time deposits, partially offset by a $3.0 million increase in brokered and wholesale time deposits. The increase in average other borrowings primarily related to Federal Home Loan Bank Borrowings.

-34-

SOUTHCOAST FINANCIAL CORPORATION

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

Net Interest Income – (continued)

The following table compares the average balances, yields and rates for the interest sensitive segments of the Company’s balance sheets for the nine months ended September 30, 2014 and 2013.

	For the nine months ended							For the nine months ended
	September 30, 2014							September 30, 2013
	Average		Income/		Yield/			Average		Income/		Yield/
	Balance		Expense		Rate⁽¹⁾			Balance		Expense		Rate⁽¹⁾
Assets
Cash and Federal funds sold	$	13,046	$	24		0.24	%	$	13,182	$	24		0.24	%
Investments – taxable		40,652		725		2.38			42,903		677		2.11
Investments - nontaxable⁽²⁾		3,920		176		6.04			4,471		206		6.16
Total investments and federal funds sold		57,618		925		2.15			60,556		907		2.00
Loans ⁽³⁾⁽⁴⁾		335,285		12,703		5.06			319,735		12,468		5.21
Total earning assets/interest income		392,903		13,628		4.63	%		380,291		13,375		4.70	%
Other assets		55,446							54,035
Total assets	$	448,349						$	434,326
Liabilities
Savings and transaction accounts	$	137,778		501		0.49	%	$	120,311		488		0.54	%
Time deposits		136,397		728		0.71			149,509		937		0.84
Other borrowings		64,903		1,343		2.77			63,805		1,346		2.82
Subordinated debt		10,310		134		1.73			10,310		140		1.81
Total interest bearing liabilities/interest expense		349,388		2,706		1.03	%		343,935		2,911		1.13	%
Non-interest bearing liabilities		54,846							52,132
Total liabilities		404,234		2,706		0.90	%		396,067		2,911		0.98	%
Equity		44,115							38,259
Total liabilities and equity	$	448,349						$	434,326
Net interest income/margin ⁽⁵⁾			$	10,922		3.69	%			$	10,464		3.65	%
Net interest spread ⁽⁶⁾						3.60	%						3.57	%


	(1)	Annualized
	(2)	Yield is calculated on a tax equivalent basis.
	(3)	Does not include nonaccruing loans.
	(4)	Income includes loan fees of $529,000 in 2014 and $474,000 in 2013.
	(5)	Net interest income divided by total earning assets.
	(6)	Total interest earning assets yield less interest bearing liabilities rate.

-35-

SOUTHCOAST FINANCIAL CORPORATION

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

Net Interest Income – (continued)

As shown above, for the nine months ended September 30, 2014 the average yield on earning assets was 4.63 percent, while the average cost of interest bearing liabilities was 1.03 percent. For the nine months ended September 30, 2013 the average yield on earning assets was 4.70 percent and the average cost of interest-bearing liabilities was 1.13 percent. The moderate decrease in the overall asset yield is primarily due to loan yields, which decreased to 5.06% for the nine months ended September 30, 2014 from 5.21% for the nine months ended September 30, 2013. Partially offsetting this decrease was an increase in yields on taxable investments, which had yields of 2.38% and 2.11% for the nine months ended September 30, 2014 and September 30, 2013, respectively. The increased yields on these investments were primarily due to significantly lower levels of prepayments on mortgage backed securities during the nine months ended September 30, 2014. Prepayments on the Company’s mortgage backed securities totaled $2,060,000 and $6,906,000 during the nine months ended September 30, 2014 and September 30, 2013, respectively. All mortgage backed securities in the Company’s investment portfolio were purchased at a premium, so slower prepayment speeds have the effect of increasing the interest income and yield on these investments. The decrease in the cost of average interest bearing liabilities was primarily due to decreases in average rates paid on time deposits and other borrowings. The net interest margin was 3.69 percent and 3.65 percent for the nine months ended September 30, 2014 and 2013, respectively. The increase in the net interest margin was attributable to an increase of $458,000 in net interest income, which was comprised of an increase in interest income of $253,000 and a decrease in interest expense of $205,000. The increase in interest income was primarily due to a $235,000 increase in interest income on loans, driven by an increase in overall volume, while the interest expense reduction was primarily attributable to a $209,000 decrease in interest expense on time deposits, which was mostly driven by a decline in rate.

The following table presents changes in the Company’s net interest income which are primarily a result of changes in the volume and rates of its interest-earning assets and interest-bearing liabilities.

	Analysis of Changes in Net Interest Income
	For the nine months ended September 30, 2014
	Versus nine months ended September 30, 2013 ⁽¹⁾
	Volume			Rate			Net Change
Interest income:

Cash and Federal funds sold	$	-		$	-		$	-
Investments - taxable		(36	)		84			48
Investments - non taxable⁽²⁾		(26	)		(4	)		(30	)
Total investments and federal funds sold		(62	)		80			18
Net loans ⁽³⁾⁽⁴⁾		608			(373	)		235
Total interest income		546			(293	)		253
Interest expense:
Savings and transaction accounts		71			(58	)		13
Time deposits		(83	)		(126	)		(209	)
Other borrowings		24			(27	)		(3	)
Subordinated debt		-			(6	)		(6	)
Total interest expense		12			(217	)		(205	)
Net interest income	$	534		$	(76	)	$	458

(1)

Changes in rate/volume have been allocated to each category on a consistent basis between rate and volume.

(2)

Yield is calculated on a tax equivalent basis.

(3)

Income includes loan fees of $529,000 in 2014 and $474,000 in 2013.

(4)

Does not include nonaccruing loans.

-36-

SOUTHCOAST FINANCIAL CORPORATION

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

Net Interest Income – (continued)

Average earning assets for the three months ending September 30, 2014 increased 4.3 percent to $398.3 million from the $381.8 million reported for the three months ending September 30, 2013. The increase was primarily attributable to an increase of $25.0 million in average loans, partially offset by an $8.5 million decrease in average investments and federal funds sold. The increase in average loans between the two periods was primarily due to the Company’s retaining a greater percentage of residential 1-4 family mortgage loans in its loan portfolio in 2014.

Average interest bearing liabilities for the three months ending September 30, 2014 increased 2.0 percent to $349.0 million from $342.3 million for the three months ending September 30, 2013. The increase was attributable to an increase of $13.4 million in average savings and transacation accounts, partially offset by a decrease of $6.6 million in average time deposits, as well as a $0.1 million decrease in other borrowings. The decrease in average time deposits was attributable to a decrease of $17.6 million in average retail time deposits, partially offset by an increase of $11.0 million in brokered and wholesale time deposits.

-37-

SOUTHCOAST FINANCIAL CORPORATION

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

Net Interest Income – (continued)

The following table compares the average balances, yields and rates for the interest sensitive segments of the Company’s balance sheets for the three months ended September 30, 2014 and 2013.

(Dollars in thousands)	For the three months ended							For the three months ended
	September 30, 2014							September 30, 2013
	Average		Income/		Yield/			Average		Income/		Yield/
	Balance		Expense		Rate⁽¹⁾			Balance		Expense		Rate⁽¹⁾
Assets
Cash and Federal funds sold	$	12,763	$	8		0.23	%	$	16,420	$	11		0.28	%
Investments – taxable		37,869		222		2.32			42,702		280		2.60
Investments - nontaxable ⁽²⁾		3,922		58		5.98			3,907		59		5.99
Total investments and federal funds sold		54,554		288		2.10			63,029		350		2.21
Loans ⁽³⁾⁽⁴⁾		343,722		4,286		4.95			318,748		4,106		5.11
Total earning assets/interest income		398,326		4,574		4.56	%		381,777		4,456		4.63	%
Other assets		54,039							55,047
Total assets	$	452,365						$	436,824
Liabilities
Savings and transaction accounts	$	139,677		162		0.46	%	$	126,236		183		0.57	%
Time deposits		134,556		239		0.70			141,090		269		0.76
Other borrowings		64,481		452		2.78			64,641		452		2.78
Subordinated debt		10,310		44		1.71			10,310		47		1.81
Total interest bearing liabilities/interest expense		349,024		897		1.02			342,277		951		1.10
Non-interest bearing liabilities		58,176							56,110
Total liabilities		407,200		897		0.87			398,387		951		0.95
Equity		45,165							38,437
Total liabilities and equity	$	452,365						$	436,824
Net interest income/margin ⁽⁵⁾			$	3,677		3.66	%			$	3,505		3.64	%
Net interest spread ⁽⁶⁾						3.54	%						3.53	%


	(1)	Annualized
	(2)	Yield is calculated on a tax equivalent basis.
	(3)	Does not include nonaccruing loans.
	(4)	Income includes loan fees of $188,000 in 2014 and $155,000 in 2013.
	(5)	Net interest income divided by total earning assets.
	(6)	Total interest earning assets yield less interest bearing liabilities rate.

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SOUTHCOAST FINANCIAL CORPORATION

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

Net Interest Income – (continued)

As shown above, for the three months ended September 30, 2014 the average yield on earning assets was 4.56 percent, while the average cost of interest bearing liabilities was 1.02 percent. For the three months ended September 30, 2013 the average yield on earning assets was 4.63 percent and the average cost of interest-bearing liabilities was 1.10 percent. The moderate decrease in the overall asset yield is primarily due to loan yields, which decreased to 4.95% for the three months ended September 30, 2014 from 5.11% for the three months ended September 30, 2013. The decrease in the cost of average interest bearing liabilities from the third quarter of 2013 to the third quarter of 2014 was primarily due to decreases in average rates paid on time deposits and savings and transaction accounts. The net interest margin was 3.66 percent and 3.64 percent for the three months ended September 30, 2014 and 2013, respectively. The increase in the net interest margin was attributable to an increase of $172,000 in net interest income, which was comprised of an increase in interest income of $118,000 and a decrease in interest expense of $54,000. The increase in interest income was primarily due to a $160,000 increase in interest income on loans, while the interest expense reduction was primarily attributable to a $30,000 decrease in interest expense on time deposits.

The following tables present changes in the Company’s net interest income which are primarily a result of changes in the volume and rates of its interest-earning assets and interest-bearing liabilities.

	Analysis of Changes in Net Interest Income
	For the three months ended September 30, 2014
	Versus three months ended September 30, 2013 ⁽¹⁾
	Volume			Rate			Net Change
Interest income:

Cash and Federal funds sold	$	(2	)	$	(1	)	$	(3	)
Investments - taxable		(32	)		(26	)		(58	)
Investments - non taxable⁽²⁾		-			(1	)		(1	)
Total investments and federal funds sold		(34	)		(28	)		(62	)
Net loans ⁽³⁾⁽⁴⁾		323			(143	)		180
Total interest income		289			(171	)		118
Interest expense:
Savings and transaction accounts		19			(40	)		(21	)
Time deposits		(12	)		(18	)		(30	)
Other borrowings		(1	)		1			-
Subordinated debt		-			(3	)		(3	)
Total interest expense		6			(60	)		(54	)
Net interest income	$	283		$	(111	)	$	172

(1)

Changes in rate/volume have been allocated to each category on a consistent basis between rate and volume.

(2)

Yield is calculated on a tax equivalent basis.

(3)

Income includes loan fees of $188,000 in 2014 and $155,000 in 2013.

(4)

Does not include nonaccruing loans.

-39-

SOUTHCOAST FINANCIAL CORPORATION

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

Noninterest Income and Expenses

Noninterest income for the nine months ended September 30, 2014 was approximately $1,630,000, compared to approximately $1,840,000 for the nine months ended September 30, 2013, a decrease of approximately $210,000. This was primarily due to a decrease of approximately $176,000 in gains on sale of mortgage loans held for sale. The decrease in the gain on sale of mortgage loans held for sale was reflective of the Company’s decision to keep a much higher percentage of mortgage loans originated during the nine months ended September 30, 2014, as compared to those originated during the nine months ended September 30, 2013.

Noninterest income for the three months ended September 30, 2014 was approximately $512,000, compared to approximately $560,000 for the three months ended September 30, 2013, a decrease of approximately $48,000. This was primarily due to a decrease of approximately $26,000 in gains on sale of mortgage loans held for sale. The decrease in the gain on sale of mortgage loans held for sale was again reflective of the Company’s decision to keep a much higher percentage of mortgage loans originated during the three months ended September 30, 2014, as compared to those originated during the three months ended September 30, 2013.

Noninterest expenses for the nine months ended September 30, 2014 were $8,983,000, compared to $9,858,000 for the nine months ended September 30, 2013, a decrease of $875,000. The largest contributing factor to this decrease was a $380,000 decrease in salaries and benefits. The decrease in salaries and benefits was primarily attributable to the sale and benefit obligation settlement of a split dollar life insurance policy to the Company’s CEO. Proceeds received on this transaction represent a partial refund of insurance premiums, which was recorded as a $271,000 reduction to life insurance expense. Also contributing to the decrease in salaries and benefits was a $156,000 decrease in bonus accruals, partially offset by higher compensation expense related to increases in health insurance costs and other employee benefits. Other decreases for the nine months ended September 30, 2014 included occupancy expenses and insurance costs, which decreased $120,000 and $136,000, respectively. The decrease in occupancy expenses primarily resulted from reduced rents owed on bank property, reduced maintenance costs, and lower real estate taxes. The lower insurance costs related to improved asset quality which contributed to reduced FDIC insurance premiums. Finally, during the nine months ended September 30, 2014, professional fees decreased $97,000. These decreases related to legal fees and shareholder expenses.

Noninterest expenses for the three months ended September 30, 2014 were $2,738,000, compared to $3,350,000 for the three months ended September 30, 2013, a decrease of $612,000. The largest single contributing factor to this decrease was a $274,000 decrease in salaries and benefits. As was the case for the nine-month period, the decrease in salaries and benefits was due primarily due to the sale of a split dollar life insurance policy to the Company’s CEO, which resulted in a $271,000 reduction to life insurance expense. Also contributing to the reduction in noninterest expenses during the three months ended September 30, 2014 was the recognition of $184,000 of gains on the sale of other real estate. There were no such gains in the three months ended September 30, 2013. Other decreases for the three months ended September 30, 2014 included insurance and professional fees, which decreased $41,000 and $33,000, respectively. As in the nine month period, the decrease in insurance expenses related to the Company’s improved asset quality between the two periods, which contributed to lower FDIC premiums, and the decrease in profeesional fees expenses related to legal fees and shareholder expenses.

Income Taxes

At June 30, 2013, as referenced in Note 7 to the Condensed Consolidated Financial Statements, the Company reversed the majority of its valuation allowance on its deferred tax assets. The net amount of the Company’s deferred tax assets totaled $6,196,000 at September 30, 2014. The Company’s income tax expense for the nine months ended September 30, 2014 totaled $1,121,000, comprised of $1,012,000 for Federal income taxes and $109,000 for South Carolina income taxes. The Company’s income tax benefit for the nine months ended September 30, 2013 totaled $6,363,000, which was comprised of a Federal income tax benefit of $6,770,000 and South Carolina income tax expense of $407,000. The Federal income tax benefit related to the reversal of the Company’s deferred tax valuation allowance, and the South Carolina income tax expense related primarily to the impact of the deferred tax valuation allowance reversal on South Carolina taxable income.

The Company’s income tax expense for the three months ended September 30, 2014 totaled $397,000, comprised of $355,000 for Federal income taxes and $42,000 for South Carolina income taxes. The Company’s effective tax rate for this period was 28%, as compared to 35% for the six months ended June 30, 2014. The cause of this change in effective rate was the tax treatment of the previously discussed $271,000 reduction of life insurance expense related to the sale and benefit obligation settlement of a split dollar life insurance policy. The proceeds of this transaction were nontaxable, as they represented a partial refund of nondeductible key man life insurance premiums. The Company recorded no income tax expense or benefit for the three months ended September 30, 2013, as it had already accrued estimates for these amounts at the June 30, 2013 period, netting these accruals out of the income tax benefit recognized as the result of the reversal of its deferred tax valuation allowance. The Company determined that no revision to its income tax estimate was necessary for the three months ended September 30, 2013.

-40-

SOUTHCOAST FINANCIAL CORPORATION

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

Liquidity

Liquidity is the ability to meet current and future obligations through liquidation or maturity of existing assets or the acquisition of additional liabilities. Adequate liquidity is necessary to meet the requirements of customers for loans and deposit withdrawals in the most timely and economical manner. Some liquidity is ensured by maintaining assets which may be immediately converted into cash at minimal cost (amounts due from banks and federal funds sold). However, the most manageable sources of liquidity are composed of liabilities, with the primary focus of liquidity management being on the ability to obtain deposits within the Bank’s service area. Core deposits (total deposits less certificates of deposit $100,000 or more, wholesale and brokered deposits) provide a relatively stable funding base, and were equal to 80.3% of total deposits as of September 30, 2014. Asset liquidity is provided from several sources, including amounts due from banks and federal funds sold and funds from maturing loans. The Bank is a member of the Federal Home Loan Bank of Atlanta (”FHLBA”) and, as such has the ability to borrow against pledges of its 1-4 family residential mortgage loans and its commercial real estate loans. Available borrowings under this line totaled $49.3 million at September 30, 2014. The Company also has federal funds accommodations of $10 million with Alostar Bank of Commerce, $10 million with Zion’s Bank, $5 million with Center State Bank, and $8 million with First Tennessee Bank. These accommodations may be withdrawn at any time at the sole discretion of these institutions. Additionally, the Company has a borrowing line with the Federal Reserve Bank of Richmond’s discount window. The Company has pledged its portfolios of construction and land development loans and commercial and industrial loans against this borrowing line. Total available borrowings under this line were $26.4 million at September 30, 2014.

Loans

Gross loans totaled approximately $354,938,000 and $331,906,000 at September 30, 2014 and December 31, 2013, respectively. At September 30, 2014, the Company had $8 million of nonaccrual loans and no loans 90 days delinquent and still accruing interest. Of these, $7.0 million are secured by real estate. The primary risk of loss on these loans is a potential deterioration of real estate collateral values. At December 31, 2013, the Company had $9.9 million of nonaccrual loans and no loans 90 days past due and still accruing interest. At September 30, 2013, the Company had $9.2 million of nonaccrual loans and no loans 90 days past due and still accruing interest. The allowance for loan losses was 1.67 percent of loans as of September 30, 2014, compared to 1.82 percent as of December 31, 2013 and 2.02 percent as of September 30, 2013.

For the nine months and three months ended September 30, 2014 and 2013, the Company recorded no loan loss provision. Net chargeoffs for the nine months ended September 30, 2014 totaled approximately $103,000. Net chargeoffs for the nine months ended September 30, 2013 totaled approximately $1.5 million. The need for future loan loss provisions will be influenced by loan delinquency levels, loan chargeoffs beyond what has already been provided for on individual loans, the level of loans with credit grades of 6 through 9, and the need for additional specific reserves on loans individually evaluated for impairment, among other factors. In reviewing the adequacy of the allowance for loan losses at each quarter end, management takes into consideration historical loan losses, current levels of past due loans by loan type, the historical severity of loan losses by loan type, loan to value exceptions in our loan portfolio, potential repayment risk for floating and adjustable rate loans due to the potential for rising interest rates, risks posed by unseasoned loans durings periods of growth in the loan portfolio, and collateral values of impaired loans deemed to be collateral dependent. The Company’s September 30, 2014 allowance for loan losses calculation used a twelve quarter lookback period for historical losses, in contrast to the four quarter timeframe used for prior periods. The twelve quarter lookback period, reflecting losses experienced during the economic cycle of the last three years, was deemed by management to most closely approximate the level of probable incurred losses in the loan portfolio. As referenced in Note 6 to the Condensed Consolidated Financial Statements, the Company’s other general reserves portion of its allowance for loan losses increased by $14,000 during the nine months ended September 30, 2014, from $1,339,000 at December 31, 2013 to $1,353,000 at September 30, 2014.

-41-

SOUTHCOAST FINANCIAL CORPORATION

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

Loans – (continued)

Other general reserves at September 30, 2014 and December 31, 2013 were comprised of the following risk factors:

(Dollars in Thousands)	September 30, 2014		December 31, 2013

Loan to value exposure	$	705	$	672
Floating and adjustable rate exposure		645		665
Portfolio growth exposure		3		2
Total	$	1,353	$	1,339

As shown above, a significant portion of the increase in other general reserves during the nine months ended September 30, 2014 was attributable to reserves related to loan to value exposure, which increased by $33,000. This increase was intended to capture the incremental loss for loans with loan to value exposure that also carry interest only terms and have credit risk grades of 7 or below. The exposure from loans with these additional risk characteristics is now calculated at 2.5 times the base amount due to the additional risks posed by these characteristics. After charging off all known losses, management considers the allowance for loan losses adequate to cover its estimate of inherent losses in the loan portfolio as of September 30, 2014.

For the nine months ended September 30, 2014, net chargeoffs to average loans outstanding totaled less than .05% on an annualized basis while the allowance for loan losses to gross loans totaled 1.67% at September 30, 2014. For the nine months ended September 30, 2013, net chargeoffs to average loans outstanding totaled 0.61% on an annualized basis while the allowance for loan losses to gross loans totaled 2.02% at September 30, 2013.

Management identifies and maintains a list of potential problem loans. These are loans that are internally risk graded substandard or below but which are not included in nonaccrual status and are not past due 90 days or more. A loan is added to the potential problem list when management becomes aware of information about possible credit problems of the borrower which raises serious doubts as to the ability of such borrower to comply with the current loan repayment terms. At September 30, 2014 potential problem loans totaled $10.8 million, and were comprised of $719,000 of construction and land development real estate loans, $6.6 million of nonfarm, nonresidential real estate loans, $2.6 million of 1-4 family mortgage loans, $348,000 of multifamily real estate loans, and $479,000 of various loan types not secured by real estate, primarily commercial and industrial loans. At September 30, 2013 potential problem loans totaled $14.4 million, and were comprised of $2.4 million of construction and land development real estate loans, $7.6 million of nonfarm, nonresidential real estate loans, $3.4 million of 1-4 family mortgage loans, and $1.0 million of various loan types not secured by real estate, primarily commercial and industrial loans. As the majority of potential problem loans are real estate secured, management closely tracks the current values of real estate collateral when assessing the collectibility of these loans.

Other Real Estate Owned

Other real estate owned totaled approximately $4.1 million as of September 30, 2014, $5.2 million at December 31, 2013, and $5.4 million as of September 30, 2013, net of a valuation reserve. Sales of other real estate owned totaled approximately $2.2 million and $2.9 million for the nine months ended September 30, 2014, and 2013, respectively. The Company generated loans to facilitate the sales of other real estate owned totaling $1.0 million and $2.1 million during the nine months ended September 30, 2014 and September 30, 2013, respectively. Impairment charges on other real estate owned totaled $6,000 and $4,000 for the nine months ended September 30, 2014, and 2013, respectively.

Deposits

Deposits increased $8.1 million during the first nine months of 2014 to $323.9 million at September 30, 2014. Included in this amount was an increase of $10.9 million in noninterest bearing deposits partially offset by a $2.8 million decrease in interest bearing accounts. The decrease in interest bearing deposits was primarily comprised of a decrease of $5.2 million of time deposits, partially offset by a $2.4 million overall increase in savings, money market, and interest bearing transaction accounts. The decrease in time deposits was attributable to a $16.2 million decrease in retail time deposits, which was substantially offset by an $11.0 million increase in brokered and wholesale time deposits. Brokered and wholesale time deposits totaled $12.3 million and $1.2 million at September 30, 2014 and December 31, 2013, respectively. The reduction in retail time deposits relative to the growth in the Company’s noninterest bearing transaction accounts lowered the Company’s cost of funds and improved the deposit mix, a key strategic objective identified by management.

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SOUTHCOAST FINANCIAL CORPORATION

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

Federal Home Loan Bank Borrowings

Other borrowings are primarily comprised of FHLBA advances. FHLBA advances are collateralized by pledged FHLBA stock and certain residential mortgage and commercial real estate loans. FHLBA advances outstanding at September 30, 2014 and December 31, 2013 are summarized as follows:

September 30, 2014
(Dollars in Thousands)
Maturity	Rate		Balance

February 2015		0.36%	$	8,000
March 2016		2.04%		10,000
May 2016		0.75%		2,000
March 2017		2.31%		2,000
May 2017		1.07%		2,000
March 2018		2.33%		5,000
April 2018		3.03%		5,000
May 2018		1.38%		2,000
March 2019		3.56%		5,000
March 2019		3.51%		5,000
May 2019		1.69%		2,000
May 2020		2.01%		2,000
March 2021		3.71%		5,000
March 2021		3.74%		5,000
March 2021		3.80%		5,000
March 2021		3.87%		5,000

Balance			$	70,000

December 31, 2013
(Dollars in Thousands)
Maturity	Rate		Balance

February 2014		0.36%	$	7,000
March 2016		2.04%		10,000
May 2016		0.75%		2,000
March 2017		2.31%		2,000
May 2017		1.07%		2,000
March 2018		2.33%		5,000
April 2018		3.03%		5,000
May 2018		1.38%		2,000
March 2019		3.56%		5,000
March 2019		3.51%		5,000
May 2019		1.69%		2,000
May 2020		2.01%		2,000
March 2021		3.71%		5,000
March 2021		3.74%		5,000
March 2021		3.80%		5,000
March 2021		3.87%		5,000

Balance			$	69,000

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SOUTHCOAST FINANCIAL CORPORATION

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

Junior Subordinated Debentures

On August 5, 2005 Southcoast Capital Trust III (the "Capital Trust"), a non-consolidated subsidiary of the Company, issued and sold a total of 10,310 floating rate securities, with a $1,000 liquidation amount per security (the "Capital Securities"). Institutional buyers bought 10,000 of the Capital Securities denominated as preferred securities and the Company bought the other 310 Capital Securities which are denominated as common securities. The proceeds of those sales, $10.3 million, were used by the Capital Trust to buy $10.3 million of junior subordinated debentures from the Company which are reported on its consolidated balance sheets. The Capital Securities mature or are mandatorily redeemable upon maturity on September 30, 2035, or upon earlier optional redemption as provided in the indenture. The Company had the right to redeem the Capital Securities in whole or in part, on or after September 30, 2010. See Note 11 to the consolidated financial statements for the year ended December 31, 2013, and the information set forth in Exhibit 13 under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations- Junior Subordinated Debentures” filed with our Form 10-K/A for the year ended December 31, 2013, for more information about the terms of the junior subordinated debentures.

Capital Resources

The Company’s total shareholders’ equity increased by approximately $3,093,000 during the first nine months of 2014, primarily due to net income of $2,385,000, other comprehensive income of $633,000, and proceeds from stock issuances of approximately $75,000 pursuant to our Employee Stock Purchase Plan. The Company’s Tier 1 capital to average assets ratio was 11.46 percent as of September 30, 2014 compared to 11.10 percent as of December 31, 2013.

The Federal Reserve Board and other bank regulatory agencies require bank holding companies and financial institutions to maintain capital at adequate levels based on a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 100%. Under the risk-based standard, capital is classified into two tiers. The Company’s and the Bank’s Tier 1 capital consists of common shareholders’ equity minus a portion of deferred tax assets plus, in the case of the Company, junior subordinated debt subject to certain limitations. The Company’s and the Bank’s Tier 2 capital consists of the allowance for loan losses subject to certain limitations and, in the case of the Company, its junior subordinated debt in excess of 25% of its Tier 1 capital. A bank holding company’s qualifying capital base for purposes of its risk-based capital ratio consists of the sum of its Tier 1 and Tier 2 capital. The regulatory minimum requirements are 4% of average assets for Tier 1 and 8% of risk-weighted assets for total risk-based capital. The Company and the Bank are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio. These requirements are set by regulation and are shown in the table below. These requirements are applicable to all but the most highly-rated institutions that are not anticipating or experiencing significant growth and have well-diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity and good earnings. The regulators may require individual bank holding companies and banks to maintain higher levels of capital depending on the regulators’ assessment of the risks faced by the bank holding company or the bank. As of September 30, 2014, the Company and the Bank exceeded each of the capital requirements shown in the following table.

	Capital Ratios
						Well Capitalized					Adequately Capitalized
	Actual					Requirement					Requirement
(Dollars in thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio
The Bank
Total capital (to risk-weighted assets)	$	52,067		15.94	%	$	32,659		10.00	%	$	26,127		8.00	%
Tier 1 capital (to risk-weighted assets)		47,957		14.68	%		19,595		6.00	%		13,063		4.00	%
Tier 1 capital (to average assets)		47,957		10.81	%		22,183		5.00	%		17,747		4.00	%
The Company
Total capital (to risk-weighted assets)		56,917		17.11	%	N/A		N/A				26,606		8.00	%
Tier 1 capital (to risk-weighted assets)		52,736		15.86	%	N/A		N/A				13,303		4.00	%
Tier 1 capital (to average assets)		52,736		11.46	%	N/A		N/A				18,403		4.00	%

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SOUTHCOAST FINANCIAL CORPORATION

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

Off Balance Sheet Risk

The Company makes contractual commitments to extend credit and issues standby letters of credit in the ordinary course of its business activities. These commitments are legally binding agreements to lend money to customers at predetermined interest rates for a specified period of time. In addition to commitments to extend credit, the Company also issues standby letters of credit which are assurances to a third party that it will not suffer a loss if the customer fails to meet a contractual obligation to the third party. At September 30, 2014, the Company had issued commitments to extend credit of approximately $25.9 million and letters of credit of approximately $27,000 through various types of commercial lending arrangements. Approximately $16.1 million of these commitments to extend credit had variable rates.

The following table sets forth the length of time until maturity for unused commitments to extend credit and standby letters of credit at September 30, 2014.

	Within One Month		After One Through Three Months		After Three Through Twelve Months		Within One Year		Greater Than One Year		Total

Unused commitments to extend credit	$	1,559	$	1,596	$	5,982	$	9,137	$	16,798	$	25,935
Standby letters of credit		-		27		5		32		-		32
Totals	$	1,559	$	1,623	$	5,987	$	9,169	$	16,798	$	25,967

Based on historical experience, many of the commitments and letters of credit will expire unfunded. Accordingly, the amounts shown in the table above do not necessarily reflect the Company’s need for funds in the periods shown. Further, through its various sources of liquidity, the Company believes it will be able to fund these obligations as they arise. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on the Company’s credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate.

Item 3. - Quantitative and Qualitative Disclosures About Market Risk.

Information about the Company’s exposure to market risk was disclosed in its Annual Report on Form 10-K/A for the year ended December 31, 2013, which was filed with the Securities and Exchange Commission on March 24, 2014. There have been no material quantitative or qualitative changes in market risk exposure since the date of that filing.

Item 4. - Controls and Procedures.

Based on the evaluation required by 17 C.F.R. Sections 240.13a-15(b) or 240.15d-15(b) of the Company’s disclosure controls and procedures (as defined in 17 C.F.R. Section 240.13a-15(e) and 240.15d-15(e), the Company's chief executive officer and chief financial officer concluded that such controls and procedures, as of the end of the period covered by this quarterly report, were effective.

There has been no change in the Company’s internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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SOUTHCOAST FINANCIAL CORPORATION

PART II - OTHER INFORMATION

Item 6. Exhibits

10	Split Dollar Termination Agreement, dated August 11, 2014, between the Registrant and L. Wayne Pearson
	(incorporated by reference to Report on Form 8-K, filed August 14, 2014)

31-1	Rule 13a-14(a) Certifications of CEO

31-2	Rule 13a-14(a) Certifications of CFO

32	Section 1350 Certification

101.INS**	XBRL Instance

101.SCH**	XBRL Taxonomy Extension Schema

101.CAL**	XBRL Taxonomy Extension Calculation

101.DEF**	XBRL Taxonomy Extension Definition

101.LAB**	XBRL Taxonomy Extension Labels

101.PRE**	XBRL Taxonomy Extension Presentation

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.

Date: November 13, 2014	By:	/s/ L. Wayne Pearson
		L. Wayne Pearson
		Chief Executive Officer

Date: November 13, 2014	By:	/s/ William C. Heslop
		William C. Heslop
		Chief Financial Officer

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SOUTHCOAST FINANCIAL CORPORATION

Exhibit Index

10	Split Dollar Termination Agreement, dated August 11, 2014, between the Registrant and L. Wayne Pearson (incorporated by reference to Report on Form 8-K, filed August 14, 2014)

31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32	Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. This exhibit is not “filed” for purposes of Section 18 of the Securities Exchange Act of 1934 but is instead furnished as provided by applicable rules of the Securities and Exchange Commission.

101.INS**	XBRL Instance

101.SCH**	XBRL Taxonomy Extension Schema

101.CAL**	XBRL Taxonomy Extension Calculation

101.DEF**	XBRL Taxonomy Extension Definition

101.LAB**	XBRL Taxonomy Extension Labels

101.PRE**	XBRL Taxonomy Extension Presentation

** XBRL information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, as amended, and otherwise is not subject to liability under these sections.

-47-

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