UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

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

For the Quarterly Period Ended March 31, 2015

OR

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

 

Commission file number 001-10897

 

 

Carolina Financial Corporation

(Exact name of registrant as specified in its charter)

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 8,133,460 shares of common stock, par value $0.01 per share, were issued and outstanding as of May 8, 2015.

 

TABLE OF CONTENTS

 

		Page
PART 1 –	FINANCIAL INFORMATION	3
Item 1.	Financial Statements	3
Item 2.	Management’s Discussion and Analysis of Financial Conditions and Results of Operations	37
Item 3.	Quantitative and Qualitative Disclosure about Market Risks	59
Item 4.	Controls and Procedures	59
PART II -	OTHER INFORMATION	60
Item 1.	Legal Proceedings	60
Item 1A.	Risk Factors	60
Item 2.	Unregistered Sale of Equity Securities and Use of Proceeds	60
Item 3.	Defaults Upon Senior Securities	60
Item 4.	Mine Safety Disclosures	60
Item 5.	Other Information	60
Item 6.	Exhibits	60

 

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED BALANCE SHEETS

 

		March 31, 2015				December 31, 2014
		(Unaudited)				(Audited)
		(In thousands)
ASSETS
Cash and due from banks		$	15,293				10,453
Interest-bearing cash			11,107				10,694
Cash and cash equivalents			26,400				21,147
Securities available-for-sale (cost of $286,404 at March 31, 2015 and $246,435 at December 31, 2014)			289,485				251,717
Securities held-to-maturity (fair value of $20,055 at March 31, 2015 and $27,385 at December 31, 2014)			18,947				25,544
Federal Home Loan Bank stock, at cost			7,773				5,405
Other investments			2,653				2,309
Derivative assets			2,739				1,689
Loans held for sale			51,950				40,912
Loans receivable, net of allowance for loan losses of $9,379 at March 31, 2015 and $9,035 at December 31, 2014			794,492				768,122
Premises and equipment, net			31,686				31,075
Accrued interest receivable			4,033				3,628
Real estate acquired through foreclosure, net			3,166				3,239
Deferred tax assets, net			4,277				4,715
Mortgage servicing rights			10,361				10,181
Cash value life insurance			21,554				21,532
Core deposit intangible			3,217				3,303
Other assets			3,400				4,499
Total assets		$	1,276,133				1,199,017
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Noninterest-bearing deposits		$	164,030				142,900
Interest-bearing deposits			825,619				821,290
Total deposits			989,649				964,190
Short-term borrowed funds			115,836				57,800
Long-term debt			56,665				61,740
Derivative liabilities			1,577				1,036
Drafts outstanding			3,037				3,320
Advances from borrowers for insurance and taxes			919				613
Accrued interest payable			332				312
Reserve for mortgage repurchase losses			4,671				4,999
Dividends payable to stockholders			244				243
Accrued expenses and other liabilities			5,584				11,064
Total liabilities			1,178,514				1,105,317
Commitments and contingencies
Stockholders’ equity:
Preferred stock, par value $.01; 1,000,000 shares authorized at March 31, 2015 and December 31, 2014; no shares issued or outstanding			—				—
Common stock, par value $.01; 10,000,000 shares authorized at March 31, 2015 and December 31, 2014; 8,124,781 and 8,097,536 issued and outstanding			81				81
Additional paid-in capital			23,468				23,210
Retained earnings			72,394				69,625
Accumulated other comprehensive income, net of tax			1,676				784
Total stockholders’ equity			97,619				93,700
Total liabilities and stockholders’ equity		$	1,276,133				1,199,017

 

See accompanying notes to consolidated financial statements.

 

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

		For the Three Months
		Ended March 31,
		2015				2014
		(In thousands, except share data)
Interest income
Loans		$	9,463				6,833
Debt securities			1,894				1,521
Dividends from FHLB			78				34
Other interest income			22				23
Total interest income			11,457				8,411
Interest expense
Deposits			961				815
Short-term borrowed funds			66				5
Long-term debt			473				511
Total interest expense			1,500				1,331
Net interest income			9,957				7,080
Provision for loan losses			—				—
Net interest income after provision for loan losses			9,957				7,080
Noninterest income
Net gain on sale of loans held for sale			4,017				2,454
Deposit service charges			840				431
Net gain  on sale of securities			471				316
Fair value adjustments on interest rate swaps			(595	)			(255	)
Net gain on sale of servicing assets			—				776
Net increase in cash value life insurance			178				186
Mortgage loan servicing income			1,308				1,277
Other			371				184
Total noninterest income			6,590				5,369
Noninterest expense
Salaries and employee benefits			6,963				5,344
Occupancy and equipment			1,784				984
Marketing and public relations			402				274
FDIC insurance			165				127
Provision for mortgage loan repurchase losses			(250	)			—
Legal expense			177				170
Other real estate expense, net			67				247
Mortgage subservicing expense			395				363
Amortization of mortgage servicing rights			460				472
Other			2,012				1,625
Total noninterest expense			12,175				9,606
Income before income taxes			4,372				2,843
Income tax expense			1,359				899
Net income		$	3,013				1,944
Earnings per common share:
Basic		$	0.39				0.25
Diluted		$	0.38				0.25
Weighted average common shares outstanding:
Basic			7,805,143				7,702,852
Diluted			8,010,029				7,872,174

 

See accompanying notes to consolidated financial statements.

 

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

		For the Three Months
		Ended March 31,
		2015				2014
		(In thousands)
Net income		$	3,013				1,944
Other comprehensive income, net of tax:
Unrealized gain on securities			1,801				2,392
Tax effect			(648	)			(861	)
Reclassification adjustment for gains included in earnings			(471	)			(316	)
Tax effect			169				114
Accretion of unrealized losses on held-to-maturity securities previously recognized in other comprehensive income			64				49
Tax effect			(23	)			(18	)
Other comprehensive income, net of tax			892				1,360
Comprehensive income		$	3,905				3,304

 

See accompanying notes to consolidated financial statements.

 

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

FOR THE THREE MONTHS ENDED MARCH 31, 2015 AND 2014

(Unaudited)

 

																		Accumulated
										Additional								Other
		Common Stock								Paid-in				Retained				Comprehensive
		Shares				Amount				Capital				Earnings				Income (Loss)				Total
		(In thousands, except share data)
Balance, December 31, 2013			8,030,408			$	80				22,353				62,169				(2,375	)			82,227
Stock awards			25,246				—				—				—				—				—
Stock-based compensation expense, net			—				—				247				—				—				247
Net income			—				—				—				1,944				—				1,944
Dividends declared to stockholders			—				—				—				(201	)			—				(201	)
Other comprehensive income, net of tax			—				—				—				—				1,360				1,360
Balance, March 31, 2014			8,055,654			$	80				22,600				63,912				(1,015	)			85,577
Balance, December 31, 2014			8,097,536			$	81				23,210				69,625				784				93,700
Stock awards			21,805				—				—				—				—				—
Stock options exercised			5,440				—				33				—				—				33
Stock-based compensation expense, net			—				—				225				—				—				225
Net income			—				—				—				3,013				—				3,013
Dividends declared to stockholders			—				—				—				(244	)			—				(244	)
Other comprehensive income, net of tax			—				—				—				—				892				892
Balance, March 31, 2015			8,124,781			$	81				23,468				72,394				1,676				97,619

 

See accompanying notes to consolidated financial statements.

 

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

		For the Three Months
		Ended March 31,
		2015				2014
		(In thousands)
Cash flows from operating activities:
Net income		$	3,013				1,944
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Deferred tax benefit			(75	)			(448	)
Amortization of unearned discount/premiums on investments, net			735				504
Amortization of deferred loan fees			(716	)			(577	)
Amortization of mortgage servicing rights			460				472
Amortization of core deposit intangibles			86				2
Gain on sale of available-for-sale securities, net			(471	)			(316	)
Gain on sale of loans held for sale, net			(4,017	)			(2,454	)
Originations of loans held for sale			(244,143	)			(206,114	)
Proceeds from sale of loans held for sale			236,018				213,452
Provision for mortgage loan repurchase losses			(250	)			—
Mortgage loan losses paid, net of recoveries			(78	)			(238	)
Fair value adjustments on interest rate swaps			595				255
Stock-based compensation			225				247
Decrease (increase) in cash surrender value of bank owned life insurance			6				(159	)
Depreciation			427				271
Loss on disposals of premises and equipment			9				—
Gain (loss) on sale of real estate acquired through foreclosure			27				(28	)
Write-down of real estate acquired through foreclosure			—				239
Gain on sale of servicing assets			—				(776	)
Originations of mortgage servicing assets			(640	)			(367	)
Decrease (increase) in:
Accrued interest receivable			(405	)			18
Income taxes receivable			—				(634	)
Other assets			1,099				2,334
Increase (decrease) in:
Accrued interest payable			20				13
Dividends payable to stockholders			1				201
Accrued expenses and other liabilities			(5,778	)			(3,486	)
Cash flows (used in) provided by operating activities			(13,852	)			4,355

 

Continued

 

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED

(Unaudited)

 

		For the Three Months
		Ended March 31,
		2015				2014
		(In thousands)
Cash flows from investing activities:
Activity in available-for-sale securities:
Purchases		$	(69,191	)			(47,805	)
Maturities, payments and calls			12,628				8,448
Proceeds from sales			27,151				9,818
Activity in held-to-maturity securities:
Purchases			(497	)			—
Maturities, payments and calls			167				317
Increase in other investments			(334	)			(63	)
(Increase) decrease in Federal Home Loan Bank stock			(2,368	)			723
Increase in loans receivable, net			(25,854	)			(36,427	)
Proceeds from the sale of servicing assets			—				1,576
Purchase of premises and equipment			(1,081	)			(1,340	)
Proceeds from disposals of premises and equipment			34				—
Proceeds from sale of real estate acquired through foreclosure			246				1,157
Increase in core deposit intangibles			—				(175	)
Purchase of bank owned life insurance			(203	)			—
Distribution of bank owned life insurance			175				—
Cash flows used in investing activities			(59,127	)			(63,771	)
Cash flows from financing activities:
Net increase in deposit accounts			25,459				48,087
Net increase (decrease) in Federal Home Loan Bank advances			53,000				(10,000	)
Net decrease in other short-term borrowed funds			36				—
Principal repayment of subordinated debt			(75	)			(75	)
Net decrease in drafts outstanding			(283	)			(793	)
Net increase in advances from borrowers for insurance and taxes			306				173
Cash dividends paid on common stock			(244	)			(201	)
Proceeds from exercise of stock options			33				—
Cash flows provided by financing activities			78,232				37,191
Net increase (decrease) in cash and cash equivalents			5,253				(22,225	)
Cash and cash equivalents, beginning of period			21,147				38,665
Cash and cash equivalents, end of period		$	26,400				16,440
Supplemental disclosure:
Cash paid for:
Interest on deposits and borrowed funds		$	1,480				1,318
Income taxes paid, net of refunds			219				2,768
Noncash investing and financing activities:
Transfer of loans receivable to real estate acquired through foreclosure		$	200				837
Transfer of held-to-maturity securities to available-for-sale securities			10,471				—
Change in unrealized gain on available-for-sale securities			1,330				2,076

 

See accompanying notes to consolidated financial statements.

 

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Organization

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

At March 31, 2015 and December 31, 2014, statutory business trusts (“Trusts”) created by the Company had outstanding trust preferred securities with an aggregate par value of $15,000,000. The principal assets of the Trusts are $15,465,000 of the Company’s subordinated debentures with identical rates of interest and maturities as the trust preferred securities. The Trusts have issued $465,000 of common securities to the Company and are included in other investments in the accompanying consolidated balance sheets. The Trusts are not consolidated subsidiaries of the Company.

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2015 are not necessarily indicative of the results that may be expected for the year ending December 31, 2015. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014 as filed with the Securities and Exchange Commission on March 20, 2015. There have been no significant changes to the accounting policies as disclosed in the Company’s Form 10-K.

Management’s Estimates

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

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

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

Earnings Per Share

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

On January 15, 2014, the Board of Directors of the Company declared a two-for-one stock split to stockholders of record dated February 10, 2014, issued on February 28, 2014.

On October 15, 2014, the Board of Directors of the Company declared an additional two-for-one stock split to stockholders of record as of October 31, 2014, issued on November 14, 2014.

As such, all share, earnings per share, and per share data have been retroactively adjusted to reflect the stock splits for all periods presented in accordance with GAAP.

Subsequent Events

Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. Non-recognized subsequent events are events that provide evidence about conditions that did not exist at the date of the statement of financial condition but arose after that date. Management has reviewed events occurring through the date the financial statements were issued and no subsequent events occurred requiring accrual or disclosure except for the following:

On April 29, 2015, the stockholders of the Company approved an increase in the number of authorized common shares from 10,000,000 to 15,000,000.

On April 29, 2015, the Company declared a $0.03 per share dividend to stockholders of record on June 24, 2015, payable July 10, 2015.

Reclassification

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

Recently Issued Accounting Pronouncements

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

 

In May 2014, the FASB issued guidance to change the recognition of revenue from contracts with customers. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. The guidance will be effective for the Company for reporting periods beginning after December 15, 2017. The Company will apply the guidance using a modified retrospective approach. The Company does not expect these amendments to have a material effect on its financial statements.

 

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

 

In June 2014, the FASB issued guidance which clarifies that performance targets associated with stock compensation should be treated as a performance condition and should not be reflected in the grant date fair value of the stock award. The amendments will be effective for the Company for fiscal years that begin after December 15, 2015. The Company will apply the guidance to stock awards with performance targets that are outstanding at the start of the first fiscal year in the financial statements and to all stock awards that are granted or modified after the effective date. The Company does not expect these amendments to have a material effect on its financial statements.

 

In January 2015, the FASB issued guidance that eliminated the concept of extraordinary items from GAAP. Existing GAAP required that an entity separately classify, present, and disclose extraordinary events and transactions. The amendments will eliminate the requirements for reporting entities to consider whether an underlying event or transaction is extraordinary, however, the presentation and disclosure guidance for items that are unusual in nature or occur infrequently will be retained and will be expanded to include items that are both unusual in nature and infrequently occurring. The amendments are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. The amendments may be applied either prospectively or retrospectively to all prior periods presented in the financial statements. Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. The Company does not expect these amendments to have a material effect on its financial statements.

 

In February 2015, the FASB issued guidance which amends the consolidation requirements and significantly changes the consolidation analysis required under GAAP. Although the amendments are expected to result in the deconsolidation of many entities, the Company will need to reevaluate all its previous consolidation conclusions. The amendments will be effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015 with early adoption permitted (including during an interim period), provided that the guidance is applied as of the beginning of the annual period containing the adoption date. The Company does not expect these amendments to have a material effect on its financial statements.

 

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

 

NOTE 2 - SECURITIES

The amortized cost, gross unrealized gains, gross unrealized losses and fair value of investments securities available-for-sale and held-to-maturity at March 31, 2015 and December 31, 2014 follows:

		March 31, 2015																December 31, 2014
						Gross				Gross												Gross				Gross
		Amortized				Unrealized				Unrealized				Fair				Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				Losses				Value				Cost				Gains				Losses				Value
		(In thousands)
Securities available-for-sale:
Municipal securities		$	53,189				1,702				(115	)			54,776				43,119				1,621				(23	)			44,717
US government agencies			10,333				78				(6	)			10,405				4,770				—				(22	)			4,748
Collateralized loan obligations			26,708				—				(34	)			26,674				25,883				11				(22	)			25,872
Mortgage-backed securities:
Agency			137,596				2,844				(58	)			140,382				122,727				2,856				(41	)			125,542
Non-agency			48,196				838				(189	)			48,845				49,936				1,065				(163	)			50,838
Total mortgage-backed securities			185,792				3,682				(247	)			189,227				172,663				3,921				(204	)			176,380
Trust preferred securities			10,382				1,391				(3,370	)			8,403				—				—				—				—
Total		$	286,404				6,853				(3,772	)			289,485				246,435				5,553				(271	)			251,717
Securities held-to-maturity:
Municipal securities		$	17,227				928				(1	)			18,154				16,787				882				(17	)			17,652
Trust preferred securities			1,720				319				(138	)			1,901				8,757				3,125				(2,149	)			9,733
Total		$	18,947				1,247				(139	)			20,055				25,544				4,007				(2,166	)			27,385

 

The following table presents unrealized losses related to the trust preferred securities that were recognized within other comprehensive income at the time of transfer to held-to-maturity as well as the unrealized gains and losses that are not presented in other comprehensive income for March 31, 2015 and December 31, 2014.

 

		At March 31, 2015
														Recognized in OCI												Not Recognized in OCI
														Gross Unrealized												Gross Unrealized
		Purchased Face Value				Cumulative OTTI				Carrying Value				Gains				Losses				Amortized Cost				Gains				Losses				Estimated Fair Value				Collateralization Percentage
		(In thousands)
Held-to-Maturity:
Trust Preferred Securities
Total A-Class		$	2,214				—				2,214				—				(494	)			1,720				319				(138	)			1,901			181%-402%
		$	2,214				—				2,214				—				(494	)			1,720				319				(138	)			1,901

 

		At December 31, 2014
														Recognized in OCI												Not Recognized in OCI
														Gross Unrealized												Gross Unrealized
		Purchased Face Value				Cumulative OTTI				Carrying Value				Gains				Losses				Amortized Cost				Gains				Losses				Estimated Fair Value				Collateralization Percentage
		(In thousands)
Held-to-Maturity:
Trust Preferred Securities
Total A-Class		$	2,381				—				2,381				—				(558	)			1,823				336				(75	)			2,084			175% - 378%
Total B-Class			11,718				(2,635	)			9,083				—				(2,458	)			6,625				1,788				(2,074	)			6,339			96% - 111%
Total C-Class			2,727				(1,340	)			1,387				—				(1,078	)			309				1,001				—				1,310			92% - 92%
		$	16,826				(3,975	)			12,851				—				(4,094	)			8,757				3,125				(2,149	)			9,733

 

As of December 31, 2014, the Company had all trust preferred securities classified as held-to-maturity. As a result of the implementation of the regulatory change in risk weightings dictated by Basel III, the Company transferred all B and C Class (mezzanine) trust preferred securities to available-for-sale. The transfer was in accordance with ASC 320-10-25-6 as a result of the change in risk weightings related to these securities; therefore, management has determined the transfer out of held-to-maturity is consistent with the original designation and does not taint the remaining portfolio. The senior tranche, or A Class, trust preferred securities remained in held-to-maturity as Basel III did not have a material effect on the risk weightings of these securities. The amortized cost of the securities reclassified to available-for-sale from held-to-maturity was $10.4 million. The net unrealized gains recorded in other comprehensive income during the first quarter of 2015 as a result of this reclassification were approximately $715,000.

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

As of March 31, 2015, $769,000 of the pooled trust preferred securities were investment grade, $951,000 were split-rated, and $6.9 million were below investment grade. As of December 31, 2014, $0.9 million of the pooled trust preferred securities were investment grade, $1.0 million were split-rated, and $6.9 million were below investment grade. In terms of risk-based capital calculation, the Company allocates additional risk-based capital to the below investment grade securities.

 

As of March 31, 2015, senior tranches (classified as held-to-maturity) represent $1.7 million in amortized cost of the Company’s trust preferred securities, while mezzanine tranches (classified as available-for-sale) represented $10.4 million. All of the $10.4 million in mezzanine tranches are still subordinate to senior tranches as the senior notes have not been paid to a zero balance.

 

The amortized cost and fair value of debt securities by contractual maturity at March 31, 2015 follows:

 

		At March 31, 2015
		Amortized				Fair
		Cost				Value
		(In thousands)
Securities available-for-sale:
Less than one year		$	9,123				9,189
One to five years			104,943				107,163
Six to ten years			123,085				125,269
After ten years			49,253				47,864
Total		$	286,404				289,485
Securities held-to-maturity:
Less than one year		$	—				—
One to five years			11,008				11,993
Six to ten years			6,988				7,249
After ten years			951				813
Total		$	18,947				20,055

 

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

 

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

 

		For the Three Months
		Ended March 31,
		2015				2014
		(In thousands)
Proceeds		$	27,151				9,818
Realized gains			474				316
Realized losses			(3	)			—
Total investment securities gains, net		$	471				316

 

At March 31, 2015, the Company had pledged $56.3 million of securities for Federal Home Loan Bank (“FHLB”) advances.

The gross unrealized losses and fair value of the Company’s investments available-for-sale with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2015 are as follows:

		At March 31, 2015
		Less than 12 Months												12 Months or Greater												Total
		Amortized				Fair				Unrealized				Amortized				Fair				Unrealized				Amortized				Fair				Unrealized
		Cost				Value				Losses				Cost				Value				Losses				Cost				Value				Losses
		(In thousands)
Available-for-sale:
Municipal securities		$	11,168				11,056				(112	)			336				333				(3	)			11,504				11,389				(115	)
US government agencies			1,693				1,687				(6	)			—				—				—				1,693				1,687				(6	)
Collateralized loan obligations			13,208				13,174				(34	)			—				—				—				13,208				13,174				(34	)
Mortgage-backed securities:
Agency			7,708				7,650				(58	)			—				—				—				7,708				7,650				(58	)
Non-agency			9,564				9,502				(62	)			6,739				6,612				(127	)			16,303				16,114				(189	)
Total mortgage-backed securities			17,272				17,152				(120	)			6,739				6,612				(127	)			24,011				23,764				(247	)
Trust preferred securities			—				—				—				7,943				4,573				(3,370	)			7,943				4,573				(3,370	)
Total		$	43,341				43,069				(272	)			15,018				11,518				(3,500	)			58,359				54,587				(3,772	)
Held-to-maturity:
Municipal securities		$	497				496				(1	)			—				—				—				497				496				(1	)
Trust preferred securities			—				—				—				951				813				(138	)			951				813				(138	)
Total		$	497				496				(1	)			951				813				(138	)			1,448				1,309				(139	)

 

The gross unrealized losses and fair value of the Company’s investments available-for-sale with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2014 are as follows:

 

		At December 31, 2014
		Less than 12 Months												12 Months or Greater												Total
		Amortized				Fair				Unrealized				Amortized				Fair				Unrealized				Amortized				Fair				Unrealized
		Cost				Value				Losses				Cost				Value				Losses				Cost				Value				Losses
		(In thousands)
Available-for-sale:
Municipal securities		$	2,479				2,475				(4	)			1,504				1,485				(19	)			3,983				3,960				(23	)
US government agencies			4,770				4,748				(22	)			—				—				—				4,770				4,748				(22	)
Collateralized loan obligations			14,708				14,686				(22	)			—				—				—				14,708				14,686				(22	)
Mortgage-backed securities:
Agency			17,541				17,500				(41	)			—				—				—				17,541				17,500				(41	)
Non-agency			14,284				14,138				(146	)			3,114				3,097				(17	)			17,398				17,235				(163	)
Total mortgage-backed securities			31,825				31,638				(187	)			3,114				3,097				(17	)			34,939				34,735				(204	)
Total		$	53,782				53,547				(235	)			4,618				4,582				(36	)			58,400				58,129				(271	)
Held-to-maturity:
Municipal securities		$	—				—				—				2,363				2,346				(17	)			2,363				2,346				(17	)
Trust preferred securities			—				—				—				7,326				5,177				(2,149	)			7,326				5,177				(2,149	)
Total		$	—				—				—				9,689				7,523				(2,166	)			9,689				7,523				(2,166	)

 

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

 

At March 31, 2015 and December 31, 2014, the Company had 33 and 26, respectively, individual investments available-for-sale that were in an unrealized loss position. The unrealized losses on the Company’s investments in US government-sponsored agencies, municipal securities and mortgage-backed securities (agency and non-agency) summarized above were attributable primarily to changes in interest rates. Management has performed various analyses, including cash flows, and determined that no OTTI expense was necessary for the three months ended March 31, 2015.

The Company had 1 and 4 trust preferred securities within the held-to-maturity portfolio that were in an unrealized loss position at March 31, 2015 and December 31, 2014, respectively.

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

In 2009, the Company adopted a four year “burst” scenario for its modeled default rates (2010 - 2013) that replicated the default rates for the banking industry from the four peak years of the savings and loan crisis, which then reduced to 0.25% annually. The elevated default rate ended in 2013, and the constant default rate used by the Company is now 0.25% annually. All issuers that were currently in deferral were presumed to be in default. Additionally, all defaults are assumed to have a 15% recovery after two years and 1% of the pool is presumed to prepay annually. If this analysis results in a present value of expected cash flows that is less than the book value of a security (that is, a credit loss exists), OTTI is considered to have occurred. If there is no credit loss, any impairment is considered temporary. The cash flow analysis we performed used discount rates equal to the credit spread at the time of purchase for each security and then added the current three-month LIBOR forward interest rate curve. Based on the cash flow analysis performed at period end, management believes that there are no additional securities other-than-temporarily impaired at March 31, 2015.

There was no OTTI recognized for the three months ended March 31, 2015 or 2014.

Management believes that there are no additional securities other-than-temporarily impaired at March 31, 2015. The Company does not intend to sell these securities and it is more likely than not that the Company will not be required to sell these securities before recovery of their amortized cost. Management continues to monitor these securities with a high degree of scrutiny. There can be no assurance that the Company will not conclude in future periods that conditions existing at that time indicate some or all of the securities may be sold or are other-than-temporarily impaired, which would require a charge to earnings in such periods.

NOTE 3 – DERIVATIVES

The derivative positions of the Company at March 31, 2015 and December 31, 2014 are as follows:

		At March 31,								At December 31,
		2015								2014
		Fair				Notional				Fair				Notional
		Value				Value				Value				Value
		(In thousands)
Derivative assets:
Mortgage loan interest rate lock commitments		$	2,181				173,311				1,122				106,440
Mortgage loan forward sales commitments			558				33,159				567				27,292
		$	2,739				206,470				1,689				133,732
Derivative liabilities:
Mortgage-backed securities forward sales commitments		$	622				138,507				506				93,000
Interest rate swaps			955				25,000				530				20,000
		$	1,577				163,507				1,036				113,000

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

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

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

NOTE 4 - LOANS RECEIVABLE, NET

Loans receivable, net at March 31, 2015 and December 31, 2014 are summarized by category as follows:

 

		At March 31,								At December 31,
		2015								2014
						% of Total								% of Total
		Amount				Loans				Amount				Loans
		(Dollars in thousands)
Loans secured by real estate:
One-to-four family		$	271,941				33.78	%			252,819				32.48	%
Home equity			28,130				3.50	%			27,547				3.54	%
Commercial real estate			318,769				39.61	%			317,912				40.85	%
Construction and development			83,488				10.37	%			92,008				11.82	%
Consumer loans			5,277				0.66	%			5,675				0.73	%
Commercial business loans			97,244				12.08	%			82,305				10.58	%
Total gross loans receivable			804,849				100.00	%			778,266				100.00	%
Less:
Allowance for loan losses			9,379								9,035
Deferred fees, net			978								1,109
Total loans receivable, net		$	794,492								768,122

 

Included in the loan totals were $78.0 and $80.2 million in loans acquired through branch acquisitions at March 31, 2015 and December 31, 2014, respectively. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk.

 

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

 

		At March 31,								At December 31,
		2015								2014
		(Dollars in thousands)
Variable rate loans		$	350,006				43.49	%			337,802				43.40	%
Fixed rate loans			454,843				56.51	%			440,464				56.60	%
Total loans outstanding		$	804,849				100.00	%			778,266				100.00	%

 

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

 

Allowance for loan losses:		For the Three Months Ended March 31, 2015
		Loans Secured by Real Estate
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Unallocated				Total
		(In thousands)
Balance at January 1, 2015		$	2,888				221				3,283				1,069				30				1,430				114				9,035
Provision for loan losses			(179	)			5				(217	)			15				(12	)			242				146				—
Charge-offs			—				—				—				(90	)			(1	)			(41	)			—				(132	)
Recoveries			175				—				225				12				12				52				—				476
Balance at March 31, 2015		$	2,884				226				3,291				1,006				29				1,683				260				9,379

 

		For the Three Months Ended March 31, 2014
		Loans Secured by Real Estate
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Unallocated				Total
		(In thousands)
Balance at January 1, 2014		$	2,472				231				2,855				1,418				42				339				734				8,091
Provision for loan losses			114				3				444				(339	)			(40	)			115				(297	)			—
Charge-offs			(37	)			—				(28	)			(170	)			(13	)			—				—				(248	)
Recoveries			19				—				—				327				40				172				—				558
Balance at March 31, 2014		$	2,568				234				3,271				1,236				29				626				437				8,401

 

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

 

		Loans Secured by Real Estate
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Unallocated				Total
		(In thousands)
At March 31, 2015:
Allowance for loan losses ending balances:
Individually evaluated for impairment		$	318				—				130				—				—				—				—				448
Collectively evaluated for impairment			2,566				226				3,161				1,006				29				1,683				260				8,931
		$	2,884				226				3,291				1,006				29				1,683				260				9,379
Loans receivable ending balances:
Individually evaluated for impairment		$	4,258				62				8,205				177				63				1,717				—				14,482
Collectively evaluated for impairment			267,683				28,068				310,564				83,311				5,214				95,527				—				790,367
Total loans receivable		$	271,941				28,130				318,769				83,488				5,277				97,244				—				804,849
At December 31, 2014:
Allowance for loan losses ending balances:
Individually evaluated for impairment		$	364				—				30				90				1				—				—				485
Collectively evaluated for impairment			2,524				221				3,253				979				29				1,430				114				8,550
		$	2,888				221				3,283				1,069				30				1,430				114				9,035
Loans receivable ending balances:
Individually evaluated for impairment		$	3,249				63				8,153				267				30				1,730				—				13,492
Collectively evaluated for impairment			249,570				27,485				309,759				91,741				5,644				80,575				—				764,774
Total loans receivable		$	252,819				27,548				317,912				92,008				5,674				82,305				—				778,266

 

The following table presents impaired loans individually evaluated for impairment in the segmented portfolio categories and the corresponding allowance for loan losses as of March 31, 2015 and December 31, 2014. The recorded investment is defined as the original amount of the loan, net of any deferred costs and fees, less any principal reductions and direct charge-offs. Unpaid principal balance includes amounts previously included in charge-offs.

 

		At March 31, 2015												At December 31, 2014
						Unpaid												Unpaid
		Recorded				Principal				Related				Recorded				Principal				Related
		Investment				Balance				Allowance				Investment				Balance				Allowance
		(In thousands)
With no related allowance recorded:
Loans secured by real estate:
One-to-four family		$	3,253				4,800				—				2,008				3,731				—
Home equity			62				409				—				63				410				—
Commercial real estate			7,821				8,365				—				7,893				8,439				—
Construction and development			177				2,000				—				—				1,733				—
Consumer loans			63				539				—				29				506				—
Commercial business loans			1,717				2,887				—				1,730				2,927				—
			13,093				19,000				—				11,723				17,746				—
With an allowance recorded:
Loans secured by real estate:
One-to-four family			1,005				1,005				318				1,241				1,241				364
Home equity			—				—				—				—				—				—
Commercial real estate			384				384				130				260				260				30
Construction and development			—				—				—				267				267				90
Consumer loans			—				—				—				1				1				1
Commercial business loans			—				—				—				—				—				—
			1,389				1,389				448				1,769				1,769				485
Total:
Loans secured by real estate:
One-to-four family			4,258				5,805				318				3,249				4,972				364
Home equity			62				409				—				63				410				—
Commercial real estate			8,205				8,749				130				8,153				8,699				30
Construction and development			177				2,000				—				267				2,000				90
Consumer loans			63				539				—				30				507				1
Commercial business loans			1,717				2,887				—				1,730				2,927				—
		$	14,482				20,389				448				13,492				19,515				485

 

The following table presents the average recorded investment and interest income recognized on impaired loans individually evaluated for impairment in the segmented portfolio categories for the three months ended March 31, 2015 and 2014.

 

		For the Three Months Ended March 31,
		2015								2014
		Average				Interest				Average				Interest
		Recorded				Income				Recorded				Income
		Investment				Recognized				Investment				Recognized
		(In thousands)
With no related allowance recorded:
Loans secured by real estate:
One-to-four family		$	2,482				69				5,107				53
Home equity			62				—				—				—
Commercial real estate			7,856				87				16,807				148
Construction and development			245				—				450				2
Consumer loans			37				—				23				4
Commercial business loans			1,718				73				2,480				77
			12,400				229				24,867				284
With an allowance recorded:
Loans secured by real estate:
One-to-four family			1,007				—				545				5
Home equity			—				—				—				—
Commercial real estate			290				3				311				6
Construction and development			—				—				—				—
Consumer loans			—				—				7				—
Commercial business loans			—				—				5				—
			1,297				3				868				11
Total:
Loans secured by real estate:
One-to-four family			3,489				69				5,652				58
Home equity			62				—				—				—
Commercial real estate			8,146				90				17,118				154
Construction and development			245				—				450				2
Consumer loans			37				—				30				4
Commercial business loans			1,718				73				2,485				77
		$	13,697				232				25,735				295

 

A loan is considered past due if the required principal and interest payment has not been received as of the due date. The following schedule is an aging of past due loans receivable by portfolio segment as of March 31, 2015 and December 31, 2014.

 

		At March 31, 2015
		Real estate loans
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Total
		(In thousands)
30-59 days past due		$	137				—				253				69				24				—				483
60-89 days past due			27				61				—				—				72				—				160
90 days or more past due			1,802				—				323				177				42				3				2,347
Total past due			1,966				61				576				246				138				3				2,990
Current			269,975				28,069				318,193				83,242				5,139				97,241				801,859
Total loans receivable		$	271,941				28,130				318,769				83,488				5,277				97,244				804,849

 

		At December 31, 2014
		Real estate loans
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Total
		(In thousands)
30-59 days past due		$	336				18				260				60				21				27				722
60-89 days past due			188				—				—				—				6				—				194
90 days or more past due			1,589				—				333				267				6				—				2,195
Total past due			2,113				18				593				327				33				27				3,111
Current			250,706				27,530				317,319				91,681				5,641				82,278				775,155
Total loans receivable		$	252,819				27,548				317,912				92,008				5,674				82,305				778,266

 

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

 

There were no loans past due 90 days or more and still accruing at March 31, 2015 or December 31, 2014.

 

The following is a schedule of loans receivable, by portfolio segment, on nonaccrual at March 31, 2015 and December 31, 2014.

 

		At March 31,				At December 31,
		2015				2014
		(In thousands)
Loans secured by real estate:
One-to-four family		$	1,846				1,720
Home equity			62				63
Commercial real estate			575				333
Construction and development			177				267
Consumer loans			46				12
Commercial business loans			39				39
		$	2,745				2,434

 

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

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

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

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

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

 

The Company uses the following definitions in the tables below:

 

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

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

The following is a schedule of the credit quality of loans receivable, by portfolio segment, as of March 31, 2015 and December 31, 2014.

 

		At March 31, 2015
		Real estate loans
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Total
		(In thousands)
Internal Risk Rating Grades:
Pass		$	269,068				28,068				308,360				83,017				5,264				96,441				790,218
Special Mention			383				—				9,687				294				—				197				10,561
Substandard			2,490				62				722				177				13				606				4,070
Total loans receivable		$	271,941				28,130				318,769				83,488				5,277				97,244				804,849
Performing		$	270,095				28,068				318,194				83,311				5,231				97,205				802,104
Nonperforming:
90 days or more and still accruing			—				—				—				—				—				—				—
Nonaccrual			1,846				62				575				177				46				39				2,745
Total nonperforming			1,846				62				575				177				46				39				2,745
Total loans receivable		$	271,941				28,130				318,769				83,488				5,277				97,244				804,849

 

		At December 31, 2014
		Real estate loans
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				development				Consumer				business				Total
		(In thousands)
Internal Risk Rating Grades:
Pass		$	249,781				27,485				307,283				91,441				5,661				81,499				763,150
Special Mention			1,318				—				10,037				300				1				217				11,873
Substandard			1,720				63				592				267				12				589				3,243
Total loans receivable		$	252,819				27,548				317,912				92,008				5,674				82,305				778,266
Performing		$	251,099				27,485				317,579				91,741				5,662				82,266				775,832
Nonperforming:
90 days or more and still accruing			—				—				—				—				—				—				—
Nonaccrual			1,720				63				333				267				12				39				2,434
Total nonperforming			1,720				63				333				267				12				39				2,434
Total loans receivable		$	252,819				27,548				317,912				92,008				5,674				82,305				778,266

 

Troubled Debt Restructurings

 

At March 31, 2015, there were $11.8 million in loans designated as troubled debt restructurings of which $11.7 million were accruing. At December 31, 2014, there were $10.8 million in loans designated as troubled debt restructurings of which $10.7 million were accruing.

 

There was one relationship totaling fourteen loans designated as a troubled debt restructuring during the three months ended March 31, 2015. All loans within this relationship were designated as troubled debt restructuring due to a change in payment structure. Eleven loans were within the one-to-four family loan segment with a premodification and post modification recorded investment of $749,000. Two loans were within the commercial real estate loan segment with a premodification and post modification recorded investment of $147,000. One loan was within the commercial and industrial loan segment with a premodification and post modification recorded investment of $14,000.

 

There were no loans designated as a troubled debt restructuring during the three months ended March 31, 2014.

 

No loans previously restructured in the twelve months prior to March 31, 2015 and 2014 went into default during the period ended March 31, 2015 and 2014.

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

NOTE 5 – REAL ESTATE ACQUIRED THROUGH FORECLOSURE

The following presents summarized activity in other real estate owned for the periods ended March 31, 2015 and December 31, 2014:

		March 31,				December 31,
		2015				2014
		(In thousands)
Balance at beginning of period		$	3,239				6,273
Additions			200				1,461
Sales			(273	)			(3,969	)
Write downs			—				(526	)
Balance at end of period		$	3,166				3,239

 

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

 

		At March 31,				At December 31,
		2015				2014
		(In thousands)
Real estate loans:
One-to-four family		$	188				245
Commercial real estate			450				954
Construction and development			2,528				2,040
		$	3,166				3,239

 

NOTE 6 - DEPOSITS

Deposits outstanding by type of account at March 31, 2015 and December 31, 2014 are summarized as follows:

 

		At March 31,				At December 31,
		2015				2014
		(In thousands)
Noninterest-bearing demand accounts		$	164,030				142,900
Interest-bearing demand accounts			175,848				183,550
Savings accounts			38,296				36,630
Money market accounts			248,492				246,116
Certificates of deposit:
Less than $250,000			345,820				335,740
$250,000 or more			17,163				19,254
Total certificates of deposit			362,983				354,994
Total deposits		$	989,649				964,190

 

The aggregate amount of brokered certificates of deposit was $86.6 million and $77.3 million at March 31, 2015 and December 31, 2014, respectively. Brokered certificates of deposit are included in the table above under certificates of deposit less than $250,000. The aggregate amount of institutional certificates of deposit was $48.1 million and $44.8 million at March 31, 2015 and December 31, 2014, respectively.

 

The Company has pledged $16.9 million of securities as of March 31, 2015 to secure public agency funds.

 

NOTE 7 – ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS

 

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

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

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

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

Level 1	Quoted prices (unadjusted) in active markets for identical assets and liabilities for the instrument or security to be valued. Level 1 assets include marketable equity securities as well as U.S. Treasury securities that are highly liquid and are actively traded in over-the-counter markets.

 

 

Level 2

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

 

Level 3

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

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

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

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

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

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

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

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

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

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

 

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

 

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

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

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

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

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

The carrying amount and estimated fair value of the Company’s financial instruments at March 31, 2015 and December 31, 2014 are as follows:

		At March 31, 2015
		Carrying				Fair Value
		Amount				Total				Level 1				Level 2				Level 3
		(In thousands)
Financial assets:
Cash and due from banks		$	15,293				15,293				15,293				—				—
Interest-bearing cash			11,107				11,107				11,107				—				—
Securities available-for-sale			289,485				289,485				—				289,485				—
Securities held-to-maturity			18,947				20,055				—				20,055				—
Federal Home Loan Bank stock			7,773				7,773				—				—				7,773
Other investments			2,653				2,653				—				—				2,653
Derivative assets			2,739				2,739				—				2,739				—
Loans held for sale			51,950				51,950				—				51,950				—
Loans receivable, net			794,492				828,803				—				—				828,803
Cash value life insurance			21,554				21,554				—				21,554				—
Accrued interest receivable			4,033				4,033				—				4,033				—
Mortgage servicing rights			10,361				15,098				—				15,098				—
Financial liabilities:
Deposits			989,649				989,539				—				989,539				—
Short-term borrowed funds			115,836				115,725				—				115,725				—
Long-term debt			56,665				60,782				—				60,782				—
Derivative liabilities			1,577				1,577				955				622				—
Accrued interest payable			332				332				—				332				—

 

		At December 31, 2014
		Carrying				Fair Value
		Amount				Total				Level 1				Level 2				Level 3
		(In thousands)
Financial assets:
Cash and due from banks		$	10,453				10,453				10,453				—				—
Interest-bearing cash			10,694				10,694				10,694				—				—
Securities available-for-sale			251,717				251,717				—				251,717				—
Securities held-to-maturity			25,544				27,385				—				27,385				—
Federal Home Loan Bank stock			5,405				5,405				—				—				5,405
Other investments			2,309				2,309				—				—				2,309
Derivative assets			1,689				1,689				—				1,689				—
Loans held for sale			40,912				40,912				—				40,912				—
Loans receivable, net			768,122				785,109				—				—				785,109
Cash value life insurance			21,532				21,532				—				21,532				—
Accrued interest receivable			3,628				3,628				—				3,628				—
Mortgage servicing rights			10,181				15,147				—				15,147				—
Financial liabilities:
Deposits			964,190				962,763				—				962,763				—
Short-term borrowed funds			57,800				57,745				—				57,745				—
Long-term debt			61,740				65,516				—				65,516				—
Derivative liabilities			1,036				1,036				530				506				—
Accrued interest payable			312				312				—				312				—

 

 

		At March 31, 2015								At December 31, 2014
		Notional				Estimated				Notional				Estimated
		Amount				Fair Value				Amount				Fair Value
		(In thousands)
Off-Balance Sheet Financial Instruments:
Commitments to extend credit		$	64,642				—				68,181				—
Standby letters of credit			1,463				—				1,982				—
Derivative assets:
Mortgage loan interest rate lock commitments			173,311				2,181				106,440				1,122
Mortgage loan forward sales commitments			33,159				558				27,292				567
Derivative liabilities:
Mortgage-backed securities forward sales commitments			138,507				622				93,000				506
Interest rate swaps			25,000				955				20,000				530

 

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

 

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

Investment Securities Available-for-Sale

Measurement is on a recurring basis upon quoted market prices, if available. If quoted market prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for prepayment assumptions, projected credit losses, and liquidity. At March 31, 2015 and December 31, 2014, the Company’s investment securities available-for-sale are recurring Level 2.

Mortgage Loans Held for Sale

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

Derivative Assets and Liabilities

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

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

Impaired Loans

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

Other Real Estate Owned (“OREO”)

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

Assets and liabilities measured at fair value on a recurring basis are as follows as of March 31, 2015 and December 31, 2014:

		Quoted market price				Significant other				Significant other
		in active markets				observable inputs				unobservable inputs
		(Level 1)				(Level 2)				(Level 3)
		(In thousands)
March 31, 2015
Available-for-sale investment securities:
Municipal securities		$	—				54,776				—
US government agencies			—				10,405				—
Collateralized loan obligations			—				26,674				—
Mortgage-backed securities:
Agency			—				140,382				—
Non-agency			—				48,845				—
Trust Preferred Securities			—				8,403				—
Loans held for sale			—				51,950				—
Derivative assets:
Mortgage loan interest rate lock commitments			—				2,181				—
Mortgage loan forward sales commitments			—				558				—
Derivative liabilities:
Mortgage-backed securities forward sales commitments			—				622
Interest rate swaps			955				—				—
Total		$	955				344,796				—
December 31, 2014
Available-for-sale investment securities:
Municipal securities		$	—				44,717				—
US government agencies			—				4,748				—
Collateralized loan obligations			—				25,872				—
Mortgage-backed securities:
Agency			—				125,542				—
Non-agency			—				50,838				—
Loans held for sale			—				40,912				—
Derivative assets:
Mortgage loan interest rate lock commitments			—				1,122				—
Mortgage loan forward sales commitment			—				567				—
Derivative liabilities:
Mortgage-backed securities forward sales commitments			—				506				—
Interest rate swaps			530				—				—
Total		$	530				294,824				—

 

Assets measured at fair value on a nonrecurring basis are as follows as of March 31, 2015 and December 31, 2014:

 

		Quoted market price				Significant other				Significant other
		in active markets				observable inputs				unobservable inputs
		(Level 1)				(Level 2)				(Level 3)
		(In thousands)
March 31, 2015
Impaired loans:
Loans secured by real estate:
One-to-four family		$	—				—				3,940
Home equity			—				—				62
Commercial real estate			—				—				8,075
Construction and development			—				—				177
Consumer loans			—				—				63
Commercial business loans			—				—				1,717
Real estate owned:
One-to-four family			—				—				188
Commercial real estate			—				—				450
Construction and development			—				—				2,528
Total		$	—				—				17,200
December 31, 2014
Impaired loans:
Loans secured by real estate:
One-to-four family		$	—				—				2,885
Home equity			—				—				63
Commercial real estate			—				—				8,123
Construction and development			—				—				177
Consumer loans			—				—				29
Commercial business loans			—				—				1,730
Real estate owned:
One-to-four family			—				—				2,040
Commercial real estate			—				—				245
Construction and development			—				—				954
Total		$	—				—				16,246

 

For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of March 31, 2015 and December 31, 2014, the significant unobservable inputs used in the fair value measurements were as follows:

	March 31, 2015 and December 31, 2014
			Significant		Significant Unobservable
	Valuation Technique		Observable Inputs		Inputs
Impaired Loans	Appraisal Value		Appraisals and or sales of		Appraisals discounted 10% to 20% for
			comparable properties		sales commissions and other holding costs
Real estate owned	Appraisal Value/		Appraisals and or sales of		Appraisals discounted 10% to 20% for
	Comparison Sales/		comparable properties		sales commissions and other holding costs
	Other estimates

 

NOTE 8 - EARNINGS PER SHARE

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

As stated in Note 1, on January 15, 2014, the Board of Directors of the Company declared a two-for-one stock split to stockholders of record as of February 10, 2014, issued on February 28, 2014.

On October 15, 2014, the Board of Directors of the Company declared an additional two-for-one stock split to stockholders of record as of October 31, 2014, issued on November 14, 2014.

All share, earnings per share, and per share data have been retroactively adjusted to reflect the stock splits for all periods presented in accordance with GAAP.

The following is a summary of the reconciliation of weighted average shares outstanding for the three months ended March 31, 2015 and 2014:

		For the Three Months Ended March 31,
		2015								2014
		Basic				Diluted				Basic				Diluted
Weighted average shares outstanding			7,805,143				7,805,143				7,702,852				7,702,852
Effect of dilutive securities			—				204,886				—				169,322
Weighted average shares outstanding			7,805,143				8,010,029				7,702,852				7,872,174

 

NOTE 9 – SUPPLEMENTAL SEGMENT INFORMATION

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

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

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

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

The following tables present selected financial information for the Company’s reportable business segments for the three months ended March 31, 2015 and 2014:

 

		Community				Mortgage
For the Three Months Ended March 31, 2015		Banking				Banking				Other				Eliminations				Total
		(In thousands)
Interest income		$	11,022				392				4				39				11,457
Interest expense			1,355				11				145				(11	)			1,500
Net interest income (expense)			9,667				381				(141	)			50				9,957
Provision for loan losses			(37	)			37				—				—				—
Noninterest income from external customers			1,700				4,890				—				—				6,590
Intersegment noninterest income			1				36				1,768				(1,805	)			—
Noninterest expense			6,335				3,908				1,932				—				12,175
Intersegment noninterest expense			1,528				241				—				(1,769	)			—
Income (loss) before income taxes			3,542				1,121				(305	)			14				4,372
Income tax expense (benefit)			1,069				410				(125	)			5				1,359
Net income (loss)		$	2,473				711				(180	)			9				3,013

 

		Community				Mortgage
For the Three Months Ended March 31, 2014		Banking				Banking				Other				Eliminations				Total
		(In thousands)
Interest income		$	8,091				285				4				31				8,411
Interest expense			1,197				—				134				—				1,331
Net interest income (expense)			6,894				285				(130	)			31				7,080
Provision for loan losses			—				—				—				—				—
Noninterest income from external customers			915				4,444				10				—				5,369
Intersegment noninterest income			—				72				1,510				(1,582	)			—
Noninterest expense			4,114				3,846				1,646				—				9,606
Intersegment noninterest expense			1,270				240				—				(1,510	)			—
Income (loss) before income taxes			2,425				715				(256	)			(41	)			2,843
Income tax expense (benefit)			735				275				(95	)			(16	)			899
Net income (loss)		$	1,690				440				(161	)			(25	)			1,944

 

The following tables present selected financial information for the Company’s reportable business segments for March 31, 2015 and December 31, 2014:

		Community				Mortgage
At March 31, 2015		Banking				Banking				Other				Eliminations				Total
		(In thousands)
Assets		$	1,268,260				71,312				112,875				(176,314	)			1,276,133
Loans receivable, net			790,002				14,744				—				(10,254	)			794,492
Loans held for sale			14,013				37,937				—				—				51,950
Deposits			991,410				—				—				(1,761	)			989,649
Borrowed funds			157,000				9,500				15,501				(9,500	)			172,501

 

		Community				Mortgage
At December 31, 2014		Banking				Banking				Other				Eliminations				Total
		(In thousands)
Assets		$	1,192,419				67,952				111,096				(172,450	)			1,199,017
Loans receivable, net			764,881				10,808				—				(7,567	)			768,122
Loans held for sale			1,547				39,365				—				—				40,912
Deposits			966,309				—				—				(2,119	)			964,190
Borrowed funds			104,076				6,800				15,465				(6,801	)			119,540

 

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

 

The following discussion reviews our results of operations for the three months ended March 31, 2015 as compared to the three months ended March 31, 2014 and assesses our financial condition as of March 31, 2015 as compared to December 31, 2014. You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements and the related notes and the consolidated financial statements and the related notes for the year ended December 31, 2014 included in our Form 10-K for that period. Results for the three months ended March 31, 2015 are not necessarily indicative of the results for the year ending December 31, 2015 or any future period.

 

Cautionary Warning Regarding Forward-Looking Statements

 

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

 

·

our ability to maintain appropriate levels of capital and to comply with our capital ratio requirements;

·

examinations by our regulatory authorities, including the possibility that the regulatory authorities may, among other things, require us to increase our allowance for loan losses or write-down assets or otherwise impose restrictions or conditions on our operations, including, but not limited to, our ability to acquire or be acquired;

·

changes in economic conditions, either nationally or regionally and especially in our primary service areas, resulting in, among other things, a deterioration in credit quality;

	·	an increase in interest rates, resulting in a decline in our mortgage production and a decrease in the profitability of our mortgage banking operations;
	·	credit losses as a result of declining real estate values, increasing interest rates, increasing unemployment, changes in payment behavior or other factors;

·

credit losses because our loans are concentrated by loan type, industry segment, borrower type, or location of the borrower or collateral;

·

changes in the amount of our loan portfolio collateralized by real estate and weaknesses in the Carolinas and national real estate markets;

·

the rate of delinquencies and amount of loans charged-off;

·

the adequacy of the level of our allowance for loan losses and the amount of loan loss provisions required in future periods;

·

the rate of loan growth in recent or future years;

	·	our ability to attract and retain key personnel;
	·	our ability to retain our existing customers, including our deposit relationships;
	·	significant increases in competitive pressure in the banking and financial services industries;
	·	adverse changes in asset quality and resulting credit risk-related losses and expenses;
	·	changes in the interest rate environment which could reduce anticipated or actual margins;
	·	changes in political conditions or the legislative or regulatory environment, including, but not limited to, the Dodd-Frank Wall Street Reform and Consumer Protection Act and regulations adopted thereunder, changes in federal or state tax laws or interpretations thereof by taxing authorities and other governmental initiatives affecting the banking and financial service industries;

·

inflation;

·

increased funding costs due to market illiquidity, increased competition for funding, or increased regulatory requirements with regard to funding;

 

 

	·	our business continuity plans or data security systems could prove to be inadequate, resulting in a material interruption in, or disruption to, business and a negative impact on results of operations;
	·	changes in deposit flows;

·

changes in technology;

·

changes in monetary and tax policies;

	·	changes in accounting policies, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board and the Financial Accounting Standards Board;
	·	loss of consumer confidence and economic disruptions resulting from terrorist activities or other military actions;
	·	our expectations regarding our operating revenues, expenses, effective tax rates and other results of operations;
	·	the general decline in the real estate and lending markets;
	·	our anticipated capital expenditures and our estimates regarding our capital requirements and our ability to successfully integrate acquired businesses;
	·	our liquidity and working capital requirements;

·

competitive pressures among depository and other financial institutions;

	·	the growth rates of the markets in which we compete;
	·	our anticipated strategies for growth and sources of new operating revenues;
	·	our current and future products, services, applications and functionality and plans to promote them;

·

our ability to retain and hire necessary employees and to staff our operations appropriately;

·

management compensation and the methodology for its determination;

	·	our ability to compete in our industry and innovation by our competitors;
	·	our ability to stay abreast of new or modified laws and regulations that currently apply or become applicable to our business;
	·	increased cybersecurity risk, including potential business disruptions or financial losses; and
	·	estimates and estimate methodologies used in preparing our consolidated financial statements and determining option exercise prices.

 

If any of these risks or uncertainties materialize, or if any of the assumptions underlying such forward-looking statements proves to be incorrect, our results could differ materially from those expressed, implied or projected by us in such forward-looking statements. For information with respect to factors that could cause actual results to differ from the expectations stated in the forward-looking statements, see “Risk Factors” under Part I, Item 1A of our Annual Report on Form10-K for the year ended December 31, 2014. We urge investors to consider all of these factors carefully in evaluating the forward-looking statements contained in this Quarterly Report on Form 10-Q and our other reports filed pursuant to the Securities Exchange Act of 1934. We make these forward-looking statements as of the date of this document and we do not intend, and assume no obligation, to update the forward-looking statements or to update the reasons why actual results could differ from those expressed, implied or projected by us in the forward-looking statements.

 

Company Overview

 

The Company is a Delaware corporation and bank holding company that was incorporated in 1996 and began operations in 1997. It operates principally through CresCom Bank, a South Carolina state-chartered bank (the “Bank”). Crescent Mortgage Company operates as a wholly-owned subsidiary of CresCom Bank. CresCom Bank provides a full range of commercial and retail banking financial services designed to meet the financial needs of our customers through its branch network in South Carolina and North Carolina. Crescent Mortgage Company, headquartered in Atlanta, Georgia, is a wholesale mortgage company that provides mortgage banking services in 45 states and has partnered with over 2,000 community banks, credit unions and mortgage brokers.

  

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

 

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

 

In addition to earning interest on our loans and investments, we derive a portion of our income from Crescent Mortgage Company through net gain on sale of loans held for sale as well as servicing income. We also earn income through fees that we charge to our customers. Likewise, we incur other operating expenses as well.

 

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

 

Executive Summary of Operating Results

 

At March 31, 2015, our total assets were $1.3 billion, an increase of $77.1 million, from total assets of $1.2 billion at December 31, 2014. The largest components of our total assets are loans receivable and securities which were $794.5 million and $308.4 million, respectively at March 31, 2015. Comparatively, our loans receivable and securities totaled $768.1 million and $277.2 million, respectively, at December 31, 2014. At March 31, 2015 loans held for sale were $52.0 million compared to $40.9 million as of December 31, 2014. Our liabilities and stockholders’ equity at March 31, 2015 totaled $1.2 billion and $97.6 million, respectively, compared to liabilities of $1.1 billion and stockholders’ equity of $93.7 million at December 31, 2014. The principal components of our liabilities are deposits which were $989.6 million and $964.2 million at March 31, 2015 and December 31, 2014, respectively. The increase in total assets and deposits during 2015 primarily related to strong loan and deposit growth. 

 

The Company reported net income available to common stockholders of approximately $3.0 million, or $0.38 per diluted share, for the three months ended March 31, 2015, compared to approximately $1.9 million, or $0.25 per diluted share for three months ended March 31, 2014. The increase in net income from period to period is attributable to the significant growth in loans and securities experienced during 2014 and into 2015, increased deposit fee income, increased gain on sale of loan mortgages originated at the Bank, and improved results from Crescent Mortgage Company.

 

The allowance for loan losses was $9.4 million, or 1.17% of total loans at March 31, 2015, compared to $9.0 million, or 1.16% of total loans, at December 31, 2014. The Company experienced net recoveries of $344,000 and $310,000 during the three months ended March 31, 2015 and 2014, respectively. Asset quality has remained relatively consistent since year end, with nonperforming assets to total loans decreasing to 0.46% as of March 31, 2015 as compared to 0.47% as of December 31, 2014. No provision expense was recorded during the three months ended March 31, 2015 or 2014 due to the continued improvement in asset quality as well as the net recoveries experienced.

 

At March 31, 2015, the Company’s regulatory capital ratios exceeded the minimum levels currently required. Stockholders’ equity totaled $97.6 million as of March 31, 2015 compared to $93.7 million at December 31, 2014. The implementation of Basel III capital framework did not have a material effect on the Company’s regulatory capital ratios.

 

Recent Events

 

On April 29, 2015, the stockholders of the Company approved an increase in the number of authorized common shares from 10,000,000 to 15,000,000.

On April 29, 2015, the Company declared a $0.03 per share dividend to stockholders of record on June 24, 2015, payable July 10, 2015.

 

Critical Accounting Policies

 

We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in the notes to our consolidated financial statements within Item 1 “Financial Statements” elsewhere in this report.

 

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

 

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

 

Other-Than Temporary Impairment. The evaluation and recognition of other-than-temporary impairment, or OTTI, on certain investments including our private label mortgage-backed securities and trust preferred securities requires significant judgment and estimates. Some of the more critical judgments supporting the evaluation of OTTI include projected cash flows including prepayment assumptions, default rates and severities of losses on the underlying collateral within the security. Under different conditions or utilizing different assumptions, the actual OTTI realized by us may be different from the actual amounts recognized in our consolidated financial statements. See notes to our consolidated financial statements in item I “Financial Statements” for the disclosure of certain assumptions used in the determination of OTTI.

 

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

 

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

 

For additional discussion related to the determination of fair value related to derivative instruments, see notes to the financial statements in Item I “Financial Statements.”

 

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

 

Business Combinations. The Company accounts for its acquisitions under ASC Topic 805, Business Combinations, which requires the use of the acquisition method of accounting. All identifiable assets acquired, including loans, are recorded at fair value. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk. As provided for under GAAP, management has up to twelve months following the date of the acquisition to finalize the fair values of acquired assets and assumed liabilities. Once management has finalized the fair values of acquired assets and assumed liabilities within this twelve month period, management considers such values to be the day 1 fair values (“Day 1 Fair Values”).

 

Results of Operations

Summary

The Company reported net income available to common stockholders of approximately $3.0 million, or $0.38 per diluted share, for the three months ended March 31, 2015, compared to approximately $1.9 million, or $0.25 per diluted share for three months ended March 31, 2014. The increase in net income from period to period is attributable to the significant growth in loans and securities experienced during 2014 and into 2015, increased deposit fee income, increased gain on sale of loan mortgages originated at the Bank, and improved results from Crescent Mortgage Company.

 

For additional information regarding the effects of the wholesale mortgage banking subsidiary on net income, refer to Note 9 under Item 1 “Financial Statements”.

 

Net Interest Income and Margin

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

Net interest income increased to $10.0 million for the three months ended March 31, 2015 from $7.1 million for the three months ended March 31, 2014. The increase in net interest income for the three months ended March 31, 2015 as compared to the three months ended March 31, 2014 is a result of the increase in average interest-earning assets balances as well as a decrease in rates paid on interest-bearing liabilities and a shift to lower cost funding sources.

The increase in average earnings assets for the three months ended March 31, 2015 is primarily the result of increased balances of loans receivable and securities.

The growth in average loan balances was primarily the result of the following:

·     Residential mortgage –In addition to selling a portion of its production, the Company has retained a portion of the mortgage production. Due to the emphasis to grow the residential mortgage portfolio, loans receivable within the one-to-four family portfolio have increased $71.3 million since March 31, 2014. This growth includes loans acquired in Branch Acquisition during the fourth quarter of 2014, described further below.

·     Commercial lending – during 2014, the Company expanded its commercial lending team by hiring additional loan officers in its Charleston and Myrtle Beach markets of South Carolina. The Company has also opened a loan production office in the upstate of South Carolina. As a result, loans receivable within the commercial real estate and construction and development portfolios have grown $68.9 million and $23.4 million, respectively, since March 31, 2014. This growth includes loans acquired in the Branch acquisition described further below.

·     Syndicated loans – the Charleston and Myrtle Beach markets of South Carolina have provided limited opportunities for the Bank to develop a Commercial and Industrial (“C&I”) loan portfolio. The Company’s primary markets are generally concentrated in real estate lending. However, in order to diversify our lending portfolio, the Company began a syndicated loan program in 2014 to purchase C&I loans to retain in the loan portfolio. These loans typically have terms of seven years and are tied to a floating rate index such as libor or prime. To effectively manage this new line of lending, the Company hired an experienced senior lending executive in 2014 with relevant experience to lead and manage this area of the loan portfolio and retained a consulting firm that specializes in syndicated loans. Syndicated loans have grown $46.7 million since March 31, 2014. As of March 31, 2015, the syndicated loan portfolio outstanding was $60.3 million and is grouped within commercial business loans. As of March 31, 2015, the Moody’s weighted average credit facility rating of the syndicated loan portfolio was Ba2, with no credit rated less than B2.

·     Acquisition of 13 branches – On December 12, 2014, the Company finalized the acquisition of 13 branches from First Community Bank. Loans acquired totaled $70.0 million after fair value adjustments with approximately $20.7 million in one-to-family, $18.2 million in commercial real estate and $20.9 million in construction and development with the remaining loans consisting of consumer, home equity, and commercial business loans.

The decrease in rates paid on interest-bearing liabilities is based on the continued historically low interest rates that have positively impacted our ability to reduce funding cost. We have also shifted to lower cost funding sources through the Company’s sustained efforts to grow checking, savings, and money market accounts during 2014 and continuing into 2015. As a result of these efforts, the Company experienced significant growth in checking, savings, and money market accounts which typically yield less than other forms of interest-bearing liabilities. Checking, savings and money market balances increased $189.0 million since March 31, 2014, including $159.4 million of deposits assumed in the two branch acquisitions completed in 2014.

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

 

		For The Three Months Ended March 31,
		2015												2014
						Interest				Average								Interest				Average
		Average				Earned/				Yield/				Average				Earned/				Yield/
		Balance				Paid				Rate				Balance				Paid				Rate
Interest-earning assets:
Loans held for sale		$	30,733				289				3.76	%			25,658				266				4.15	%
Loans receivable, net (1)			779,661				9,174				4.77	%			553,427				6,567				4.81	%
Interest-bearing cash			17,988				11				0.25	%			21,009				13				0.25	%
Securities available for sale			260,599				1,735				2.70	%			182,747				1,317				2.92	%
Securities held to maturity			25,456				159				2.53	%			24,326				204				3.40	%
Federal Home Loan Bank stock			6,404				78				4.94	%			3,773				34				3.60	%
Other investments			2,513				11				1.78	%			1,686				10				2.41	%
Total interest-earning assets			1,123,354				11,457				4.14	%			812,626				8,411				4.20	%
Non-earning assets			107,590												81,528
Total assets		$	1,230,944												894,154
Interest-bearing liabilities:
Demand accounts			194,252				56				0.12	%			84,146				41				0.20	%
Money market accounts			243,687				110				0.18	%			217,868				136				0.25	%
Savings accounts			36,914				12				0.13	%			20,756				10				0.20	%
Certificates of deposit			360,346				783				0.88	%			292,362				628				0.87	%
Short-term borrowed funds			97,159				66				0.28	%			4,644				5				0.44	%
Long-term debt			45,203				473				4.24	%			73,307				511				2.83	%
Total interest-bearing liabilities			977,561				1,500				0.62	%			693,083				1,331				0.78	%
Noninterest-bearing deposits			135,982												103,583
Other liabilities			20,127												14,508
Stockholders’ equity			97,274												82,980
Total liabilities and
Stockholders’ equity		$	1,230,944												894,154
Net interest spread											3.52	%											3.42	%
Net interest margin			3.60	%											3.54	%
Net interest margin (tax equivalent) (2)			3.68	%											3.63	%
Net interest income							9,957												7,080

 

(1) Average balances of loans include nonaccrual loans.

 

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

 

Our net interest margin was 3.60%, or 3.68% on a tax equivalent basis, for the three month period ended March 31, 2015 compared to 3.54%, or 3.63% on a tax equivalent basis, for the three month period ended March 31, 2014. The increase in our net margin primarily resulted from the increase in average noninterest-bearing deposits and a shift to lower cost deposits positively impacting the rate paid on interest-bearing liabilities.

Our net interest spread, which is not on a tax equivalent basis, was 3.52% for the three months ended March 31, 2015 as compared to 3.42% for the same period in 2014. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The 10 basis point increase in net interest spread is a result of the 6 basis point decrease in yield on interest-earning assets and a 16 basis point decrease in rate paid on interest-bearing liabilities.

Provision for Loan Loss

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

Following is a summary of the activity in the allowance for loan losses during the periods ended March 31, 2015 and 2014.

		For the Three Months
		Ended March 31,
		2015				2014
		(Dollars in thousands)
Balance, beginning of period		$	9,035				8,091
Provision for loan losses			—				—
Loan charge-offs			(132	)			(248	)
Loan recoveries			476				558
Balance, end of period		$	9,379				8,401

 

The Company experienced net recoveries of $344,000 and $310,000 during the three months ended March 31, 2015 and 2014, respectively, while asset quality has remained relatively consistent since year end, with nonperforming assets to total assets decreasing to 0.46% as of March 31, 2015 as compared to 0.47% as of December 31, 2014. No provision expense was recorded during the three months ended March 31, 2015 or 2014 due to the continued improvement in asset quality as well as the net recoveries experienced.

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

Noninterest Income and Expense

 

Noninterest income provides us with additional revenues that are significant sources of income. The major components of noninterest income for the three months ended March 31, 2015 and 2014 are presented below:

 

		For the Three Months
		Ended March 31,
		2015				2014
		(In thousands)
Noninterest income:
Net gain on sale of loans held for sale		$	4,017				2,454
Deposit service charges			840				431
Net gain on sale of securities			471				316
Fair value adjustments on interest rate swaps			(595	)			(255	)
Net gain on sale of servicing assets			—				776
Net increase in cash value life insurance			178				186
Mortgage loan servicing income			1,308				1,277
Other			371				184
Total noninterest income		$	6,590				5,369

Noninterest income increased $1.2 million to $6.6 million for the three months ended March 31, 2015 from $5.4 million for the three months ended March 31, 2014. The increase in noninterest income primarily relates to the increase in the net gain on sale of loans held for sale from our retail mortgage team as well as our wholesale mortgage banking subsidiary and an increase in deposit service charges during the period.

For the three months ended March 31, 2015, net gain on sale of loans held for sale increased to $4.0 million, including $443,000 contributed by the Bank’s retail mortgage. This compares with net gain on sale of loans held for sale of $2.5 million, including $82,000 contributed by the Bank’s retail mortgage, for the three months ended March 31, 2014. Loan originations increased 18.4% to $244.0 million, including $17.6 million originations related to the Bank’s retail mortgage, for the first quarter of 2015 as compared to loan originations of $206.1 million, including $5.9 million originations related to the Bank’s retail mortgage, for the first quarter of 2014. During the first quarter of 2015, refinanced versus purchase loans originations were 43.2% and 56.8%, respectively, as compared to 31.6% and 68.4%, respectively, for the first quarter of 2014. Furthermore, gain on sale of loans were positively affected by margin expansion experienced by the Company during the first quarter of 2015.

Deposit service charges increased $409,000 to $840,000 for the three months ended March 31, 2015 as compared to $431,000 for the three months ended March 31, 2014. The increase in deposit service charge income is a result of the increase in deposits assumed as part of the two branch acquisitions during 2014 as well as the Company’s sustained efforts to grow checking, savings, and money market accounts. As a result of these efforts, the Company experienced significant growth in number of checking accounts. Furthermore, checking, savings and money market balances have increased $189.0 million since March 31, 2014, including the effect of deposits assumed in the two branch acquisitions completed in 2014.

 

Partially offsetting the overall increase in noninterest income was a decrease in the net gain on sale of servicing assets from period to period. During the first quarter of 2014, the Company sold $147.7 million in unpaid principal balance of mortgage servicing rights for a net gain of $776,000. There were no servicing rights sold during 2015.

 

During the three months ended March 31, 2015 and 2014, the Company recognized net gains on sale of available-for-sale securities of $471,000 and $316,000, respectively.

 

The fair value adjustment on interest rate swaps reduced noninterest income by $595,000 and $255,000 for the three months ended, March 31, 2015 and 2014, respectively. The change in fair value adjustment on interest rate swaps relates to the change in interest rates from period to period. The bank uses interest rate swaps to help offset fair value volatility in the balance sheet related to interest rate changes.

 

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

 

		For the Three Months
		Ended March 31,
		2015				2014
		(In thousands)
Noninterest expense:
Salaries and employee benefits		$	6,963				5,344
Occupancy and equipment			1,784				984
Marketing and public relations			402				274
FDIC insurance			165				127
Provision for mortgage loan repurchase losses			(250	)			—
Legal expense			177				170
Other real estate expense, net			67				247
Mortgage subservicing expense			395				363
Amortization of mortgage servicing rights			460				472
Other			2,012				1,625
Total noninterest expense		$	12,175				9,606

 

Noninterest expense represents the largest expense category for the Company. Noninterest expense increased $1.6 million to $12.2 million for the three months ended March 31, 2015 from $9.6 million for the three months ended March 31, 2014. The increase in noninterest expense for the three months ended March 31, 2015 compared to the prior period is primarily a result of the increase in salaries and employee benefits paid as well as the increase in expenses related to occupancy and equipment.

Salaries and employee benefits increased $1.6 million to $7.0 million for the three months ended March 31, 2015 as compared to $5.3 million for the comparable prior period while occupancy and equipment increased $800,000 to $1.8 million for the three months ended March 31, 2015 as compared to $984,000 for the prior period. These increases are primarily a result of the personnel and occupancy costs associated with the two acquisitions of branches completed during 2014. In addition, the increase in salaries and occupancy and equipment can also be attributed to the addition of three branches and one loan production office opened after the first quarter of 2014 and the related depreciation and operational expenses related to those branches.

Offsetting the increase in noninterest expense was a negative provision for mortgage loan repurchase losses of $250,000 for the first quarter of March 31, 2015. There was no provision recorded during the first quarter of 2014. The Company evaluates its mortgage repurchase reserves quarterly and considers a combination of factors including production volumes, estimated levels of defects on internal quality assurance, default exceptions, historical investor repurchase demand and appeals success rates, reimbursement by correspondent and other third party originators and projected loss severity. In addition, during 2013 and 2014, there was a change in the framework of certain federal agencies that, in management’s opinion, favorably impacted the Company’s mortgage loan repurchase loss exposure. As a result of a significant reduction in production volumes, favorable trends in the factors discussed above and the change in federal framework related to mortgage loan repurchase loss exposure, management believed it was appropriate to reduce the reserve for mortgage repurchase losses.

 

Income Tax Expense

Our effective tax rate decreased to 31.1% for three month period ended March 31, 2015, compared to 31.6% for the three month period ended March 31, 2014.

Balance Sheet Review

 

Investment Securities

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

At March 31, 2015, our investment securities portfolio, excluding FHLB stock and other investments, was $308.4 million or approximately 24.2% of our assets. Our available-for-sale investment portfolio included US agency securities, municipal securities, collateralized loan obligations, mortgage-backed securities (agency and non-agency), and trust preferred securities with a fair value of $289.5 million and an amortized cost of $286.4 million for a net unrealized gain of $3.1 million. Our held-to-maturity portfolio included municipal securities and asset-backed securities, made up of pooled trust preferred securities, with a fair value of $20.1 million and a cost of $18.9 million for a net unrealized gain of $1.1 million.

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

The following table summarizes issuer concentrations of agency mortgage-backed securities for which aggregate fair values exceed 10% of stockholders’ equity at March 31, 2015:

		Aggregate				Aggregate				Fair Value
		Amortized				Fair				as a % of
Issuer		Cost				Value				Stockholders’ Equity
(Dollars in thousands)
GNMA		$	73,856				75,093				76.92	%
FNMA			49,194				50,338				51.57	%
FHLMC			14,546				14,951				15.32	%
		$	137,596				140,382				143.81	%

 

See Note 2 under Item 1 “Financial Statements” herein for additional disclosures related to the Company’s evaluation of securities for OTTI as well as the transfer of held-to-maturity securities to available-for-sale during the first quarter of 2015.

Loans by Type

 

Since loans typically provide higher interest yields than other types of interest-earning assets, a substantial percentage of our earning assets are invested in our loan portfolio. Loans outstanding, net of the allowance at March 31, 2015 and December 2014 were $794.5 million and $768.1 million, respectively.

Our loan portfolio consists primarily of loans secured by real estate mortgages. As of March 31, 2015, our loan portfolio included $702.3 million, or 87.3%, of gross loans secured by real estate. As of December 31, 2014, our loan portfolio included $690.3 million, or 88.7%, of gross loans secured by real estate. Substantially all of our real estate loans are secured by residential or commercial property. We obtain a security interest in real estate, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans to coincide with the appropriate regulatory guidelines. The Bank’s primary markets are generally concentrated in real estate lending. In order to diversify our lending portfolio, the Bank began a syndicated loan program during 2014. As of March 31, 2015, syndicated loans were $60.3 million and are included within commercial business loans in the table below. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral and business types.

As shown in the table below, gross loans receivable increased $26.6 million since December 31, 2014. The increase in loans receivable primarily relates to the Bank’s focus on growing residential mortgage, commercial lending, and syndicated loans.

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

		At March 31,								At December 31,
		2015								2014
						% of Total								% of Total
		Amount				Loans				Amount				Loans
		(Dollars in thousands)
Loans secured by real estate:
One-to-four family		$	271,941				33.78	%			252,819				32.48	%
Home equity			28,130				3.50	%			27,547				3.54	%
Commercial real estate			318,769				39.61	%			317,912				40.85	%
Construction and development			83,488				10.37	%			92,008				11.82	%
Consumer loans			5,277				0.66	%			5,675				0.73	%
Commercial business loans			97,244				12.08	%			82,305				10.58	%
Total gross loans receivable			804,849				100.00	%			778,266				100.00	%
Less:
Allowance for loan losses			9,379								9,035
Deferred fees, net			978								1,109
Total loans receivable, net		$	794,492								768,122

Maturities and Sensitivity of Loans to Changes in Interest Rates

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

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

		At March 31, 2015
						After one
		One Year				but within				After five
		or Less				five years				years				Total
		(In thousands)
Loans secured by real estate:
One-to-four family		$	8,094				47,313				216,534				271,941
Home equity			4,327				11,715				12,088				28,130
Commercial real estate			28,255				229,304				61,210				318,769
Construction and development			25,568				47,003				10,917				83,488
Consumer loans			1,029				3,432				816				5,277
Commercial business loans			14,766				27,571				54,907				97,244
Total gross loans receivable			82,039				366,338				356,472				804,849
Less:
Deferred fees, net			77				857				44				978
Total loans receivable		$	81,962				365,481				356,428				803,871
Loans maturing - after one year
Variable rate loans														$	302,995
Fixed rate loans															418,914
														$	721,909

 

Nonperforming and Problem Assets

 

Nonperforming assets include loans on which interest is not being accrued, accruing loans that are 90 days or more delinquent and foreclosed property. Foreclosed property consists of real estate and other assets acquired as a result of a borrower’s loan default. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when we believe, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction of principal when received. In general, a nonaccrual loan may be placed back onto accruing status once the borrower has made a minimum of six consecutive payments in accordance with the loan terms. Further, the borrower must show capacity to continue performing into the future prior to restoration of accrual status. As of March 31, 2015 and December 31 2014, we had no loans 90 days past due and still accruing.

Troubled Debt Restructurings (“TDRs”)

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

 

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

 

		At March 31,				At December 31,
		2015				2014
		(In thousands)
Loans receivable:
Nonaccrual loans-renegotiated loans		$	58				58
Nonaccrual loans-other			2,687				2,376
Accruing loans 90 days or more delinquent			—				—
Real estate acquired through foreclosure, net			3,166				3,239
Total Non-Performing Assets		$	5,911				5,673
Problem Assets not included in Non-Performing Assets-
Accruing renegotiated loans outstanding		$	11,737				10,798

At March 31, 2015, nonperforming assets were $5.9 million, or 0.46% of total assets. Comparatively, nonperforming assets were $5.7 million, or 0.47% of total assets, at December 31, 2014. Nonperforming loans were 0.34% and 0.31% of gross loans receivable at March 31, 2015 and December 31, 2014, respectively.

Potential problem loans, which are not included in nonperforming loans, amounted to approximately $11.7 million, or 1.5% of gross loans at March 31, 2015, compared to $10.8 million, or 1.38% of gross loans at December 31, 2014. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms.

Substantially all of the nonaccrual loans, accruing loans 90 days or more delinquent and accruing renegotiated loans at March 31, 2015 and December 31, 2014 are collateralized by real estate. The Bank utilizes third party appraisers to determine the fair value of collateral dependent loans. Our current loan and appraisal policies require the Bank to obtain updated appraisals on an annual basis, either through a new external appraisal or an internal appraisal evaluation. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment. We typically charge-off a portion or create a specific reserve for impaired loans when we do not expect repayment to occur as agreed upon under the original terms of the loan agreement. Management believes based on information known and available currently, the probable losses related to problem assets are adequately reserved in the allowance for loan losses.

Credit quality indicators generally showed improvement during 2014 and continuing into 2015 as the Company experienced reduced loan migrations to nonaccrual status, and lower loss severity on individual problem asset. The Company believes this general trend in reduced loans migrating into nonaccrual status is an indication of improving credit quality in the Company’s overall loan portfolio and a leading indicator of reduced credit losses going forward. Nevertheless, the Company can make no assurances that nonperforming assets will continue to improve in future periods. The Company continues to monitor the loan portfolio and foreclosed assets very carefully and is continually working to reduce its problem assets.

Allowance for Loan Losses

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

The general component covers nonimpaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by major loan category and is based on the actual loss history trends for the previous 16 quarters. The actual loss experience is supplemented with internal and external qualitative factors as considered necessary at each period and given the facts at the time. These qualitative factors adjust the 16 quarter historical loss rate to recognize the most recent loss results and changes in the economic conditions to ensure the estimated losses in the portfolio are recognized in the period incurred and that the allowance at each balance sheet date is adequate and appropriate in accordance with GAAP. Qualitative factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries for the most recent twelve quarters; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations.

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

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

At March 31, 2015 and December 31, 2014, the allowance for loan losses was $9.4 million and $9.0 million, respectively, or 1.17% and 1.16% of outstanding loans, respectively. The Company experienced net recoveries of $344,000 and $310,00 during the three months ended March 31, 2015 and 2014, respectively, while asset quality has remained relatively consistent since year end, with nonperforming assets to total loans decreasing to 0.46% as of March 31, 2015 as compared to 0.47% as of December 31, 2014. No provision expense was recorded during the three months ended March 31, 2015 or 2014 due to the continued improvement in asset quality as well as the net recoveries experienced.

The following table summarizes the activity related to our allowance for loan losses for the three months ended March 31, 2015 and 2014.

		For the Three Months
		Ended March 31,
		2015				2014
		(Dollars in thousands)
Balance, beginning of period		$	9,035				8,091
Provision for loan losses			—				—
Loan charge-offs:
Loans secured by real estate:
One-to-four family			—				(37	)
Home equity			—				—
Commercial real estate			—				(28	)
Construction and development			(90	)			(170	)
Consumer loans			(1	)			(13	)
Commercial business loans			(41	)			—
Total loan charge-offs			(132	)			(248	)
Loan recoveries:
Loans secured by real estate:
One-to-four family			175				19
Home equity			—				—
Commercial real estate			225				—
Construction and development			12				327
Consumer loans			12				40
Commercial business loans			52				172
Total loan recoveries			476				558
Net loan recoveries			344				310
Balance, end of period		$	9,379				8,401
Allowance for loan losses as a percentage of loans receivable (end of period)			1.17	%			1.45	%
Net charge-offs (recoveries) to average loans receivable (annualized)			-0.18	%			-0.22	%

Mortgage Operations

Mortgage Activities and Servicing

Our wholesale mortgage banking operations are conducted through our mortgage origination subsidiary, Crescent Mortgage Company. Mortgage activities involve the purchase of mortgage loans and table funded originations for the purpose of generating gains on sales of loans and fee income on the origination of loans. While the Company originates residential one-to-four family loans that are held in its loan portfolio, the majority of new loans are generally sold pursuant to secondary market guidelines through Crescent Mortgage Company. Generally, residential mortgage loans are sold and, depending on the pricing in the marketplace, servicing rights are either sold or retained. The level of loan sale activity and its contribution to the Company’s profitability depends on maintaining a sufficient volume of loan originations and margin. Changes in the level of interest rates and the local economy affect the volume of loans originated by the Company and the amount of loan sales and loan fees earned. Discussion related to the impact and changes within the mortgage operations are provided in “Results of Operations”. Additional segment information is provided in Note 9 under Item 1 “Financial Statements”

Loan Servicing

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

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

The Company was servicing $1.9 billion of loans for others at March 31, 2015 and December 31, 2014. In the aggregate, the net servicing asset had a balance of $10.4 million and $10.2 million at March 31, 2015 and December 31, 2014, respectively. The economic estimated fair value of the mortgage servicing rights was $15.1 million and $15.2 million at March 31, 2015 and December 31, 2014, respectively. The amortization expense related to the mortgage servicing rights were $460,000 and $472,000 during the three months ended March 31, 2015 and 2014, respectively.

Below is a roll-forward of activity in the balance of the servicing assets for the three months ended March 31, 2015 and March 31, 2014.

		For the Three Months
		Ended March 31,
		2015				2014
		(In thousands)
MSR beginning balance		$	10,181				10,908
Amount capitalized			640				367
Amount sold			—				(800	)
Amount amortized			(460	)			(472	)
MSR ending balance		$	10,361				10,003

Reserve For Mortgage Repurchase Losses

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

The following table demonstrates the activity for the reserve for mortgage repurchase losses for the three months ended March 31, 2015 and 2014.

 

		For the Three Months
		Ended March 31,
		2015				2014
		(In thousands)
Beginning Balance		$	4,999				6,109
Losses paid			(78	)			(260	)
Recoveries			—				22
Provision for mortgage repurchase losses			(250	)			—
Ending balance		$	4,671				5,871

 

For the three months ended March 31, 2015, the Company recorded a negative provision for mortgage repurchase losses of $250,000. No provision for mortgage repurchases losses was recorded for the three months ended March 31, 2014. The decline in the provision for mortgage loan repurchase losses is related to several factors. The Company sells mortgage loans to various third parties, including government-sponsored entities (“GSEs”), under contractual provisions that include various representations and warranties as previously stated. The Company establishes the reserve for mortgage loan repurchase losses based on a combination of factors, including estimated levels of defects on internal quality assurance, default expectations, historical investor repurchase demand and appeals success rates, reimbursement by correspondent and other third party originators, and projected loss severity. Prior to 2012, there was no expiration date related to representations and warranties as long as the loan sold to the investor was outstanding. As a result, the Company received loan repurchase requests years after the loan was originated and sold to various third parties. In the latter part of 2012, the regulatory framework for certain GSEs changed where, under certain circumstances, the loan repurchase risk was limited for production beginning in January 2013. In addition, in May 2014, additional regulatory changes further limited loan repurchase risk.

As a result, the Company performed an analysis of its reserve for mortgage loan repurchase losses and, based on management’s judgment and interpretation of such regulatory changes, reduced the reserve accordingly. Management will continue to monitor how the GSEs implement the regulatory changes and trends. If such trends continue to be favorable, there is a possibility that additional reductions in this reserve could occur in future periods.

Deposits

We provide a range of deposit services, including noninterest-bearing demand accounts, interest-bearing demand and savings accounts, money market accounts and time deposits. These accounts generally pay interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. Deposits continue to be our primary funding source. At March 31, 2015 deposits totaled $989.6 million, an increase of $25.5 million from deposits of $964.2 million at December 31, 2014.

Our retail deposits represented $855.0 million, or 86.4% of total deposits at March 31, 2015, while our out-of-market, comprised of our brokered and institutional deposits, represented $134.7 million, or 13.6% of our total deposits. Our retail deposits represented $842.1 million, or 87.3% of total deposits at December 31, 2014, while our out-of-market, comprised of our brokered and institutional deposits, represented $122.1 million, or 12.7% of our total deposits

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

		For the Three Months
		Ended March 31,
		2015								2014
		Average				Average				Average				Average
		Balance				Rate				Balance				Rate
		(In thousands)
Interest-bearing demand accounts		$	194,252				0.12	%			84,146				0.20	%
Money market accounts			243,687				0.18	%			217,868				0.25	%
Savings accounts			36,914				0.13	%			20,756				0.20	%
Certificates of deposit less than $100,000			225,381				0.85	%			201,094				0.90	%
Certificates of deposit of $100,000 or more			134,965				0.90	%			91,268				0.78	%
Total interest-bearing average deposits			835,199								615,132
Noninterest-bearing deposits			135,982								103,583
Total average deposits		$	971,181								718,715

 

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

		At March 31,
		2015
		(In thousands)
Three months or less		$	22,586
Over three through six months			19,087
Over six through twelve months			19,099
Over twelve months			75,781
Total certificates of deposits		$	136,553

 

Liquidity

 

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

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

 

Lines of credit with the FHLB of Atlanta are based upon FHLB-approved percentages of Bank assets, but must be supported by appropriate collateral to be available. The Company has pledged first lien residential mortgage, second lien residential mortgage, residential home equity line of credit, commercial mortgage and multifamily mortgage portfolios under blanket lien agreements. At March 31, 2015, the Company had FHLB advances of $155.5 million outstanding with excess collateral pledged to the FHLB during those periods that would support additional borrowings of approximately $51.4 million.

 

Lines of credit with the FRB are based on collateral pledged. At March 31, 2015, the Company had lines available with the FRB for $83.4 million. At March 31, 2015, the Company had no FRB advances outstanding.

 

Capital Resources

 

The Company and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements.

 

The prompt corrective action regulations provide five categories, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If a bank is only adequately capitalized, regulatory approval is required to, among other things, accept, renew or roll-over brokered deposits. If a bank is undercapitalized, capital distributions and growth and expansion are limited, and plans for capital restoration are required.

 

In July 2013, the Board of Governors of the Federal Reserve Board and the FDIC approved the final rules implementing the Basel Committee on Banking Supervision’s capital guidelines for U.S. banks (commonly known as Basel III). Under the final rules, which began for the Company and the Bank on January 1, 2015 and are subject to a phase-in period through January 1, 2019, minimum requirements will increase for both the quantity and quality of capital held by the Company and the Bank. The rules include a new common equity Tier 1 capital to risk-weighted assets ratio (CET1 ratio) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, which when fully phased-in, results in a minimum CET1 ratio of 7.0%. Basel III raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% (which, with the capital conservation buffer, results in a minimum Tier 1 capital ratio of 8.5% when fully phased-in), results in a minimum total capital to risk-weighted assets ratio of 10.5% (with the capital conservation buffer fully phased-in), and requires a minimum leverage ratio of 4.0%. Basel III also makes changes to risk weights for certain assets and off-balance-sheet exposures. Management expects that the capital ratios for the Company and the Bank under Basel III will continue to exceed the well capitalized minimum capital requirements.

 

The actual capital amounts and ratios as well as minimum amounts for each regulatory defined category for the Company and the Bank at March 31, 2015 and December 31, 2014 are as follows:

																		To Be Well
										Minimum Required								Capitalized Under
										For Capital								Prompt Corrective
		Actual								Adequacy Purposes								Action Regulations
		Amount				Ratio				Amount				Ratio				Amount				Ratio
		(Dollars in thousands)
March 31, 2015
Carolina Financial Corporation
CET1 capital (to risk weighted assets)		$	94,655				10.59	%			40,239				4.50	%			N/A				N/A
Tier 1 capital (to risk weighted assets)			109,655				12.26	%			53,652				6.00	%			N/A				N/A
Total capital (to risk weighted assets)			119,634				13.38	%			71,536				8.00	%			N/A				N/A
Tier 1 capital (to total average assets)			109,655				8.92	%			49,167				4.00	%			N/A				N/A
CresCom Bank
CET1 capital (to risk weighted assets)			108,028				12.10	%			40,168				4.50	%			58,021				6.50	%
Tier 1 capital (to risk weighted assets)			108,028				12.10	%			53,558				6.00	%			71,410				8.00	%
Total capital (to risk weighted assets)			118,007				13.22	%			71,410				8.00	%			89,263				10.00	%
Tier 1 capital (to total average assets)			108,028				8.80	%			49,186				4.00	%			61,483				5.00	%
December 31, 2014
Carolina Financial Corporation
Tier 1 capital (to risk weighted assets)		$	104,613				12.03	%			34,787				4.00	%			N/A				N/A
Total risk based capital (to risk weighted assets)			114,323				13.15	%			69,574				8.00	%			N/A				N/A
Tier 1 capital (to total average assets)			104,613				9.49	%			44,079				4.00	%			N/A				N/A
CresCom Bank
Tier 1 capital (to risk weighted assets)			103,319				11.90	%			34,716				4.00	%			52,074				6.00	%
Total risk based capital (to risk weighted assets)			113,029				13.02	%			69,433				8.00	%			86,791				10.00	%
Tier 1 capital (to total average assets)			103,319				9.40	%			43,985				4.00	%			54,981				5.00	%

 

Market Risk Management and Interest Rate Risk

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

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

As of March 31, 2015, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward movements in interest rates of 100, 200, and 300 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates. Downward movements do not appear to be applicable due to the low interest rate environment experienced since 2013. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the Consolidated Financial Statements. Therefore, management’s assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. In addition, this analysis does not consider any strategic changes to our balance sheet which management may consider as a result of changes in market conditions.

Interest Rate Scenario										Annualized Hypothetical Percentage Change in
	Change					Prime Rate				Net Interest Income
	0.00%					3.25%				0.00%
	1.00%					4.25%				0.50%
	2.00%					5.25%				1.50%
	3.00%					6.25%				1.50%

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

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

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

Accounting, Reporting, and Regulatory Matters

 

Information regarding recent authoritative pronouncements that could impact the accounting, reporting, and/or disclosure of the financial information by the Company are included in Note 1 under Item 1 “Financial Statements.”

 

Effect of Inflation and Changing Prices

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

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

 

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

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

 

Item 4. CONTROLS AND PROCEDURES.

 

Evaluation of Disclosure Controls and Procedures

 

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

 

Changes in Internal Control over Financial Reporting

 

There has been no change in the Company’s internal control over financial reporting during the three months ended March 31, 2015, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

Item 1.  LEGAL PROCEEDINGS.

 

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

 

Item 1A  RISK FACTORS.

 

Not applicable

 

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

 

Not applicable

 

Item 3.  DEFAULTS UPON SENIOR SECURITIES.

 

Not applicable

 

Item 4.  MINE SAFETY DISCLOSURES.

 

Not applicable

 

Item 5.  OTHER INFORMATION.

 

Not applicable

 

Item 6.   EXHIBITS.

 

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

 

SIGNATURES

 

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

  

 

		CAROLINA FINANCIAL CORPORATION
		Registrant
Date: May 8, 2015		/s/ Jerold L. Rexroad
		Jerold L. Rexroad
		President and Chief Executive Officer
		(Principal Executive Officer)
Date: May 8, 2015		/s/ William A. Gehman, III
		William A. Gehman III
		Executive Vice President and Chief Financial Officer
		(Principal Financial and Accounting Officer)

 

INDEX TO EXHIBITS

 

Exhibit   Number		Description
10		Amendment No. 1 to the Carolina Financial Corporation 2013 Equity Incentive Plan (1)
31.1		Rule 13a-14(a) Certification of the Principal Executive Officer.
31.2		Rule 13a-14(a) Certification of the Principal Financial Officer.
32		Section 1350 Certifications.
101		The following materials from the Quarterly Report on Form 10-Q of Carolina Financial Corporation for the quarter ended March 31, 2015, formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statement of Changes in Stockholders’ Equity, (v) Consolidated Statements of Cash Flows and (vi) Notes to Unaudited Consolidated Financial Statements.

 

(1)

Incorporated by reference from the Company’s Current Report on Form 8-K filed on January 22, 2015