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EX-32 - EXHIBIT 32 - FIRST SOUTH BANCORP INC /VA/tv478932_ex32.htm
EX-31.2 - EXHIBIT 31.2 - FIRST SOUTH BANCORP INC /VA/tv478932_ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - FIRST SOUTH BANCORP INC /VA/tv478932_ex31-1.htm

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

(Mark One)

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

 

For the quarterly period ended September 30, 2017

 

OR

 

¨       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: 0-22219

 

FIRST SOUTH BANCORP, INC.

(Exact name of registrant as specified in its charter)

 

Virginia 56-1999749
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)

 

1311 Carolina Avenue, Washington, North Carolina 27889

(Address of principal executive offices)

(Zip Code)

 

(252) 946-4178

(Registrant's telephone number, including area code)

 

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

Yes x    No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x    No ¨

 

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

 

Large Accelerated Filer ¨ Accelerated Filer x
Non-Accelerated Filer ¨ Smaller Reporting Company ¨
(Do not check if a Smaller Reporting Company) Emerging Growth Company ¨

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act ¨

 

Indicate by check mark whether registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).

Yes ¨   No   x

 

Number of shares of common stock outstanding as of October 31, 2017: 9,523,716

 

 

 

 

 

 

Explanatory Note

 

On November 1, 2017, First South Bancorp, Inc. (the “Company”), completed the previously announced merger with Carolina Financial Corporation (“CARO”), whereby the Company merged with and into CARO (the “Merger”), with CARO as the surviving corporation in the Merger. Immediately following the consummation of the Merger, First South Bank, a wholly owned subsidiary of the Company, merged with and into CresCom Bank, a wholly owned subsidiary of CARO (the “Bank Merger”), with CresCom Bank as the surviving bank in the Bank Merger.

 

The Merger and the Bank Merger were effected by the transactions contemplated in that certain Agreement and Plan of Merger and Reorganization (the “Merger Agreement”) dated as of June 9, 2017, by and between the Company and CARO.

 

This Quarterly Report on Form 10-Q of the Company for the period ended September 30, 2017, is being filed by CARO as successor to the Company. The financial information in this Quarterly Report and the accompanying Management’s Discussion and Analysis reflect the corporate status of the Company as it was on September 30, 2017.

 

 

 

 

CONTENTS 

 

    PAGE
PART I.  FINANCIAL INFORMATION    
       
Item 1. Financial Statements    
       
  Consolidated Statements of Financial Condition as of September 30, 2017 (unaudited) and December 31, 2016   1
     
  Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2017 and 2016 (unaudited)   2
     
  Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2017 and 2016 (unaudited)   3
     
  Consolidated Statements of Changes in Stockholders' Equity for the Nine Months Ended September 30, 2017 and 2016 (unaudited)   4
     
  Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2017 and 2016 (unaudited)   5
     
  Notes to Consolidated Financial Statements (unaudited)   6
     
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations   30
   
Item 3. Quantitative and Qualitative Disclosures About Market Risk   41
       
Item 4. Controls and Procedures   42
       
PART II.  OTHER INFORMATION    
       
Item 1. Legal Proceedings   42
       
Item 1A. Risk Factors   42
       
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds   43
       
Item 3. Defaults Upon Senior Securities   43
       
Item 4. Mine Safety Disclosures   43
       
Item 5. Other Information   43
       
Item 6. Exhibits   43
       
Signatures     44
       
Exhibits      

 

 

 

 

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Financial Condition

 

   September 30,   December 31, 
   2017   2016 
   (Unaudited)     
Assets          
Cash and due from banks  $19,923,410   $22,854,712 
Interest-bearing deposits with banks   36,903,842    23,320,968 
Investment securities available for sale, at fair value   190,573,089    192,606,119 
Investment securities held to maturity   506,223    509,617 
Mortgage loans held for sale   3,814,715    5,098,518 
Loans and leases held for investment   780,713,736    700,642,291 
Allowance for loan and lease losses   (9,561,535)   (8,673,172)
Net loans and leases held for investment   771,152,201    691,969,119 
           
Premises and equipment, net   10,799,043    11,291,596 
Assets held for sale   185,906    192,720 
Other real estate owned   2,183,970    3,229,423 
Federal Home Loan Bank stock, at cost   1,592,700    1,573,700 
Accrued interest receivable   3,595,669    3,525,684 
Goodwill   4,218,576    4,218,576 
Mortgage servicing rights   2,170,658    2,148,905 
Identifiable intangible assets   1,429,929    1,611,187 
Bank-owned life insurance   18,483,438    18,080,183 
Prepaid expenses and other assets   5,947,067    8,470,887 
           
Total assets  $1,073,480,436   $990,701,914 
           
Liabilities and Stockholders' Equity          
Deposits:          
Non-interest bearing demand  $212,521,157   $196,917,165 
Interest bearing demand   323,893,958    272,098,903 
Savings   146,933,193    145,031,981 
Large denomination certificates of deposit   136,211,749    122,819,510 
Other time   125,727,563    133,732,804 
Total deposits   945,287,620    870,600,363 
           
Borrowed money   16,500,000    17,000,000 
Junior subordinated debentures   10,310,000    10,310,000 
Other liabilities   6,775,248    5,607,832 
 Total liabilities   978,872,868    903,518,195 
           
Common stock, $.01 par value, 25,000,000 shares authorized; 9,504,991 and 9,494,935 shares outstanding, respectively   95,050    94,949 
Additional paid-in capital   36,191,713    36,018,743 
Retained earnings   55,405,706    49,560,595 
Accumulated other comprehensive income   2,915,099    1,509,432 
Total stockholders' equity   94,607,568    87,183,719 
           
Total liabilities and stockholders' equity  $1,073,480,436   $990,701,914 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 1 

 

 

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Operations

Three and Nine Months Ended September 30, 2017 and 2016

(Unaudited)

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2017   2016   2017   2016 
                 
Interest income:                    
Interest and fees on loans  $9,316,002   $7,915,133   $26,229,824   $22,748,826 
Interest on investments and deposits   1,360,943    1,295,051    4,143,972    4,131,333 
Total interest income   10,676,945    9,210,184    30,373,796    26,880,159 
                     
Interest expense:                    
Interest on deposits   841,961    728,106    2,426,143    2,094,809 
Interest on borrowings   70,093    55,886    192,521    187,683 
Interest on junior subordinated notes   127,011    127,011    378,272    408,628 
Total interest expense   1,039,065    911,003    2,996,936    2,691,120 
                     
Net interest income   9,637,880    8,299,181    27,376,860    24,189,039 
Provision for credit losses   100,000    220,000    850,000    770,000 
Net interest income after provision for credit losses   9,537,880    8,079,181    26,526,860    23,419,039 
                     
Non-interest income:                    
Deposit fees and service charges   1,902,246    1,907,878    5,723,130    5,746,336 
Loan fees and charges   88,799    72,578    267,566    268,212 
Mortgage loan servicing fees   356,823    343,081    995,650    850,770 
Gain on sale and other fees on mortgage loans   709,554    812,754    1,837,133    1,795,017 
Gain on sale of other real estate, net   14,343    77,416    69,843    50,932 
Gain on sale of investment securities   -    -    -    467,470 
Other income   435,418    477,343    1,469,882    1,636,428 
Total non-interest income   3,507,183    3,691,050    10,363,204    10,815,165 
                     
Non-interest expense:                    
Compensation and fringe benefits   5,130,718    4,970,846    15,245,172    14,955,785 
Federal deposit insurance premiums   156,054    157,142    460,546    479,276 
Premises and equipment   1,293,477    1,349,243    4,026,693    4,103,726 
Marketing   96,646    151,304    279,435    568,556 
Data processing   799,650    757,200    2,400,740    2,303,418 
Amortization of intangible assets   152,816    136,882    453,282    401,981 
Other real estate owned expense   2,483    119,065    272,342    425,622 
Other   1,105,912    1,286,741    3,860,278    3,842,879 
Total non-interest expense   8,737,756    8,928,423    26,998,488    27,081,243 
                     
Income before income tax expense   4,307,307    2,841,808    9,891,576    7,152,961 
Income tax expense   1,391,805    947,496    3,048,960    2,185,841 
                     
NET INCOME  $2,915,502   $1,894,312   $6,842,616   $4,967,120 
                     
Per share data:                    
Basic earnings per share  $0.31   $0.20   $0.72   $0.52 
Diluted earnings per share  $0.31   $0.20   $0.72   $0.52 
Dividends per share  $0.035   $0.030   $0.105   $0.085 
Average basic shares outstanding   9,503,800    9,494,861    9,500,809    9,493,285 
Average diluted shares outstanding   9,567,989    9,525,302    9,556,254    9,520,216 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 2 

 

 

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Comprehensive Income

Three and Nine Months Ended September 30, 2017 and 2016

(Unaudited)

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2017   2016   2017   2016 
                 
Net income  $2,915,502   $1,894,312   $6,842,616   $4,967,120 
                     
Other comprehensive income:                    
Unrealized holding gains (losses) on securities available-for-sale   12,759    (1,110,351)   2,251,081    3,679,996 
Tax effect   (4,593)   425,001    (810,389)   (1,351,969)
Unrealized holding gains (losses) on securities available-for-sale, net of tax   8,166    (685,350)   1,440,692    2,328,027 
                     
Reclassification adjustment for realized gains included in net income   -    -    -    (467,470)
Tax effect   -    -    -    134,276 
Reclassification adjustment for realized gains, net of tax   -    -    -    (333,194)
                     
Unrealized gains (losses) on interest rate hedge position   2,009    48,953    (54,728)   (138,097)
Tax effect   (723)   (25,176)   19,703    44,594 
Unrealized gains (losses) on interest rate hedge position, net of tax   1,286    23,777    (35,025)   (93,503)
                     
Other comprehensive income (loss), net of tax   9,452    (661,573)   1,405,667    1,901,330 
                     
Comprehensive income  $2,924,954   $1,232,739   $8,248,283   $6,868,450 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 3 

 

 

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Changes in Stockholders' Equity

Nine Months Ended September 30, 2017 and 2016

(Unaudited)

 

               Accumulated     
       Additional       Other     
   Common   Paid-in   Retained   Comprehensive     
Nine Months Ended September 30, 2017  Stock   Capital   Earnings   Income, Net   Total 
                     
Balance at December 31, 2016  $94,949   $36,018,743   $49,560,595   $1,509,432   $87,183,719 
                          
Net income   -    -    6,842,616    -    6,842,616 
                          
Other comprehensive income, net   -    -    -    1,405,667    1,405,667 
                          
Vesting of restricted stock awards, net   45    (1,305)   -    -    (1,260)
                          
Exercise of stock options   56    27,507    -    -    27,563 
                          
Stock based compensation expense   -    146,768    -    -    146,768 
                          
Dividends   -    -    (997,505)   -    (997,505)
                          
Balance at September 30, 2017  $95,050   $36,191,713   $55,405,706   $2,915,099   $94,607,568 

 

               Accumulated     
       Additional       Other     
   Common   Paid-in   Retained   Comprehensive     
Nine Months Ended September 30, 2016  Stock   Capital   Earnings   Income, Net   Total 
                     
Balance at December 31, 2015  $94,892   $35,936,911   $43,691,073   $2,447,898   $82,170,774 
                          
Net income   -    -    4,967,120    -    4,967,120 
                          
Other comprehensive income, net   -    -    -    1,901,330    1,901,330 
                          
Vesting of restricted stock awards, net   35    (35)   -    -    - 
                          
Exercise of stock options   22    (22)   -    -    - 
                          
Stock based compensation expense   -    61,618    -    -    61,618 
                          
Dividends   -    -    (806,894)   -    (806,894)
                          
Balance at September 30, 2016  $94,949   $35,998,472   $47,851,299   $4,349,228   $88,293,948 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 4 

 

 

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Cash Flows

Nine Months Ended September 30, 2017 and 2016

(Unaudited)

 

   Nine Months Ended 
   September 30, 
   2017   2016 
Operating activities:          
Net income  $6,842,616   $4,967,120 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for credit losses   850,000    770,000 
Depreciation   1,362,821    1,351,295 
Amortization of intangibles   181,258    213,245 
Amortization of mortgage servicing rights   272,024    188,736 
Accretion of discounts and premiums on securities, net   937,753    1,123,998 
(Gain) loss on disposal of premises and equipment   (2,000)   1,651 
Loss on sale of assets held for sale   -    87,121 
Gain on sale of other real estate owned   (69,843)   (50,932)
Gain on sale of loans held for sale   (979,799)   (1,020,678)
Gain on sale of investment securities available for sale   -    (467,470)
Valuation allowance on other real estate owned   192,139    111,170 
Stock based compensation expense   146,768    61,618 
Originations of loans held for sale, net   (30,775,714)   (30,707,244)
Proceeds from sale of loans held for sale   33,039,316    28,359,152 
Other operating activities   2,821,013    2,492,897 
Net cash provided by operating activities   14,818,352    7,481,679 
Investing activities:          
Proceeds from sale of investment securities available for sale   -    40,631,309 
Purchases of investment securities available for sale   (10,360,239)   - 
Purchases of investment securities held to maturity   (506,750)   - 
Proceeds from principal repayments of mortgage-backed securities available for sale   13,706,741    16,962,962 
Proceeds from maturity of investment securities held to maturity   510,000    - 
Proceeds from sale of assets held for sale   -    803,479 
Mortgage servicing rights from loans sold with servicing retained   (293,777)   (235,435)
Purchase of mortgage servicing rights portfolio   -    (778,392)
Originations of loans held for investment, net of principal repayments   (80,511,795)   (76,054,408)
Proceeds from disposal of other real estate owned   1,363,508    1,718,907 
Proceeds from disposal of premises and equipment   1,036,641    336,709 
Purchase of bank-owned life insurance   (403,255)   (2,302,152)
Proceeds from sale (purchase) of FHLB stock   (19,000)   668,100 
Purchase of premises and equipment   (1,904,909)   (717,004)
Net cash used in investing activities   (77,382,835)   (18,965,925)
Financing activities:          
Net increase in deposit accounts   74,687,257    48,508,852 
Net decrease in FHLB borrowings   (500,000)   (17,000,000)
Cash paid for dividends   (997,505)   (806,894)
Exercise of stock options   27,563    - 
Vesting of restricted stock awards, net   (1,260)   - 
Net cash provided by financing activities   73,216,055    30,701,958 
           
Increase (decrease) in cash and cash equivalents   10,651,572    19,217,712 
Cash and cash equivalents, beginning of year   46,175,680    37,991,268 
Cash and cash equivalents, end of year  $56,827,252   $57,208,980 
           
Supplemental disclosures:          
Other real estate acquired in settlement of loans  $440,350   $464,525 
Transfer of premises to assets held for sale  $-   $1,083,320 
Cash paid for interest  $2,982,678   $2,667,742 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 5 

 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1. Basis of Presentation. First South Bancorp, Inc. (the "Company") was formed for the purpose of issuing common stock and owning 100% of the stock of First South Bank (the "Bank") and operating through the Bank a commercial banking business. The Bank has one significant operating segment, providing commercial and retail banking services to its markets located in the state of North Carolina. The Bank also provides a full menu of leasing services through its wholly owned subsidiary, First South Leasing, LLC. In addition, under its First South Wealth Management division, the Bank makes securities brokerage services available through an affiliation with an independent broker/dealer. The Bank operates through its main office in Washington, North Carolina, and has 28 full-service branch offices located throughout eastern and central North Carolina.

 

The accompanying unaudited consolidated financial statements are prepared in pursuant to the instructions for Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements. In the opinion of management, all adjustments necessary for fair presentation of the financial position and results of operations for the periods presented are included, none of which are other than normal recurring accruals. The financial statements of the Company and the Bank are presented on a consolidated basis. The results of operations for the three and nine months ended September 30, 2017, are not necessarily indicative of the results of operations that may be expected through November 1, 2017, the date of the Company’s merger with Carolina Financial Corporation described below. The accompanying unaudited consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and related notes appearing in the 2016 Annual Report previously filed on Form 10-K.

 

On November 1, 2017, the Company completed the previously announced merger with Carolina Financial Corporation (“CARO”), whereby the Company merged with and into CARO (the “Merger”), with CARO as the surviving corporation in the Merger. Immediately following the consummation of the Merger, First South Bank, a wholly owned subsidiary of the Registrant, merged with and into CresCom Bank, a wholly owned subsidiary of CARO (the “Bank Merger”), with CresCom Bank as the surviving bank in the Bank Merger. The Merger and the Bank Merger were effected by the transactions contemplated in that certain Agreement and Plan of Merger and Reorganization (the “Merger Agreement”) dated as of June 9, 2017, by and between the Company and CARO. Subject to the terms and conditions of the Merger Agreement, at the effective time of the Merger, the Company’s stockholders had the right to receive 0.5064 shares of CARO common stock for each share of the Company’s common stock. Cash will be paid in lieu of fractional shares.

 

2. Earnings Per Share. Basic and diluted earnings per share for the three and nine months ended September 30, 2017 and 2016 are based on weighted average shares of common stock outstanding. Diluted earnings per share include the potentially dilutive effect of stock-based compensation plans. For both the three and nine months ended September 30, 2017 there were 29,250 stock options, respectively, compared to 30,441 and 26,931 stock options, respectively, for the three and nine months ended September 30, 2016, that were anti-dilutive, because the exercise and grant prices exceeded the average market price of the Company’s common stock. The anti-dilutive shares are excluded from the diluted earnings per share calculation for the three and nine months ended September 30, 2017 and 2016.

 

3. Comprehensive Income and Accumulated Other Comprehensive Income. Comprehensive income includes net income and changes in other comprehensive income. The components of other comprehensive income primarily include net changes in unrealized gains and losses on available-for-sale securities, and the reclassification of net gains and losses on available-for-sale securities recognized in income during the respective reporting periods. The following table presents changes in accumulated other comprehensive income (“AOCI”), net of taxes for the nine months ended September 30, 2017 and 2016:

 

   Unrealized Holding Gains
on Investment Securities
Available-For-Sale
   Unrealized Holding
Gain (Loss) on Cash
Flow Hedging Activities
   Total Accumulated
Other Comprehensive
Income
 
   (In thousands) 
Nine Months Ended September 30, 2017               
Balance at December 31, 2016  $1,433   $77   $1,510 
Other comprehensive income before reclassifications   1,440    (35)   1,405 
Amounts reclassified from AOCI   -    -    - 
Net current period other comprehensive income   1,440    (35)   1,405 
Balance at September 30, 2017  $2,873   $42   $2,915 
                
Nine Months Ended September 30, 2016               
Balance at December 31, 2015  $2,695   $(247)  $2,448 
Other comprehensive income (loss) before reclassifications   2,328    (94)   2,234 
Amounts reclassified from AOCI   (333)   -    (333)
Net current period other comprehensive income (loss)   1,995    (94)   1,901 
Balance at September 30, 2016  $4,690   $(341)  $4,349 

 

 6 

 

 

4. Investment Securities. The following is a summary of the investment securities portfolio by major category, with the amortized cost and fair value and gross unrealized gains and losses of each category at September 30, 2017 and December 31, 2016:

 

   Amortized   Gross   Gross   Fair 
   Cost   Unrealized Gains    Unrealized Losses   Value 
   (In thousands) 
Securities available-for-sale:                    
September 30, 2017                    
Government agencies  $23,467   $395   $25   $23,837 
Mortgage-backed securities   80,348    2,411    29    82,730 
Municipal securities   55,386    1,755    21    57,120 
Corporate bonds   26,883    135    132    26,886 
Total  $186,084   $4,696   $207   $190,573 
                     
December 31, 2016                    
Government agencies  $16,797   $245   $47   $16,995 
Mortgage-backed securities   93,124    2,155    163    95,116 
Municipal securities   53,465    536    319    53,682 
Corporate bonds   26,983    60    230    26,813 
Total  $190,369   $2,996   $759   $192,606 

 

   Amortized   Gross   Gross   Fair 
   Cost   Unrealized Gains   Unrealized Losses   Value 
   (In thousands) 
Securities held-to-maturity:                    
September 30, 2017                    
Government agencies  $506   $2   $-   $508 
Total  $506   $2   $-   $508 
                     
December 31, 2016                    
Government agencies  $510   $1   $-   $511 
Total  $510   $1   $-   $511 

 

The following table presents a summary of realized gains and losses from the sale of available-for-sale investment securities:

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2017   2016   2017   2016 
   (In thousands) 
Proceeds from Sale  $-   $-   $-   $40,631 
                     
Gross realized gains on sales   -    -    -    594 
Gross realized losses on sales   -    -    -    (127)
Total realized gains, net  $-   $-   $-   $467 

 

 7 

 

 

4. Investment Securities (Continued)

 

The following table summarizes gross unrealized losses on investment securities, fair value and length of time the securities were in a continuous unrealized loss position at September 30, 2017 and December 31, 2016. The Company deems these unrealized losses to be temporary and recoverable prior to or at maturity. The Company has the ability and intent to hold the investment securities for a reasonable period of time sufficient for a market price recovery or until maturity.

 

   Less Than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Losses   Value   Losses   Value   Losses 
   (In thousands) 
September 30, 2017                              
Government agencies  $6,726   $25   $-   $-   $6,726   $25 
Mortgage-backed securities   12,482    29    -    -    12,482    29 
Municipal securities   1,128    21    -    -    1,128    21 
Corporate bonds   3,998    1    7,868    131    11,866    132 
Total  $24,334   $76   $7,868   $131   $32,202   $207 
                               
December 31, 2016                              
Government agencies  $6,766   $47   $-   $-   $6,766   $47 
Mortgage-backed securities   27,586    163    -    -    27,586    163 
Municipal securities   24,156    319    -    -    24,156    319 
Corporate bonds   13,751    26    7,795    204    21,546    230 
Total  $72,259   $555   $7,795   $204   $80,054   $759 

 

The following table summarizes the amortized cost and fair values of the investment securities portfolio at September 30, 2017, by contractual maturity. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

   Less Than   One to   Five to   Over 
   One Year   Five Years   Ten Years   Ten Years 
   (In thousands) 
Securities available-for-sale:                    
Government agencies                    
Amortized cost  $-   $23,467   $-   $- 
Fair value   -    23,837    -    - 
Mortgage-backed securities                    
Amortized cost   2,275    57,853    2,987    17,233 
Fair value   2,319    58,932    3,109    18,370 
Municipal securities                    
Amortized cost   4,861    13,615    35,469    1,441 
Fair value   4,881    13,951    36,805    1,483 
Corporate bonds                    
Amortized cost   7,003    11,880    8,000    - 
Fair value   7,006    11,957    7,923    - 
Total Amortized cost  $14,139   $106,815   $46,456   $18,674 
Total Fair value  $14,206   $108,677   $47,837   $19,853 
                     
Securities held-to-maturity:                    
Government agencies                    
Amortized cost  $-   $506   $-   $- 
Fair value   -    508    -    - 
Total Amortized cost  $-   $506   $-   $- 
Total Fair value  $-   $508   $-   $- 

 

United States government agency and mortgage-backed securities with an amortized cost of $78.2 million were pledged as collateral for public deposits at September 30, 2017, compared to $32.6 million at December 31, 2016. In addition, a government agency bond with an amortized cost of $506,000 and $510,000 was pledged as collateral on an interest rate swap transaction at September 30, 2017 and December 31, 2016, respectively.

 

 8 

 

 

4. Investment Securities (Continued)

 

Prior to purchasing any security, the Bank ensures the security is investment grade. For a security to be investment grade it must: (1) have a low risk of default by the obligor, and (2) the Bank must expect the full and timely repayment of principal and interest over the expected life. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), certain investments are deemed investment grade. These include: U.S. Treasury securities, Federal Agency securities, Revenue Bonds, and Unlimited-Tax General Obligation Municipals. Other securities undergo a pre-purchase analysis to ensure they are investment grade.

 

To determine if a security is investment grade, if available, management utilizes the ratings of the Nationally Recognized Statistical Rating Organizations (“NRSRO”). However, they are not the sole basis of determining if a security is investment grade. In addition, on a pre-purchase basis, at least one of the following criteria pertaining to the obligor is acquired and reviewed as part of the Bank’s credit analysis: Data from debt offerings (prospectus/offering circular); data from regulatory filings- Securities and Exchange Commission (“SEC”) Forms 10-K, 10-Q, 8-K, etc.; data available from the obligor’s website (annual reports, press releases); data obtained from a third party (bond broker, analyst); NRSRO report on the initial offering and/or subsequent reviews of the issuer; or other pertinent available financial information. There have been no instances where the NRSRO’s credit rating has significantly differed from that of the Bank’s credit analysis.

 

At September 30, 2017, the investment securities portfolio included 50 taxable and tax-exempt debt instruments issued by various states, counties, cities, municipalities and school districts. The following table is a summary, listed by state, of the Company’s investment in the obligations of state and political subdivisions:

 

   September 30, 2017 
   Amortized Cost   Fair Value 
   (In thousands) 
Obligations of state and political subdivisions:          
General obligation bonds:          
California  $5,172   $5,421 
Washington   3,349    3,412 
Pennsylvania   2,771    2,780 
Indiana   2,369    2,404 
Texas   2,262    2,260 
Florida   2,217    2,277 
Alabama   1,808    1,844 
Utah   1,777    1,800 
Nevada   1,313    1,344 
Missouri   1,299    1,423 
Other (11 states)   8,646    8,919 
Total general obligation bonds   32,983    33,884 
           
Revenue bonds:          
New York   7,121    7,457 
North Carolina   4,178    4,287 
Mississippi   2,297    2,390 
Oklahoma   2,232    2,334 
Pennsylvania   1,958    1,974 
Other (4 states)   4,617    4,794 
Total revenue bonds   22,403    23,236 
Total obligations of state and political subdivisions  $55,386   $57,120 

 

The largest exposure in general obligation bonds was one bond issued by the Ambridge Area School District, Pennsylvania, with a total amortized cost basis and total fair value of $2.4 million at September 30, 2017.

 

 9 

 

 

4. Investment Securities (Continued)

 

The following table is a summary of the revenue sources related to the Company’s investment in revenue bonds:

 

   September 30, 2017 
   Amortized Cost   Fair Value 
   (In thousands) 
Revenue bonds by revenue source:          
University and college  $8,507   $8,923 
Public improvements   6,055    6,292 
Pension funding   1,958    1,974 
Refunding bonds   1,617    1,651 
Other   4,266    4,396 
Total revenue bonds  $22,403   $23,236 

 

The largest single exposure in revenue bonds is an issue from the Dormitory Authority of the State of New York (“DASNY”). DASNY was created in 1944 to finance and build dormitories for state teachers’ colleges. Its mission has expanded over time and in 1995 DASNY became the largest public authority issuer of tax-exempt bonds in the country. The debt is secured by a dedication of 25% of the New York State personal income tax. As of September 30, 2017, this issue had an amortized cost of $2.8 million and fair value of $3.0 million.

 

5. Loans Held for Sale. The Bank originates residential mortgage loans for sale in the secondary market. Pursuant to Accounting Standards Codification (“ASC”) 825, Financial Instruments, at September 30, 2017 and December 31, 2016, the Bank marked these mortgage loans to market. Mortgage loans held for sale at September 30, 2017 and December 31, 2016, had estimated fair market values of $3.8 million and $5.1 million, respectively. The Bank originates mortgage loans for sale that are approved by secondary investors. Their terms are set by secondary investors, and they are transferred within 120 days after the Bank funds the loans. The Bank issues rate lock commitments to borrowers, and depending on market conditions, may enter into forward contracts with secondary market investors to minimize interest rate risk related to mortgage loan forward sales commitments. The Bank uses forward contracts to minimize interest rate risk related to mortgage loan forward sales commitments to economically hedge a percentage of the locked-in pipeline. The Bank receives origination fees from borrowers and servicing release premiums from investors that are recognized in income when loans are sold. The following table summarizes forward contract positions of the Bank at September 30, 2017 and December 31, 2016:

 

   September 30, 2017   December 31, 2016 
   Fair   Notional   Fair   Notional 
   Value   Value   Value   Value 
   (In thousands) 
Forward Contracts                    
Mortgage Loan Forward Sales Commitments  $83   $5,622   $65   $6,036 

 

 10 

 

 

6. Loans Held for Investment. Loans held for investment at September 30, 2017 and December 31, 2016 are listed below:

 

   September 30, 2017   December 31, 2016 
   Amount   Percent of
Total
   Amount   Percent of
Total
 
   (Dollars in thousands) 
Loans Held for Investment                    
Mortgage loans:                    
Residential real estate  $70,693    9.0%  $67,264    9.6%
Residential construction   6,740    0.9    7,875    1.1 
Residential lots and raw land   130    0.0    154    0.0 
Total mortgage loans   77,563    9.9    75,293    10.7 
                     
Commercial loans and leases:                    
Commercial real estate   420,131    53.7    378,173    53.9 
Commercial construction   55,915    7.2    56,118    8.0 
Commercial lots and raw land   30,700    3.9    33,434    4.8 
Commercial and Industrial   88,893    11.4    67,980    9.7 
Lease receivables   23,311    3.0    21,236    3.0 
Total commercial loans and leases   618,950    79.2    556,941    79.4 
                     
Consumer loans:                    
Consumer real estate   21,332    2.7    16,967    2.4 
Consumer construction   444    0.1    105    0.0 
Consumer lots and raw land   9,235    1.2    8,975    1.3 
Home equity lines of credit   40,537    5.2    36,815    5.3 
Consumer other   13,403    1.7    6,347    0.9 
Total consumer loans   84,951    10.9    69,209    9.9 
                     
Gross loans held for investment   781,464    100.0%   701,443    100.0%
                     
Less deferred loan origination fees, net   750         801      
Less allowance for loan and lease losses   9,562         8,673      
                     
Net loans held for investment  $771,152        $691,969      

 

The Bank has pledged eligible loans as collateral for actual or potential borrowings from the Federal Home Loan Bank (“FHLB”) and the Federal Reserve Bank of Richmond (“FRB”). At September 30, 2017, the Bank pledged $300.3 million and $164.4 million of loans to the FHLB and FRB, respectively. See Note 13. Borrowed Money below, for additional information.

 

 11 

 

 

6. Loans Held for Investment (Continued)

 

The following tables detail nonaccrual loans held for investment, including troubled debt restructured (“TDR”) loans accounted for on a nonaccrual status, segregated by class of loans, at September 30, 2017 and December 31, 2016:

 

   September 30, 2017   December 31, 2016 
   (Dollars in thousands) 
Non-accrual loans held for investment:          
Non-TDR loans accounted for on a non-accrual status:          
Residential real estate  $627   $773 
Residential lots and raw land   -    - 
Commercial real estate   929    482 
Commercial construction   -    - 
Commercial lots and raw land   -    - 
Commercial and industrial   -    72 
Lease receivables   -    - 
Consumer real estate   230    94 
Consumer lots and raw land   23    80 
Home equity lines of credit   107    166 
Consumer other   -    - 
Total non-TDR loans accounted for on a nonaccrual status   1,916    1,667 
           
TDR loans accounted for on a nonaccrual status:          
Past Due TDRs:          
Residential real estate   -    161 
Commercial real estate   -    652 
Commercial construction   -    - 
Commercial lots and raw land   -    - 
Commercial and industrial   -    - 
Consumer real estate   -    149 
Total Past Due TDRs   -    962 
           
Current TDRs:          
Residential real estate   -    163 
Commercial real estate   -    - 
Commercial construction   -    - 
Commercial lots and raw land   -    - 
Commercial and industrial   170    170 
Consumer real estate   136    - 
Consumer lots and raw land   83    89 
Total Current TDRs   389    422 
           
Total TDR loans accounted for on a nonaccrual status   389    1,384 
Total non-performing loans  $2,305    3,051 
Percentage of total loans held for investment, net   0.3%   0.4%
Loans over 90 days past due, still accruing  $-   $- 
Other real estate owned   2,184    3,229 
Total non-performing assets  $4,489   $6,280 

 

Cumulative interest income not recorded on loans accounted for on a nonaccrual status was $96,071 and $115,318 at September 30, 2017 and December 31, 2016, respectively.

 

See “Note 8. Troubled Debt Restructurings” below for additional information.

 

 12 

 

 

6. Loans Held for Investment (Continued)

 

The following table presents an age analysis of past due loans held for investment, segregated by class of loans as of September 30, 2017 and December 31, 2016:

 

   30-59   60-89   90 Days   Total       Total   90 Days or 
   Days   Days   or More   Past       Financing   More and 
   Past Due   Past Due   Past Due   Due   Current   Receivables   Accruing 
   (In thousands) 
Past due loans held for investment:                                   
September 30, 2017                                   
Residential real estate  $-   $280   $324   $604   $70,089   $70,693   $- 
Residential construction   -    -    -    -    6,740    6,740    - 
Residential lots and raw land   -    -    -    -    130    130    - 
Commercial real estate   63    28    467    558    419,573    420,131    - 
Commercial construction   -    -    -    -    55,915    55,915    - 
Commercial lots and raw land   496    -    -    496    30,204    30,700    - 
Commercial and industrial   -    -    -    -    88,893    88,893    - 
Lease receivables   -    -    -    -    23,311    23,311    - 
Consumer real estate   235    2    125    362    20,970    21,332    - 
Consumer construction   -    -    -    -    444    444    - 
Consumer lots and raw land   35    25    -    60    9,175    9,235    - 
Home equity lines of credit   218    -    11    229    40,308    40,537    - 
Consumer other   23    -    -    23    13,380    13,403    - 
Total  $1,070   $335   $927   $2,332   $779,132   $781,464   $- 

 

   30-59   60-89   90 Days   Total       Total   90 Days or 
   Days   Days   or More   Past       Financing   More and 
   Past Due   Past Due   Past Due   Due   Current   Receivables   Accruing 
   (In thousands) 
Past due loans held for investment:                                   
December 31, 2016                                   
Residential real estate  $1,048   $176   $565   $1,789   $65,475   $67,264   $- 
Residential construction   -    -    -    -    7,875    7,875    - 
Residential lots and raw land   -    -    -    -    154    154    - 
Commercial real estate   726    4    1,022    1,752    376,421    378,173    - 
Commercial construction   -    -    -    -    56,118    56,118    - 
Commercial lots and raw land   -    -    -    -    33,434    33,434    - 
Commercial and industrial   -    -    72    72    67,908    67,980    - 
Lease receivables   -    -    -    -    21,236    21,236    - 
Consumer real estate   -    42    206    248    16,719    16,967    - 
Consumer construction   -    -    -    -    105    105    - 
Consumer lots and raw land   -    8    81    89    8,886    8,975    - 
Home equity lines of credit   121    33    98    252    36,563    36,815    - 
Consumer other   7    2    -    9    6,338    6,347    - 
Total  $1,902   $265   $2,044   $4,211   $697,232   $701,443   $- 

 

 13 

 

 

6. Loans Held for Investment (Continued)

 

The following table presents information on loans that were considered impaired as of September 30, 2017 and December 31, 2016. Impaired loans include loans modified as a TDR, whether on accrual or non-accrual status. At September 30, 2017, impaired loans included $826,000 of TDRs, compared to $1.9 million at December 31, 2016.

 

       Contractual       YTD Average   Interest Income 
   Recorded   Unpaid Principal   Related   Recorded   Recognized on 
   Investment   Balance   Allowance   Investment   Impaired Loans 
   (In thousands) 
Impaired Loans September 30, 2017                         
With no related allowance recorded:                         
Residential real estate  $270   $270   $-   $471   $10 
Commercial real estate   3,729    3,801    -    5,490    151 
Commercial lots and raw land   882    882    -    1,429    35 
Commercial and industrial   88    89    -    95    3 
Consumer real estate   240    259    -    212    12 
Consumer lots and raw land   83    90    -    105    4 
Home equity lines of credit   23    25    -    37    2 
Consumer other   35    35    -    37    1 
Subtotal:   5,350    5,451    -    7,876    218 
                          
With an allowance recorded:                         
Commercial real estate   97    97    1    236    4 
Commercial and industrial   440    444    420    274    94 
Consumer real estate   105    105    33    26    2 
Consumer lots and raw land   586    586    102    603    20 
Home equity lines of credit   53    58    36    47    4 
Subtotal   1,281    1,290    592    1,186    124 
                          
Totals:                         
Residential   270    270    -    471    10 
Commercial   5,236    5,313    421    7,524    287 
Consumer   1,125    1,158    171    1,067    45 
Grand Total  $6,631   $6,741   $592   $9,062   $342 

 

       Contractual       YTD Average   Interest Income 
   Recorded   Unpaid Principal   Related   Recorded   Recognized on 
   Investment   Balance   Allowance   Investment   Impaired Loans 
   (In thousands) 
Impaired Loans December 31, 2016                         
With no related allowance recorded:                         
Residential real estate  $597   $730   $-   $804   $32 
Commercial real estate   6,581    6,645    -    7,742    408 
Commercial lots and raw land   2,185    2,185    -    2,376    121 
Commercial and industrial   102    102    -    59    5 
Consumer real estate   221    232    -    257    8 
Consumer lots and raw land   129    135    -    86    10 
Home equity lines of credit   71    73    -    50    3 
Consumer other   38    38    -    40    2 
Subtotal:   9,924    10,140    -    11,414    589 
                          
With an allowance recorded:                         
Commercial real estate   287    287    -    579    15 
Commercial and industrial   242    678    226    48    35 
Consumer real estate   647    647    144    687    34 
Consumer lots and raw land   23    25    23    18    3 
Subtotal   1,199    1,637    393    1,332    87 
                          
Totals:                         
Residential   597    730    -    804    32 
Commercial   9,397    9,897    226    10,804    584 
Consumer   1,129    1,150    167    1,138    60 
Grand Total  $11,123   $11,777   $393   $12,746   $676 

 

 14 

 

 

6. Loans Held for Investment (Continued)

 

Credit Quality Indicators. The Bank assigns a risk grade to each loan in the portfolio as part of the on-going monitoring of the credit quality of the loan portfolio.

 

Commercial loans are graded on a scale of 1 to 9 as follows:

 

Risk Grade 1 (Excellent) - Loans in this category are considered to be of the highest quality.
Risk Grade 2 (Above Average) - Loans are supported by above average financial strength and stability.
Risk Grade 3 (Average) - Credits in this group are supported by upper tier industry-average financial strength and stability.
Risk Grade 4 (Acceptable) - Credits in this group are supported by lower end industry-average financial strength and stability.
Risk Grade 5 (Watch) - An asset in this category is one that has been identified by the lender, or credit administration as a loan that has shown some degree of deterioration from its original status.
Risk Grade 6 (Special Mention) - An asset in this category is currently protected by collateral but has potential weaknesses that deserve management’s close attention.
Risk Grade 7 (Substandard) - A Substandard loan is inadequately protected by the current sound net worth and paying capacity of the debtor(s) or of the collateral pledged, if any.
Risk Grade 8 (Doubtful) - A loan graded in this category has all the weaknesses inherent in one graded Substandard with the added characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable.
Risk Grade 9 (Loss) - A loan graded as Loss is considered uncollectible and of such little value that continuance as a bankable asset is not warranted.

 

Consumer loans are graded on a scale of 1 to 9 as follows:

 

 • Risk Grades 1 - 5 (Pass) - Loans in this category generally show little to no signs of weakness or have adequate mitigating factors that minimize the risk of loss.  
 • Risk Grade 6 (Special Mention) - An asset in this category is currently protected by collateral but has potential weaknesses that deserve management’s close attention.
 • Risk Grade 7 (Substandard) - A Substandard loan is inadequately protected by the current sound net worth and paying capacity of the debtor(s) or of the collateral pledged, if any.
 • Risk Grade 8 (Doubtful) - A loan graded in this category has all the weaknesses inherent in one graded Substandard with the added characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable.
•  Risk Grade 9 (Loss) - A loan graded as Loss is considered uncollectible and of such little value that continuance as a bankable asset is not warranted.

 

Mortgage loans are graded on a scale of 1 to 9 as follows:

 

Risk Grades 1 - 4 (Pass) - Loans in this category generally show little to no signs of weakness or have adequate mitigating factors that minimize the risk of loss.  
Risk Grade 5 (Pass -Watch) – Watch loans have shown credit quality changes from the original status.  
Risk Grade 6 (Special Mention) – Special Mention loans are currently protected by collateral but have potential weaknesses that deserve management’s close attention.
Risk Grade 7 (Substandard) - Substandard loans are inadequately protected by the sound net worth and paying capacity of the borrower(s).
Risk Grade 8 (Doubtful) - Loans classified Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable.
Risk Grade 9 (Loss) - Loans classified Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted.

 

 15 

 

 

6. Loans Held for Investment (Continued)

 

The following table presents information on risk ratings of the commercial, consumer, mortgage and lease receivable portfolios, segregated by loan class as of September 30, 2017 and December 31, 2016:

 

September 30, 2017
Commercial Credit Exposure by Assigned Risk Grade  Commercial
Real Estate
   Commercial
Construction
   Commercial Lots
and Raw Land
   Commercial and
Industrial
 
   (In thousands) 
1-Excellent  $-   $-   $-   $9 
2-Above Average   2,641    -    784    381 
3-Average   124,840    11,570    2,431    22,628 
4-Acceptable   267,753    44,170    20,492    56,293 
5-Watch   17,130    69    5,412    7,529 
6-Special Mention   5,965    -    1,581    1,883 
7-Substandard   1,802    106    -    170 
8-Doubtful   -    -    -    - 
9-Loss   -    -    -    - 
Total  $420,131   $55,915   $30,700   $88,893 

 

September 30, 2017
Consumer Credit Exposure by Assigned
Risk Grade
  Consumer Real
Estate
   Consumer
Construction
   Consumer Lots
and Raw Land
   Home Equity
Line of Credit
   Consumer
Other
 
   (In thousands) 
Pass  $20,884   $444   $8,909   $40,308   $13,367 
6-Special Mention   116    -    194    39    1 
7-Substandard   332    -    132    190    35 
8-Doubtful   -    -    -    -    - 
9-Loss   -    -    -    -    - 
Total  $21,332   $444   $9,235   $40,537   $13,403 

 

September 30, 2017
Mortgage and Lease Receivable Credit Exposure by
Assigned Risk Grade
  Residential Real
Estate
   Residential
Construction
   Residential Lots
and Raw Land
   Lease Receivable 
   (In thousands) 
Pass  $69,327   $6,740   $130   $22,865 
6-Special Mention   739    -    -    355 
7-Substandard   627    -    -    91 
8-Doubtful   -    -    -    - 
9-Loss   -    -    -    - 
Total  $70,693   $6,740   $130   $23,311 

 

 16 

 

 

6. Loans Held for Investment (Continued)

 

December 31, 2016
Commercial Credit Exposure by Assigned Risk Grade  Commercial
Real Estate
   Commercial
Construction
   Commercial Lots
and Raw Land
   Commercial and
Industrial
 
   (In thousands) 
1-Excellent  $-   $-   $-   $72 
2-Above Average   2,567    -    203    520 
3-Average   112,489    13,986    2,237    14,331 
4-Acceptable   237,473    40,819    22,042    48,305 
5-Watch   17,869    1,184    7,027    1,890 
6-Special Mention   3,424    129    1,384    672 
7-Substandard   4,351    -    541    2,190 
8-Doubtful   -    -    -    - 
9-Loss   -    -    -    - 
Total  $378,173   $56,118   $33,434   $67,980 

 

December 31, 2016
Consumer Credit Exposure by Assigned
Risk Grade
  Consumer Real
Estate
   Consumer
Construction
   Consumer Lots
and Raw Land
   Home Equity
Line of Credit
   Consumer
Other
 
   (In thousands) 
Pass  $16,472   $105   $8,595   $36,474   $6,345 
6-Special Mention   252    -    211    84    2 
7-Substandard   243    -    169    257    - 
8-Doubtful   -    -    -    -    - 
9-Loss   -    -    -    -    - 
Total  $16,967   $105   $8,975   $36,815   $6,347 

 

December 31, 2016
Mortgage and Lease Receivable Credit Exposure by
Assigned Risk Grade
  Residential Real
Estate
   Residential
Construction
   Residential Lots
and Raw Land
   Lease Receivable 
   (In thousands) 
Pass  $65,406   $7,875   $154   $21,236 
6-Special Mention   761    -    -    - 
7-Substandard   1,097    -    -    - 
8-Doubtful   -    -    -    - 
9-Loss   -    -    -    - 
Total  $67,264   $7,875   $154   $21,236 

 

 17 

 

 

7. Allowance for Loan and Lease Losses. The following table presents a roll forward summary of activity in the allowance for loan and lease losses (“ALLL”), by loan category, for the nine months ended September 30, 2017 and 2016:

 

   September 30, 2017 
   Beginning   Charge-           Ending   Total 
   Balance   Offs   Recoveries   Provisions   Balance   Loans 
   (In thousands) 
Collectively evaluated for impairment:                              
Residential real estate  $695   $(33)  $-   $16   $678   $70,423 
Residential construction   89    -    -    (17)   72    6,740 
Residential lots and raw land   2    -    -    (1)   1    130 
Commercial real estate   4,562    (4)   23    361    4,942    416,305 
Commercial construction   689    -    -    (41)   648    55,915 
Commercial lots and raw land   365    -    -    (38)   327    29,818 
Commercial and industrial   840    (20)   3    182    1,005    88,365 
Lease receivables   226    (5)   -    16    237    23,311 
Consumer real estate   186    -    7    36    229    20,987 
Consumer construction   1    -    -    4    5    444 
Consumer lots and raw land   134    -    2    (29)   107    8,566 
Home equity lines of credit   414    (5)   22    (4)   427    40,461 
Consumer other   77    (8)   26    197    292    13,368 
Total   8,280    (75)   83    682    8,970    774,833 
Individually evaluated for impairment:                              
Residential real estate   -    -    16    (16)   -    270 
Commercial real estate   -    -    -    1    1    3,826 
Commercial lots and raw land   -    -    89    (89)   -    882 
Commercial and industrial   226    (67)   -    261    420    528 
Consumer real estate   -    -    -    33    33    345 
Consumer lots and raw land   144    (26)   15    (31)   102    669 
Home equity lines of credit   23    -    4    9    36    76 
Consumer other   -    -    -    -    -    35 
Total   393    (93)   124    168    592    6,631 
Grand Total  $8,673   $(168)  $207   $850   $9,562   $781,464 

 

 18 

 

 

7. Allowance for Loan and Lease Losses (Continued)

 

   September 30, 2016 
   Beginning   Charge-           Ending   Total 
   Balance   Offs   Recoveries   Provisions   Balance   Loans 
   (In thousands) 
Collectively evaluated for impairment:                              
Residential real estate  $730   $-   $-   $2   $732   $67,799 
Residential construction   47    -    -    27    74    6,372 
Residential lots and raw land   2    -    -    -    2    160 
Commercial real estate   4,065    (33)   22    465    4,519    364,320 
Commercial construction   518    -    70    91    679    54,854 
Commercial lots and raw land   303    -    -    52    355    30,151 
Commercial and industrial   641    (2)   4    126    769    59,683 
Lease receivables   196    -    -    28    224    20,452 
Consumer real estate   198    (6)   11    (5)   198    17,323 
Consumer construction   2    -    -    1    3    252 
Consumer lots and raw land   125    (4)   -    4    125    8,557 
Home equity lines of credit   351    (13)   1    65    404    34,921 
Consumer other   71    (40)   21    23    75    6,484 
Total   7,249    (98)   129    879    8,159    671,328 
Individually evaluated for impairment:                              
Residential real estate   -    (2)   1    1    -    774 
Commercial real estate   -    (68)   3    224    159    7,509 
Commercial construction   -    -    -    -    -    - 
Commercial lots and raw land   365    -    -    (365)   -    2,325 
Commercial and industrial   14    -    -    (14)   -    68 
Consumer real estate   30    (36)   -    30    24    399 
Consumer lots and raw land   209    (73)   2    (5)   133    785 
Home equity lines of credit   -    -    4    19    23    53 
Consumer other   -    -    -    -    -    39 
Total   618    (179)   10    (110)   339    11,952 
Grand Total  $7,867   $(277)  $139   $769   $8,498   $683,280 

 

8. Troubled Debt Restructurings. The following table details performing TDR loans at September 30, 2017 and December 31, 2016, segregated by class of financing receivables:

 

   September 30, 2017   December 31, 2016 
   (Dollars in thousands) 
Performing TDRs accounted for on accrual status:          
Residential real estate  $-   $- 
Commercial real estate   351    461 
Consumer real estate   33    - 
Consumer lots and raw land   53    95 
Total  $437   $556 
Percentage of total loans, net   0.0%   0.1%

 

 19 

 

 

8. Troubled Debt Restructurings (Continued)

 

The following table presents a roll forward of performing TDR loans for the nine months ended September 30, 2017 and 2016:

 

   Beginning
Balance
   Additions (1)   Charge-offs (2)   Other (3)   Ending Balance 
   (In thousands) 
Performing TDRs                         
September 30, 2017                         
Residential mortgage  $-   $-   $-   $-   $- 
Commercial   461    252    -    (362)   351 
Consumer   95    -    -    (9)   86 
Total  $556   $252   $-   $(371)  $437 
                          
September 30, 2016                         
Residential mortgage  $-   $-   $-   $-   $- 
Commercial   770    92    -    (394)   468 
Consumer   107    -    -    (9)   98 
Total  $877   $92   $-   $(403)  $566 

 

The following table presents a roll forward of non-performing TDR loans for the nine months ended September 30, 2017 and 2016:

 

   Beginning
Balance
   Additions (1)   Charge-offs (2)   Other (4)   Ending Balance 
   (In thousands) 
Non-Performing TDRs                         
September 30, 2017                         
Residential mortgage  $324   $-   $-   $(324)  $- 
Commercial   822    -    -    (652)   170 
Consumer   238    -    -    (19)   219 
Total  $1,384   $-   $-   $(995)  $389 
                          
September 30, 2016                         
Residential mortgage  $809   $-   $(2)  $(308)  $499 
Commercial   534    -    -    (235)   299 
Consumer   159    92    -    (9)   242 
Total  $1,502   $92   $(2)  $(552)  $1,040 

 

1.Includes new TDRs and increases to existing TDRs.
2.Post modification charge-offs.
3.Includes principal payments, paydowns and performing loans previously restructured at market rates that are no longer reported as TDRs.
4.Includes principal payments, paydowns and loans previously designated as non-performing that are currently performing in compliance with their modified terms.

 

The Bank performs restructurings on certain troubled loan workouts, whereby existing loans are restructured into a multiple note structure (i.e., Note A and Note B structure). The Bank separates a portion of the current outstanding debt into a new legally enforceable note (“Note A”) that is reasonably assured of repayment and performance according to prudently modified terms. The portion of the debt that is not reasonably assured of repayment (“Note B”) is adversely classified and charged-off as appropriate. The following table provides information on multiple note restructures for certain commercial real estate loan workouts as of September 30, 2017 and 2016:

 

   September 30, 2017   September 30, 2016 
   (In thousands) 
Note A Structure          
Commercial real estate (1)  $334   $352 
Note B Structure          
Commercial real estate (2)  $207   $207 
Reduction of interest income (3)  $7   $8 

 

(1)If Note A was on nonaccrual status, it may be placed back on accrual status based on sustained historical payment performance of generally nine months.
(2)Note B is immediately charged-off upon restructuring; however, payment in full is due at maturity of the note.
(3)Reflects amount of interest income reduction during the nine months ended September 30, 2017 and 2016, as a result of multiple note restructures.

 

 20 

 

 

8. Troubled Debt Restructurings (Continued)

 

The benefit of this workout strategy is for Note A note to remain or become a performing asset for which the borrower has the willingness and ability to meet the restructured payment terms and conditions. In addition, this workout strategy reduces the prospects of further write downs and charge offs, and also reduces the prospects of a potential foreclosure. Following this restructuring, the Note A credit classification generally improves to an unclassified risk grade after a period of sustained payments.

 

The general terms of the new loans restructured under the Note A and Note B structure differ as follows:

·Note A: First lien position; fixed or adjustable current market interest rate; fixed month term to maturity; payments – interest only to maturity, or full principal and interest to maturity. Note A is underwritten in accordance with the Bank’s customary underwriting standards and is generally on an accrual basis.
·Note B: Second lien position; fixed or adjustable below current market interest rate; fixed month term to maturity; payments – due in full at maturity. Note B is underwritten in accordance with the Bank’s customary underwriting standards, except for the below market interest rate and payment terms, is on a nonaccrual basis and is charged off.

 

9. Other Real Estate Owned. The following table reflects the changes in other real estate owned (“OREO”) during the nine months ended September 30, 2017 and 2016:

 

   Beginning           Fair Value   Ending 
   Balance   Additions   Sales, net   Adjustments   Balance 
   (In thousands) 
Nine Months Ended:                         
                          
September 30, 2017  $3,229   $440   $(1,293)  $(192)  $2,184 
                          
September 30, 2016  $6,125   $464   $(1,668)  $(111)  $4,810 

 

Fair value adjustments are recorded in order to adjust the carrying values of OREO properties to estimated fair market values. In most cases, estimated fair market values are derived from an initial appraisal, an updated appraisal or other forms of internal evaluations. In certain instances when a listing agreement is renewed for a lesser amount, carrying values will be adjusted to the lesser fair value amount. Additionally, in certain instances when an offer to purchase is received near the end of a quarterly accounting period for less than the carrying value, and the sale does not close until the next accounting period, the carrying value will be adjusted to the lesser fair value amount. At September 30, 2017, OREO consisted of residential and commercial properties, developed lots and raw land.

 

10. Premises and Equipment. The following table presents premises and equipment at September 30, 2017 and December 31, 2016:

 

   September 30, 2017   December 31, 2016 
Land  $2,807,558   $2,817,308 
Office buildings and improvements   10,232,652    9,667,612 
Furniture, fixtures and equipment   9,704,526    9,877,872 
Vehicles   623,039    621,238 
Projects/work in process   543,844    571,784 
    23,911,619    23,555,814 
Less accumulated depreciation   13,112,576    12,264,218 
Total  $10,799,043   $11,291,596 

 

The Bank leases certain branch facilities and equipment under separate agreements that expire at various dates through October 30, 2027. Rental expense of $331,985 and $997,401 during the three and nine months ended September 30, 2017, and $344,166 and $1,032,125 during the three and nine months ended September 30, 2016, respectively, is included in premises and equipment expense on the accompanying consolidated statements of operations.

 

Future rental expenses under these leases as of September 30, 2017 are as follows:

 

2017  $331,421 
2018   1,120,227 
2019   860,528 
2020   640,102 
2021   541,209 
Thereafter   1,553,207 
Total  $5,046,694 

 

 21 

 

 

11. Goodwill and Other Intangibles. The following table presents activity for goodwill and other intangible assets for the nine months ended September 30, 2017 and 2016:

 

  Goodwill   Identifiable Intangibles   Total 
Nine Months Ended September 30, 2017:               
Balance at December 31, 2016  $4,218,576   $1,611,187   $5,829,763 
Amortization   -    (181,258)   (181,258)
Balance at September 30, 2017  $4,218,576   $1,429,929   $5,648,505 
                
Nine Months Ended September 30, 2016               
Balance at December 31, 2015  $4,218,576   $1,895,514   $6,114,090 
Amortization   -    (213,245)   (213,245)
Balance at September 30, 2016  $4,218,576   $1,682,269   $5,900,845 

 

The following table presents a rollforward of the gross carrying amount, new acquisitions, accumulated amortization and net book value for the Company’s core deposit intangible (“CDI”), related to the acquisition of branch offices from Bank of America, N.A. on December 12, 2014. The CDI is the only identifiable intangible asset subject to amortization at September 30, 2017 and December 31, 2016, respectively:

 

   Identifiable Intangibles 
Net book value at December 31, 2015  $1,895,514 
Accumulated amortization   (284,327)
Net book value at December 31, 2016   1,611,187 
Accumulated amortization   (181,258)
Net book value at September 30, 2017  $1,429,929 

 

The following table presents estimated future amortization expense of the CDI. At September 30, 2017, the remaining life of the CDI was 7.25 years.

 

2017  $60,419 
2018   223,002 
2019   223,002 
2020   223,002 
2021   223,002 
Thereafter   477,502 
Total  $1,429,929 

 

12. Deposits. The following table presents the distribution of the Company’s deposit accounts as of September 30, 2017 and December 31, 2016:

 

   September 30, 2017   December 31, 2016 
   (In thousands) 
Demand accounts:          
Non-interest bearing checking  $212,521   $196,917 
Interest bearing checking   231,529    189,401 
Money market   92,366    82,698 
Savings accounts   146,933    145,032 
Certificate accounts   261,939    256,552 
Total deposits  $945,288   $870,600 

 

At September 30, 2017, the scheduled maturities of certificate accounts were as follows:

 

   $250,000 or
Less
   More than
$250,000
   Total 
   (In thousands) 
Three months or less  $54,899   $10,302   $65,201 
Over three months through one year   77,480    20,437    97,917 
Over one year through three years   52,179    25,259    77,438 
Over three years   15,463    5,920    21,383 
Total time deposits  $200,021   $61,918   $261,939 

 

The aggregate amount of time deposits with balances of $250,000 or more was $61.9 million and $39.2 million at September 30, 2017 and December 31, 2016, respectively.

 

 22 

 

 

13. Borrowed Money. The Bank had $16.5 million of FHLB borrowings outstanding at September 30, 2017, compared to $17.0 million at December 31, 2016. The Bank pledges its stock in the FHLB and certain loans as collateral for actual or potential FHLB advances. At September 30, 2017 and December 31, 2016, the Bank had $265.0 million and $246.2 million, respectively, of credit available with the FHLB. At September 30, 2017, the Bank had lendable collateral value with the FHLB totaling $222.9 million. Additional collateral would be required in order to access total borrowings up to the credit availability limit.

 

The following table details the Bank’s FHLB advances outstanding and the related maturity dates and interest rates at September 30, 2017:

 

Maturity Date  Interest Rate   Amount 
       (Dollars in thousands) 
June 22, 2018   1.330%  $1,000 
June 25, 2018   0.870%   1,000 
June 25, 2018   1.360%   2,000 
June 29, 2018   1.340%   1,000 
December 21, 2018   1.470%   2,500 
June 24, 2019   1.048%   1,000 
July 8, 2019   1.620%   2,000 
June 22, 2020   1.720%   3,000 
June 29, 2020   1.980%   2,000 
July 6, 2020   1.890%   1,000 
        $16,500 

 

14. Junior Subordinated Debentures. The Company has sponsored a trust, First South Preferred Trust I (the “Trust”), of which 100% of its common equity is owned by the Company. The Trust was formed for the purpose of issuing Company-obligated trust preferred securities (the “Trust Preferred Securities”) to third-party investors and investing the proceeds from the sale of the Trust Preferred Securities solely in junior subordinated debt securities of the Company (the “Debentures”). The Debentures held by the Trust are the sole assets of the Trust. Distributions on the Trust Preferred Securities issued by the Trust are payable quarterly at a rate equal to the interest rate being earned by the Trust on the Debentures held by the Trust. The Trust Preferred Securities are subject to mandatory redemption, in whole or in part, upon repayment of the Debentures. The Company has entered into an agreement which fully and unconditionally guarantees the Trust Preferred Securities subject to the terms of the guarantee. The Debentures held by the Trust are redeemable, in whole or in part, by the Company after September 30, 2008. Subject to certain limitations, the Junior Subordinated Debentures qualify as Tier 1 capital for the Company under current Federal Reserve Board guidelines.

 

In July of 2013, the banking regulators issued the final Basel III capital rules. Under these rules, bank holding companies with less than $15 billion in consolidated total assets as of December 31, 2009, that issued trust preferred securities prior to May 19, 2010, are permanently grandfathered as Tier 1 or Tier 2 capital.

 

Consolidated debt obligations as of September 30, 2017 related to the Trust holding solely Debentures of the Company follows:

 

LIBOR + 2.95% junior subordinated debentures owed to First South Preferred Trust I due September 26, 2033  $10,000,000 
LIBOR + 2.95% junior subordinated debentures owed to First South Preferred Trust I due September 26, 2033   310,000 
Total junior subordinated debentures owed to unconsolidated subsidiary trust  $10,310,000 

 

The Trust Preferred Securities bear interest at three-month LIBOR plus 2.95%, payable quarterly. The Company has swapped the interest rate on the Debentures to a fixed rate of 4.97%, with a maturity date of December 30, 2024. This strategy was executed to provide the Company with protection to a rising rate environment. See Note 19 below for additional information.

 

15. Regulatory Capital. The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial condition and results of operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company’s capital amounts and ratios are not significantly different from those of the Bank. At September 30, 2017 and December 31, 2016, the Company’s and the Bank’s Tier 1 and total capital ratios and their Tier 1 leverage ratios exceeded minimum requirements.

 

 23 

 

 

15. Regulatory Capital (Continued)

 

As of September 30, 2017, the Bank’s regulatory capital position is categorized as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since September 30, 2017, that management believes have changed the Bank's well capitalized category. Beginning in 2015, the Bank became subject to the Basel III Capital Rules. As a result, certain items in the risk-based capital calculation have changed and the Common Equity Tier 1 Risk-Based Capital Ratio (“CET1”) is now being measured and monitored. For the Bank’s capital structure, the CET1 Capital Ratio and the Tier 1 Risk-Based Capital Ratio are identical.

 

Basel III limits capital distributions and certain discretionary bonus payments if a banking organization does not hold a capital conservation buffer consisting of 2.50% of CET1 capital, Tier 1 capital and total capital to risk-weighted assets in addition to the amount necessary to meet minimum risk-based capital requirements. The capital conservation buffer began to be phased in beginning January 1, 2016, at 0.625% of risk-weighted assets, and increases each year until fully implemented at 2.50% on January 1, 2019. The CET1 capital conservation buffer for 2017 is 1.25% and the Bank’s buffer as of September 30, 2017 was 4.57%. When fully phased in on January 1, 2019, Basel III will require (i) a minimum ratio of CET1 capital to risk-weighted assets of at least 4.50%, plus the capital conservation buffer, (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.00%, plus the capital conservation buffer, (iii) a minimum ratio of total capital to risk-weighted assets of at least 8.00%, plus the capital conservation buffer and (iv) a minimum leverage ratio of 4.00%. The Bank’s actual regulatory capital amounts and ratios as of September 30, 2017 and December 31, 2016 are as follows:

 

   9/30/2017   12/31/2016 
Regulatory Capital Amounts and Ratios  Amount   Ratio (1)   Amount   Ratio (2) 
   (Dollars in thousands)     
Total risk-based capital (1)  $104,381    12.947%  $96,502    13.009%
Tier 1 risk-based capital (1)   94,535    11.725%   87,517    11.798%
Common equity Tier 1 risk-based capital (1)   94,535    11.725%   87,517    11.798%
Tier 1 leverage capital   94,535    8.956%   87,517    8.894%

 

(1) Includes 1.25% phase in for capital conservation buffer.

(2) Includes 0.625% phase in for capital conservation buffer.

 

16. Stock-Based Compensation. The Company had two stock-based compensation plans at September 30, 2017. The shares outstanding are for grants under the Company’s 1997 Stock Option Plan (the “1997 Plan”) and the 2008 Equity Incentive Plan (the “2008 Plan”). In connection with the Merger discussed in Note 1 above, the vesting date on all remaining nonvested stock option shares and restricted stock awards was accelerated to September 30, 2017.

 

The 1997 Plan matured on April 8, 2008 and no additional options may be granted under the 1997 Plan. At September 30, 2017, the 1997 Plan had 18,250 vested unexercised stock option shares. At September 30, 2017, the 2008 Plan included 119,100 vested unexercised stock option shares, and 804,650 shares available to be granted.

 

Stock Option Grants. Options granted under the 2008 Plan are granted at the closing price of the Company’s common stock on the NASDAQ Stock Market on the date of grant. Stock options expire ten years from the date of grant and vest over service periods ranging from one year to five years. The Company settles stock option exercises with authorized unissued shares. The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model. The risk-free interest rate is based on the U.S. Treasury rate for the expected life at the time of grant. Volatility is based on the average volatility of the Company based upon previous trading history. The expected life and forfeiture assumptions are based on historical data. Dividend yield is based on the yield at the time of the option grant.

 

A summary of option activity under the Plans during the nine month periods ended September 30, 2017 and 2016 is presented below:

 

 

Options

Outstanding

   Price  

Aggregate

Intrinsic Value

 
Period Ended September 30, 2017:            
Outstanding at December 31, 2016   147,750   $9.91      
Granted   -    -      
Forfeited   (1,300)   8.08      
Expired   -    -      
Exercised   (9,100)   9.42      
Outstanding at September 30, 2017   137,350    9.96   $1,246,056 
Vested and Exercisable at September 30, 2017   137,350   $9.96   $1,246,056 
Period Ended September 30, 2016:            
Outstanding at December 31, 2015   165,750   $10.76      
Granted   -    -      
Forfeited   (4,550)   20.90      
Expired   (5,750)   27.71      
Exercised   (6,450)   5.84      
Outstanding at September 30, 2016   149,000    10.01   $348,910 
Vested and Exercisable at September 30, 2016   112,850   $11.00   $240,059 

  

 24 

 

 

16. Stock-Based Compensation (Continued)

 

The following table summarizes other information about the Company’s outstanding options and exercisable options as of September 30, 2017, including weighted-average remaining contractual term expressed in years (Life) and weighted average exercise price (Price):

 

   Outstanding   Exercisable 
Range of Exercise Price  Shares   Life   Price   Shares   Price 
$4.00 – 10.00   84,100    5.11   $6.00    84,100   $6.00 
$10.01 – 17.00   24,000    1.95    10.77    24,000    10.77 
$17.01 – 30.00   29,250    0.51    20.65    29,250    20.65 
    137,350    3.58   $9.96    137,350   $9.96 

 

A summary of nonvested option shares and vesting changes during the nine months ended September 30, 2017 and 2016 is presented below:

 

   September 30, 2017   September 30, 2016 
  Shares   Price   Shares   Price 
Period Ended:                    
Nonvested at beginning of period   32,150   $7.09    53,300   $6.67 
Granted   -    -    -    - 
Forfeited   (1,300)   8.08    (950)   7.39 
Vested   (30,850)   7.05    (16,150)   6.03 
Nonvested at end of period   0   $0.00    36,200   $6.94 

 

Total compensation expense charged to income for stock options was $65,473 and $84,470, respectively, for the three and nine months ended September 30, 2017, compared to compensation expense of $10,019 and $33,582, respectively, for the three and nine months ended September 30, 2016. Compensation expense charged to income for stock options for the three and nine months ended September 30, 2017 included $56,973, respectively, of expense attributable to the accelerated vesting of all remaining granted unexercised shares.

 

Restricted Stock Awards. The Company measures the fair value of restricted shares based on the price of its common stock on the grant date and compensation expense is recorded over the vesting period. There were no restricted stock awards granted during the nine months ended September 30, 2017. During the nine months ended September 30, 2016, 3,000 restricted stock awards were granted with a four year vesting period, and 2,200 restricted stock awards were granted with a five year vesting period. Total compensation expense recognized for restricted stock awards for the three and nine months ended September 30, 2017 was $43,250 and $62,298, respectively, compared to $9,470 and $28,036, respectively, for the three and nine months ended September 30, 2016. Compensation expense charged to income for restricted stock awards for the three and nine months ended September 30, 2017 included $33,727, respectively, of expense attributable to the accelerated vesting of all remaining awarded nonvested shares.

 

A summary of nonvested restricted stock awards and vesting changes during the nine months ended September 30, 2017 and 2016 is presented below:

 

   September 30, 2017   September 30, 2016 
  Shares   Price   Shares   Price 
Period Ended:                    
Nonvested at beginning of period   11,750   $8.27    10,425   $8.36 
Granted   -    -    5,200    8.15 
Forfeited   -    -    (200)   8.15 
Vested   (11,750)   8.27    (3,475)   8.36 
Nonvested at end of period   0   $0.00    11,950   $8.27 

 

 25 

 

 

16. Stock-Based Compensation (Continued)

 

The following table reflects the combined impact of fair value compensation cost recognition for stock options and restricted stock awards on income before income taxes, net income, basic earnings per share and diluted earnings per share for the three and six month periods ended September 30, 2017 and 2016:

 

  

Three Months

Ended

9/30/17

  

Three Months

Ended

9/30/16

  

Nine months

Ended

9/30/17

  

Nine months

Ended

9/30/16

 
Decrease in net income before income taxes  $108,723   $19,489   $146,768   $61,618 
Decrease in net income  $108,723   $19,489   $146,768   $61,618 
Decrease in basic earnings per share  $0.01   $0.00   $0.01   $0.01 
Decrease in diluted earnings per share  $0.01   $0.00   $0.02   $0.01 

 

17. Fair Value Measurement. Fair value is defined as the price that would be received on the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy prioritizes the inputs of valuation techniques used to measure fair value of nonfinancial assets and liabilities. The inputs are evaluated and an overall level for the fair value measurement is determined. This overall level is an indication of the market observability of the fair value measurement. In order to determine the fair value, the Bank must determine the unit of account, highest and best use, principal market, and market participants. These determinations allow the Bank to define the inputs for fair value and level of hierarchy. Outlined below is the application of the fair value hierarchy to the Bank’s financial assets that are carried at fair value.

 

Level 1: Inputs to the valuation methodology are quoted prices in active markets for identical assets or liabilities that the Bank has the ability to access at the measurement date. A quoted price in an active market provides the most reliable evidence of fair value and is used to measure fair value whenever available. The type of assets carried at Level 1 fair value generally includes investments such as U.S. Treasury and U.S. government agency securities.

 

Level 2: Inputs to the valuation methodology include quoted prices for similar assets or liabilities in active markets. Price quotations can vary substantially either over time or among market makers. The type of assets carried at Level 2 fair value generally includes securities and mortgage-backed securities issued by Government Sponsored Enterprises (“GSEs”), municipal bonds, corporate debt securities, mortgage loans held for sale and bank-owned life insurance.

 

Level 3: Inputs to the valuation methodology are unobservable to the extent that observable inputs are not available. Unobservable inputs are developed based on the best information available in the circumstances and might include the Bank’s own assumptions. The Bank considers information about market participant assumptions that is reasonably available without undue cost and effort. The type of assets carried at Level 3 fair value generally include investments backed by non-traditional mortgage loans or certain state or local housing agency obligations, of which the Bank has no such assets or liabilities. Level 3 also includes impaired loans and other real estate owned.

 

Quoted market price for similar assets in active markets is the valuation technique for determining fair value of securities available-for-sale and held-to-maturity. Unrealized gains on available-for-sale securities are included in the “accumulated other comprehensive income” component of the Stockholders’ Equity section of the Consolidated Statements of Financial Condition. The estimated fair value of loans held for sale is based on commitments from investors within the secondary market for loans with similar characteristics. The Bank does not record loans held for investment at fair value on a recurring basis. However, when a loan is considered impaired, an impairment write down is taken based on the loan’s estimated fair value. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those loans not requiring a write down represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans, and are not included below.

 

 26 

 

 

17. Fair Value Measurement (Continued)

 

Assets measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016:

 

   Fair Value  

Quoted Prices In

Active Markets for

Identical Assets

  

Significant

Observable Inputs-

Outputs

  

Significant

Unobservable

Inputs

 
   (In thousands) 
Description  September 30, 2017   Level 1   Level 2   Level 3 
Securities available-for-sale:                    
Government agencies  $23,837   $23,837   $-   $- 
Mortgage-backed securities   82,730    -    82,730    - 
Municipal securities   57,120    -    57,120    - 
Corporate bonds   26,886    -    26,886    - 
Mortgage loans held for sale   3,815    -    3,815    - 
Bank-owned life insurance   18,483    -    18,483    - 
Interest rate swap   66    -    66    - 
Total September 30, 2016  $212,937   $23,837   $189,100   $- 

 

Description  December 31, 2016   Level 1   Level 2   Level 3 
Securities available-for-sale:                    
Government agencies  $16,995   $16,995   $-   $- 
Mortgage-backed securities   95,116    -    95,116    - 
Municipal securities   53,682    -    53,682    - 
Corporate bonds   26,813    -    26,813    - 
Mortgage loans held for sale   5,099    -    5,099    - 
Bank-owned life insurance   18,080    -    18,080    - 
Interest rate swap   121    -    121    - 
Total December 31, 2016  $215,906   $16,995   $198,911   $- 

 

Assets measured at fair value on a non-recurring basis as of September 30, 2017 and December 31, 2016:

 

   Fair Value  

Quoted Prices In

Active Markets for

Identical Assets

  

Significant

Observable Inputs-

Outputs

  

Significant

Unobservable

Inputs

 
   (In thousands) 
Description  September 30, 2017   Level 1   Level 2   Level 3 
Impaired loans, net  $6,039   $-   $-   $6,039 
Other real estate owned   2,184    -    -    2,184 
Total September 30, 2016  $8,223   $-   $-   $8,223 

 

Description  December 31, 2016   Level 1   Level 2   Level 3 
Impaired loans, net  $10,730   $-   $-   $10,730 
Other real estate owned   3,229    -    -    3,229 
Total December 31, 2016  $13,959   $-   $-   $13,959 

 

Impaired loans at September 30, 2017 and December 31, 2016 include $5.4 million and $9.9 million, respectively, of loans identified as impaired, even though an impairment analysis calculated pursuant to ASC 310-10-35 resulted in no allowance.

 

Impaired loans where a write down is taken based on fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Bank records the impaired loan as non-recurring Level 3. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Bank classifies the impaired loan as non-recurring Level 3.

 

 27 

 

 

17. Fair Value Measurement (Continued)

 

OREO is recorded at fair value upon transfer of a loan to foreclosed assets, based on the appraised market value of the property. OREO is reviewed quarterly and values are adjusted as determined appropriate. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When an appraised value is not available or management determines the fair value of the collateral is impaired below the appraised value and there is no observable market price, the Bank classifies the foreclosed asset as non-recurring Level 3. Fair value adjustments of $15,220 and $192,139, respectively, were made to OREO during the three and nine months ended September 30, 2017, compared to $1,000 and $111,170, respectively, made during the three and nine months ended September 30, 2016.

 

No liabilities were measured at fair value on a recurring or non-recurring basis as of September 30, 2017 or December 31, 2016.

 

18. Fair Value of Financial Instruments. The following table represents the recorded carrying values, estimated fair values and fair value hierarchy within which the fair value measurements of the Company’s financial instruments are categorized at September 30, 2017 and December 31, 2016:

 

   Level in  September 30, 2017   December 31, 2016 
   Fair Value  Estimated   Carrying   Estimated   Carrying 
   Hierarchy  Fair Value   Amount   Fair Value   Amount 
      (In thousands) 
Financial assets:                       
Cash and due from banks  Level 1  $19,923   $19,923   $22,855   $22,855 
Interest-bearing deposits in other banks  Level 1   36,904    36,904    23,321    23,321 
Securities available for sale  Level 1   23,837    23,837    16,995    16,995 
Securities available for sale  Level 2   166,736    166,736    175,611    175,611 
Securities held to maturity  Level 2   508    506    511    510 
Loans held for sale  Level 2   3,815    3,815    5,099    5,099 
Loans and leases HFI, net, less impaired loans  Level 2   764,002    765,113    678,911    681,239 
Stock in FHLB of Atlanta  Level 2   1,593    1,593    1,574    1,574 
Accrued interest receivable  Level 2   3,596    3,596    3,526    3,526 
Interest rate swap  Level 2   66    66    121    121 
Bank-owned life insurance  Level 2   18,483    18,483    18,080    18,080 
Impaired loans HFI, net of related allowance  Level 3   6,039    6,039    10,730    10,730 
Mortgage servicing rights  Level 3   2,925    2,171    3,128    2,149 
Financial liabilities:                       
Deposits  Level 2  $943,880   $945,288   $869,591   $870,600 
Junior subordinated debentures  Level 2   10,310    10,310    10,310    10,310 

 

Fair values of financial assets and liabilities have been estimated using data which management considers as the best available, and estimation methodologies deemed suitable for the pertinent category of financial instrument. With regard to financial instruments with off-balance sheet risk, it is not practicable to estimate the fair value of future financing commitments. The estimation methodologies used by the Bank are as follows:

 

Financial assets:

 

Cash and Due from Banks and Interest –Bearing Deposits in Other Banks: The carrying amounts for cash and due from banks and interest bearing deposits in other banks are equal to their fair value. Fair value hierarchy Input level 1.

 

Investment Securities Available for Sale and Held to Maturity: The estimated fair value of investment securities is provided in Note 4 of the Notes to Consolidated Financial Statements. These are based on quoted market prices, when available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Fair value hierarchy Input levels 1 and 2.

 

Loans Held for Sale. The estimated fair value of loans held for sale is based on commitments from investors within the secondary market for loans with similar characteristics. Fair value hierarchy Input level 2.

 

Loans and Leases Held for Investment, net, less Impaired Loans: Fair values are estimated for portfolios of loans and leases held for investment with similar financial characteristics. Loans and leases are segregated by collateral type and by fixed and variable interest rate terms. The fair value of each category is determined by discounting scheduled future cash flows using current interest rates offered on loans or leases with similar characteristics. Fair value hierarchy Input level 2.

 

Stock in Federal Home Loan Bank of Atlanta: The fair value for FHLB stock approximates carrying value, based on the redemption provisions of the FHLB. Fair value hierarchy Input level 2.

 

Accrued Interest Receivable: The carrying amount of accrued interest receivable approximates fair value because of the short maturities of these instruments. Fair value hierarchy Input level 2.

 

 28 

 

 

18. Fair Value of Financial Instruments (Continued)

 

Interest Rate Swap: The Company has entered into a pay-fixed receive-floating swap to hedge our $10.0 million of floating rate Trust Preferred debt. The primary objective of the swap is to minimize future interest rate risk. See Note 19 below for additional information. Fair value hierarchy Input level 2.

 

Bank-Owned Life Insurance: The carrying value of bank-owned life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the issuer. Fair value hierarchy Input level 2.

 

Impaired Loans Held for Investment, Net: Fair values for impaired loans and leases are estimated based on discounted cash flows or underlying collateral values, where applicable. Fair value hierarchy Input Level 3.

 

Mortgage Servicing Rights (“MSRs”): The fair value of MSRs is estimated for those loans sold with servicing retained. The loans are stratified into pools by product type and within product type by interest rate and maturity. The fair value of the MSR is based upon the present value of estimated future cash flows using current market assumptions for prepayments, servicing costs and other factors. Fair value hierarchy Input level 3.

 

Financial liabilities:

 

Deposits: The fair value of demand deposits is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated using rates currently offered for similar instruments with similar remaining maturities. Fair value hierarchy Input level 2.

 

Junior Subordinated Debentures: The carrying amount of junior subordinated debentures approximates fair value of similar instruments with similar characteristics and remaining maturities. Fair value hierarchy Input level 2.

 

19. Interest Rate Hedging. The Company has executed certain strategies targeted at hedging the impact of rising interest rates on its future earnings. The Company has entered into a pay-fixed receive-floating swap to hedge our $10.0 million of floating rate Trust Preferred debt. The primary objective of the swap is to minimize future interest rate risk. During 2016, the Company restructured the terms of the swap to lower the fixed rate cost and extend its maturity. As a result, the restructured rate is 4.97% and the maturity date of the swap is December 30, 2024.

 

20. Compensated Absences. The Company has not accrued compensated absences because the amount cannot be reasonably estimated.

 

21. Subsequent Events. On November 1, 2017, the Company completed the previously announced merger with CARO, whereby the Company merged with and into CARO (the Merger), with CARO as the surviving corporation in the Merger. Immediately following the consummation of the Merger, First South Bank, a wholly owned subsidiary of the Company, merged with and into CresCom Bank, a wholly owned subsidiary of CARO (the Bank Merger), with CresCom Bank as the surviving bank in the Bank Merger. See “Explanatory Note” and Note 1. “Basis of Presentation” above for additional information.

 

We have evaluated subsequent events occurring after September 30, 2017, and concluded that no material transactions, other than the Merger transaction noted above, occurred that provided additional evidence about conditions that existed at or after September 30, 2017, that required adjustments to or disclosure in the Consolidated Financial Statements.

 

22. Recent Accounting Pronouncements. Pursuant to the Merger transaction noted above, the Company ceased to exist effective as of November 1, 2017. Consequently, after November 1, 2017 the Company is no longer subject to the Accounting Standards Updates issued by the Financial Accounting Standards Board.

 

 29 

 

 

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

 

First South Bancorp, Inc. (the "Company" or “FSBK”) was formed for the purpose of issuing common stock and owning 100% of the stock of First South Bank (the "Bank") and operating through the Bank a commercial banking business. The discussion below focuses primarily on the Bank's results of operations. The Bank has one significant operating segment, providing commercial and retail banking services to its markets located in the state of North Carolina. As of September 30, 2017, the Company’s common stock was traded on the NASDAQ Global Select Market under the symbol "FSBK". Pursuant to the merger with CARO as described below, all shares of the Company were converted into shares of CARO and trading of FSBK shares was suspended by NASDAQ effective upon opening of business on November 1, 2017.

 

Mergers and Acquisitions.

 

Merger with Carolina Financial Corporation. On June 9, 2017, the Company entered into an Agreement and Plan of Merger and Reorganization (the “Merger Agreement”) with Carolina Financial Corporation (“CARO”). As the Merger Agreement provides, the Company was merged with and into CARO (the “Merger”), with CARO continuing as the surviving corporation. In addition, following consummation of the Merger, the Bank was merged with and into CARO’s wholly-owned subsidiary, CresCom Bank ("CresCom"), with CresCom continuing as the surviving entity (the “Bank Merger”). Subject to the terms and conditions of the Merger Agreement, at the effective time of the Merger, the Company’s stockholders had the right to receive 0.5064 shares of CARO common stock for each share of the Company’s common stock. Cash will be paid in lieu of fractional shares. The transaction closed on November 1, 2017.

 

Comparison of Financial Condition at September 30, 2017, and December 31, 2016. Total assets increased by $82.8 million, or 8.4% to $1.1 billion at September 30, 2017, from $990.7 million at December 31, 2016. Earning assets increased by $90.3 million, or 9.8% to $1.0 billion at September 30, 2017, from $922.2 million at December 31, 2016. The increases are primarily attributable to growth in the loan and lease portfolio (“loans”) and interest-bearing deposits as the Bank’s robust deposit growth continues to support our strong liquidity position. The ratio of earning assets to total assets was 94.3% at September 30, 2017, compared to 93.1% at December 31, 2016.

 

Interest-bearing deposits with banks increased to $36.9 million at September 30, 2017, from $23.3 million at December 31, 2016. These funds are available to support loan originations, securities purchases, deposit withdrawals, liquidity management activities as well as daily operations of the Bank.

 

The investment securities portfolio totaled $191.1 million at September 30, 2017, versus $193.1 million at December 31, 2016. The Bank may make changes in the investment securities portfolio mix to manage sensitivity to future interest rate changes. See “Note 4. Investment Securities” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Mortgage loans held for sale totaled $3.8 million at September 30, 2017, compared to $5.1 million at December 31, 2016. During the nine months ended September 30, 2017, there were $33.0 million of loan sales, $30.8 million of loan originations, net of principal payments, and $980,000 of net realized gains. See “Note 5. Loans Held for Sale” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Total loans held for investment grew by $80.1 million during the current nine month period, or 11.4% to $780.7 million at September 30, 2017, from $700.6 million at December 31, 2016. During the nine months ended September 30, 2017, there were $80.5 million of originations, net of principal payments, and $440,000 of transfers to other real estate owned (“OREO”). The loans-to-deposit ratio increased to 83.0% at September 30, 2017, from 81.1% at December 31, 2016, as loan growth outpaced deposit growth during the nine months ended September 30, 2017. See “Note 6. Loans Held for Investment” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Improving asset quality metrics is a key component of the Bank’s performance objectives. Loans held for investment on nonaccrual status, including troubled debt restructurings (“TDRs”) on nonaccrual status declined to $2.3 million at September 30, 2017, from $3.1 million at December 31, 2016. Management and the Board of Directors (“Board”) are committed to improving asset quality, as we believe it is a key driver of stock price performance and overall stockholder value. The ratio of loans held for investment on nonaccrual status to total loans held for investment declined to 0.30% at September 30, 2017, from 0.44% at December 31, 2016.

 

 30 

 

 

Loans are generally placed on nonaccrual status and accrued unpaid interest is reversed when management determines that collectability of all interest, but not necessarily principal, payments are in doubt. This generally occurs when payments are delinquent in excess of 90 days. Consumer loans more than 180 days past due are generally charged off or a specific allowance is provided for any expected loss. All other loans are charged off when management concludes that they are uncollectible.

 

Management has evaluated all nonperforming loans and believes they are either well collateralized or adequately reserved. However, there can be no assurance in the future that regulators, increased volume and risks in the loan portfolio, adverse changes in economic conditions or other factors will not require additional adjustments to the allowance for loan and lease losses (“ALLL”).

 

The Bank maintains the ALLL at levels management believes are adequate to absorb probable losses inherent in the loan portfolio. The Bank has developed policies and procedures for assessing the adequacy of the ALLL that reflect the assessment of credit risk and impairment analysis. This assessment includes a quarterly analysis of qualitative and quantitative factors regarding the loan portfolio as well as economic conditions within the Bank’s footprint. In developing this analysis, the Bank relies on historical loss experience, estimates and exercises judgment in assessing credit risk. Future assessments of credit risk may yield different results, depending on changes in the qualitative and quantitative trends, which may require adjustments in the ALLL.

 

The quarterly assessment of ALLL adequacy includes an analysis of historical loss percentages of both classified and pass loans, as well as qualitative risk factors allocated among specific categories of loans. In developing this analysis, the Bank relies on actual loss history for the most recent twelve quarters and uses management’s best judgment in assessing credit risk. The assessment of qualitative factors includes various subjective components assessed in terms of basis points used in determining the ALLL adequacy. The evaluation of qualitative risk factors may result in a positive or negative adjustment to the ALLL methodology. There were no significant changes in accounting policy and methodology used to estimate the ALLL during the nine months ended September 30, 2017.

 

The ALLL was $9.6 million at September 30, 2017, compared to $8.7 million at December 31, 2016. The ratio of the ALLL to loans held for investment was 1.22% at September 30, 2017, compared to 1.24% at December 31, 2016. During the nine months ended September 30, 2017, there were $850,000 of provision for credit losses and $38,000 of net recoveries. See “Note 7. Allowance for Loan and Lease Losses” of “Notes to Consolidated Financial Statements (Unaudited)”and “Critical Accounting Policies - Loan Impairment and Allowance for Loan and Lease Losses” for additional information.

 

Based on an impairment analysis of loans held for investment, there were $6.6 million of loans classified as impaired, net of $110,000 in write-downs at September 30, 2017, compared to $11.1 million classified as impaired, net of $654,000 in write-downs at December 31, 2016. At September 30, 2017 and December 31, 2016, the ALLL included $592,000 and $393,000 specifically provided for impaired loans, respectively.

 

A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect scheduled payments of all principal and interest when due according to the contractual terms of the loan arrangement. The Bank uses several factors in determining if a loan is impaired. The internal asset classification procedures include a thorough review of significant loans and lending relationships and include the accumulation of related data. This data includes loan payments status, borrowers’ financial data and borrowers’ operating factors such as cash flows, operating income or loss, and various other matters. See “Note 6. Loans Held for Investment”, “Note 7. Allowance for Loan and Lease Losses” and “Note 8. Troubled Debt Restructurings” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

The Bank offers a variety of TDR programs on a loan-by-loan basis in which, for economic or legal reasons related to an individual borrower’s financial condition, it grants a concession to the borrower that would not otherwise be considered. The restructuring of a troubled loan may include, but is not limited to any one or a combination of the following: a modification of the loan terms such as a reduction of the contractual interest rate, principal, payment amount or accrued interest; an extension of the maturity date at a stated interest rate lower than the current market rate for a new debt with similar risks; a change in payment type, e.g. from principal and interest, to interest only with all principal and interest due at maturity; a substitution or acceptance of additional collateral; and a substitution or addition of new debtors for the original borrower.

 

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On a loan-by-loan basis, the Bank restructures loans that were either on non-accrual basis or on accrual basis prior to restructuring. If a loan was on nonaccrual basis prior to restructuring, it remains on nonaccrual until the borrower has demonstrated a willingness and ability to meet the terms and conditions of the restructuring and to make the restructured loan payments, generally for a period of at least nine months. If a restructured loan was on accrual basis prior to restructuring and the Bank expects the borrower to perform to the terms and conditions of the loan after restructuring (i.e. the loan was current, on accrual basis, and the borrower has the ability to make the restructured loan payments), the loan remains on an accrual basis. See “Note 8. Troubled Debt Restructurings” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

OREO acquired from foreclosures declined to $2.2 million at September 30, 2017, from $3.2 million at December 31, 2016. During the nine months ended September 30, 2017, there were $1.3 million of disposals, $192,000 of valuation adjustments and $440,000 of additions. OREO consists of residential and commercial properties, developed lots and raw land. The Bank believes the adjusted carrying values of these properties are representative of their fair market values, although there can be no assurances that ultimate sales will be equal to or greater than the carrying values. See “Note 9. Other Real Estate Owned” and “Note 17. Fair Value Measurement” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Mortgage servicing rights (“MSRs”) were $2.2 million at September 30, 2017, compared to $2.1 million at December 31, 2016. The principal amount of loans serviced for others was $366.8 million at September 30, 2017, versus $372.0 million at December 31, 2016, as principal received exceeded the volume of new loans sold servicing retained.

 

The Bank’s investment in bank-owned life insurance (“BOLI”) was $18.5 million at September 30, 2017, compared to $18.1 million at December 31, 2016. The investment returns from the BOLI are utilized to offset a portion of the cost of providing benefit plans to certain employees.

 

Goodwill was $4.2 million at both September 30, 2017 and December 31, 2016 and is tested for impairment annually. The Company’s most recent annual test determined there was no goodwill impairment. Identifiable intangible assets were $1.4 million at September 30, 2017, compared to $1.6 million at December 31, 2016, reflecting the core deposit intangible associated with a prior period branch acquisition transaction, which is being amortized over a ten year period. See “Note 11. Goodwill and Other Intangibles” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Total deposits increased by $74.7 million, or 8.6% to $945.3 million at September 30, 2017, from $870.6 million at December 31, 2016. For the current nine month period, non-maturity deposits (personal and business checking, savings and money market accounts) grew by $69.3 million, or 11.3% to $683.3 million at September 30, 2017, from $614.0 million at December 31, 2016.

 

Certificates of deposit (“CDs”) grew by $5.4 million, to $261.9 million at September 30, 2017, from $256.6 million at December 31, 2016. CDs represented 27.7% and 29.5% of total deposits at September 30, 2017 and December 31, 2016, respectively. The Bank attempts to manage its cost of deposits through a combination of monitoring the volume and pricing of new and maturing CDs and growth in non-maturity deposits, in relationship to current funding needs and market interest rates. See “Note 12. Deposits” of “Notes to Consolidated Financial Statements (Unaudited)” and “Interest Expense” below for additional information regarding deposits and the cost of funds.

 

Federal Home Loan Bank (“FHLB”) borrowings declined to $16.5 million at September 30, 2017, from $17.0 million at December 31, 2016. The Bank may use FHLB borrowings as a funding source to provide an effective means of managing its overall cost of funds and to manage its exposure to interest rate risk. There were $10.3 million of junior subordinated debentures outstanding at both September 30, 2017 and December 31, 2016, respectively. See “Note 13. Borrowed Money” and “Note 14. Junior Subordinated Debentures” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Stockholders' equity increased by $7.4 million to $94.6 million at September 30, 2017, from $87.2 million at December 31, 2016. This increase primarily reflects the $6.8 million of net income earned for the nine months ended September 30, 2017, a $1.4 million increase in accumulated other comprehensive income resulting from the mark-to-market adjustment of the available-for-sale securities portfolio, and is net of $998,000 of dividends declared. There were 9,504,991 common shares outstanding at September 30, 2017, compared to 9,494,935 shares outstanding at December 31, 2016, reflecting the net effect of 4,478 shares issued pursuant to the vesting of restricted stock awards and 5,578 shares issued pursuant to a stock option exercise during the current nine month period.

 

 32 

 

 

Accumulated other comprehensive income increased to $2.9 million at September 30, 2017, from $1.5 million at December 31, 2016, reflecting an increase in the mark-to-market adjustment in net unrealized gains in the available-for-sale investment securities portfolio, based on current market prices. See “Consolidated Statements of Comprehensive Income” and “Note 3. Comprehensive Income and Accumulated Other Comprehensive Income” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

The tangible equity to assets ratio was 8.29% at September 30, 2017, versus 8.21% at December 31, 2016; and the tangible book value per common share increased to $9.36 at September 30, 2017, from $8.57 at December 31, 2016.

 

The Bank is subject to various regulatory capital requirements administered by its federal and state banking regulators. As of September 30, 2017, the Bank's regulatory capital ratios were in excess of all regulatory requirements and the Bank’s regulatory capital position is categorized as “well capitalized”. There are no conditions or events since September 30, 2017 that management believes have changed the Bank's well capitalized category. See “Note 15. Regulatory Capital” of “Notes to Consolidated Financial Statements (Unaudited)” and “Liquidity and Capital Resources” below for additional information.

 

Comparison of Operating Results – Three and Nine Months Ended September 30, 2017 and 2016.

 

General. Net income for the three months ended September 30, 2017 increased 53.9% to $2.9 million, or $0.31 per diluted common share, from net income of $1.9 million, or $0.20 per diluted common share earned for the comparative three month period ended September 30, 2016. The improvement in net income on a comparative quarter basis is primarily due to a $1.3 million, or 16.1% increase in net interest income, and the reduction non-interest expenses, despite $109,000 of merger-related expenses incurred during the third quarter of 2017. The improvement in comparative quarterly net interest income reflects the impact of strong loan growth over the past twelve months.

 

Net income for the nine months ended September 30, 2017 increased 37.8% to $6.8 million, or $0.72 per diluted common share, compared to net income of $5.0 million, or $0.52 per diluted common share earned in the nine months ended September 30, 2016. Earnings for the current nine month period were positively impacted by increases in net interest income while containing non-interest expenses, despite $387,000 of merger-related expenses incurred during the nine months ended September 30, 2017. Strong loan growth over the past twelve month period has driven the Company’s ability to improve its revenue.

 

Impact of Merger-Related Transaction Expenses. In connection with the merger, the Company incurred $109,000 and $387,000 of merger-related expenses that impacted our results of operations for the three and nine months ended September 30, 2017, respectively. Excluding the net effects of these expenses, net income for the three and nine months ended September 30, 2017 would have been $3.0 million and $7.1 million, respectively, and earnings per share would have been $0.31 and $0.74 per diluted common share, respectively. The following table presents net income and diluted EPS for the respective September 30, 2017 third quarter and nine month periods adjusted for the impact of the merger-related transaction expenses:

 

  

Quarter Ended

9/30/17

  

Nine Months Ended

9/30/17

 
   (In thousands, except per share
data)
 
Reported Net Income (GAAP)  $2,916   $6,843 
Adjustments for Merger Expenses:          
Professional Fees and Services   15    293 
Miscellaneous Other Expenses   94    94 
Total   109    387 
Income Tax Benefit (Qtr-32.3% / YTD-30.8%)   (35)   (119)
Net Income Adjusted for Merger Expenses  $2,990   $7,111 
           
Reported Diluted EPS (GAAP)  $0.31   $0.72 
Impact of Merger Expenses on Diluted EPS  $0.00   $0.02 
Diluted EPS Adjusted for Merger Expenses  $0.31   $0.74 

 

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Interest Income. Interest income increased to $10.7 million and $30.4 million for the three and nine months ended September 30, 2017, respectively, from $9.2 million and $26.9 million for the comparable 2016 periods. The year-over-year growth in interest income is due to changes in the composition and volume of our earning asset base, coupled with an increase in yields on earning assets. The tax equivalent yield on average earning assets increased to 4.30% and 4.22% for the three and nine months ended September 30, 2017, from 4.13% and 4.12% for the three and nine months ended September 30, 2016. Average earning assets increased to $996.9 million and $973.1 million for the three and nine months ended September 30, 2017, from $895.3 million and $878.8 million for the comparative 2016 three and nine month periods.

 

Interest Expense. Interest expense increased to $1.0 million and $3.0 million for the three and nine months ended September 30, 2017, from $911,000 and $2.7 million for the comparable 2016 periods. Interest expense was primarily impacted by increased interest paid on deposits between the comparative reporting periods, reflecting the growth in total deposits discussed above. The cost of average interest-bearing liabilities increased to 0.55% and 0.54% for the respective three and nine months ended September 30, 2017, from 0.52% for both of the comparable 2016 periods. The Bank’s cost of interest-bearing liabilities has been impacted by the growth of non-maturity deposits and CDs as discussed above, as well as pricing of new and renewed CDs in the current interest rate environment.

 

Average interest-bearing liabilities increased to $752.6 million and $740.2 million for the three and nine months ended September 30, 2017, from $692.8 million and $687.9 for the comparable 2016 periods. Average non-interest-bearing demand deposits increased to $209.2 million and $202.0 million for the three and nine months ended September 30, 2017, from $181.0 million and $171.5 million for the 2016 three and nine months periods.

 

Net Interest Income. Net interest income for the three and nine months ended September 30, 2017 increased to $9.6 million and $27.4 million, from $8.3 million and $24.2 million for the comparable 2016 periods. The tax equivalent net interest margin increased to 3.89% and 3.81% for the three and nine months ended September 30, 2017, from 3.73% and 3.72% for the comparable 2016 periods. Yields on earning assets have been positively impacted by the strong growth in the Bank’s loan portfolio. This loan growth has resulted in a significant change in the mix of our earning assets over comparative periods. On the liability side of the balance sheet, continued expansion of our non-maturity deposit base, including non-interest bearing demand deposit accounts, has allowed the Company to efficiently fund its loan growth.

 

Yield/Cost Analysis. Table 1 below contains comparative information relating to the Company’s average balance sheet and reflects the yield on average earning assets and the average cost of interest-bearing liabilities for the three and nine months ended September 30, 2017 and 2016, respectively, presented on a tax equivalent yield basis. Tax equivalent yields related to certain investment securities exempt from federal income tax are stated on a fully taxable basis, using a 34% federal statutory tax rate and reduced by a disallowed portion of the tax exempt interest income. Average balances are derived from average daily balances. The interest rate spread represents the difference between the tax equivalent yield on average earning assets and the cost of average interest-bearing liabilities. The tax equivalent net interest margin represents tax adjusted net interest income divided by average earning assets.

 

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Table 1 – Yield/Cost Analysis

 

   Three Months Ended September 30, 
   2017   2016 
  

Average

Balance

   Interest  

Average

Yield Cost

  

Average

Balance

   Interest  

Average

Yield Cost

 
   (Dollars in thousands) 
Interest earning assets:                              
Loans receivable  $782,465   $9,316    4.68%  $685,441   $7,915    4.54%
Investments and deposits   214,458    1,361    2.91(1)   209,849    1,295    2.81(1)
Total earning assets   996,923    10,677    4.30(1)   895,290    9,210    4.13(1)
Nonearning assets   65,327              73,439           
Total assets  $1,062,250             $968,729           
                               
Interest bearing liabilities:                              
Deposits  $723,960    842    0.46   $663,983    728    0.44 
Borrowings   18,288    70    1.53    18,506    56    1.18 
Junior subordinated debentures   10,310    127    4.82    10,310    127    4.82 
Total interest bearing liabilities   752,558    1,039    0.55    692,799    911    0.52 
Noninterest bearing demand deposits   209,192    -    -    181,000    -    - 
Total sources of funds   961,750    1,039    0.43    873,799    911    0.41 
Other liabilities   6,516              6,449           
Stockholders’ equity   93,984              88,481           
Total liabilities and equity  $1,062,250             $968,729           
                               
Net interest income       $9,638             $8,299      
                               
Interest rate spread (1)(2)             3.75%             3.61%
Net interest margin (1)(3)             3.89%             3.73%
Ratio of earning assets to interest bearing liabilities             132.47%             129.23%

 

   Nine Months Ended September 30, 
   2017   2016 
  

Average

Balance

   Interest  

Average

Yield Cost

  

Average

Balance

   Interest  

Average

Yield Cost

 
   (Dollars in thousands) 
Interest earning assets:                              
Loans receivable  $747,448   $26,230    4.64%  $654,696   $22,749    4.59%
Investments and deposits   225,641    4,144    2.80(1)   224,065    4,131    2.78(1)
Total earning assets   973,089    30,374    4.22(1)   878,761    26,880    4.12(1)
Nonearning assets   66,548              72,970           
Total assets  $1,039,637             $951,731           
                               
Interest bearing liabilities:                              
Deposits  $710,414    2,426    0.46   $653,116    2,095    0.43 
Borrowings   19,483    193    1.32    24,450    187    1.01 
Junior subordinated debentures   10,310    378    4.84    10,310    409    5.21 
Total interest bearing liabilities   740,207    2,997    0.54    687,876    2,691    0.52 
Noninterest bearing demand deposits   202,014    -    -    171,504    -    - 
Total sources of funds   942,221    2,997    0.42    859,380    2,691    0.42 
Other liabilities   5,872              6,126           
Stockholders’ equity   91,544              86,225           
 Total liabilities and equity  $1,039,637             $951,731           
                               
Net interest income       $27,377             $24,189      
                               
Interest rate spread (1)(2)             3.68%             3.60%
Net interest margin (1)(3)             3.80%             3.72%
Ratio of earning assets to interest bearing liabilities             131.46%             127.75%

 

 

1.     Shown as a tax-adjusted yield.

2.     Represents the difference between the average yield on earning assets and the average cost of funds.

3.     Represents net interest income divided by average earning assets.

 

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Provision for Credit Losses. The Bank's methodology for determining its provision for credit losses includes amounts specifically allocated to credits that are individually determined to be impaired and general provisions allocated to groups of loans that have not been individually assessed for impairment. The Bank recorded $100,000 and $850,000 of provisions for credit losses in the three and nine months ended September 30, 2017, compared to $220,000 and $770,000 recorded in the three and nine months ended September 30, 2016. The increase in provision for credit losses was primarily to support the $4.1 million and $80.1 million net growth in loans held for investment during the three and nine months ended September 30, 2017, respectively. Provision for credit losses is necessary to maintain the ALLL at a level that management believes is adequate to absorb probable future losses in the loan portfolio. See “Note 7. Allowance for Loan and Lease Losses” of “Notes to Consolidated Financial Statements (Unaudited)” and “Allowance for Loan and Lease Losses” and “Critical Accounting Policies - Loan Impairment and Allowance for Loan and Lease Losses” included herein for additional information.

 

Non-Interest Income. Total non-interest income totaled $3.5 million and $10.4 million for the three and nine months ended September 30, 2017, compared to $3.7 million and $10.8 million for the 2016 three and nine month periods. Non-interest income consists of deposit fees and service charges; loan fees and charges; mortgage loan servicing fees; gain on sale and other fees on mortgage loans, net gain on investment securities and OREO sales; and other miscellaneous income. Fees and service charges on deposits, and fees on loans and loan servicing fees earned during each period are influenced by the volume of deposits and loans outstanding, the volume of the various types of deposit and loan account transactions processed, the volume of loans serviced for others and the collection of related fees and service charges.

 

Deposit fees and service charges remained relatively consistent at $1.9 million and $5.7 million for both the three and nine months ended September 30, 2017 and 2016. Deposit fees and service charges represented 54.2% and 55.2% of total non-interest income for the three and nine months ended September 30, 2017, compared to 51.7% and 53.1% for the 2016 three and nine month periods. The amount of service charges and fees is generally dependent upon the volume of account transaction activity and the collection of related service charges and fees.

 

Total non-interest income generated from the sale and servicing of mortgage loans and loan fees was $1.1 million and $2.8 million for the three and nine months ended September 30, 2017, compared to $1.2 million and $2.6 million for the respective 2016 three and nine month periods. The Bank may sell or securitize fixed-rate residential mortgage loans to reduce interest rate and credit risk exposure, and to provide a more balanced sensitivity to future interest rate changes, while retaining certain other mortgage loans for future securitization into available-for-sale mortgage-backed securities. Proceeds from mortgage loan sales provide liquidity to support the Bank’s operating, financing and lending activities.

 

There were no gains on sales of investment securities available-for-sale recorded for the three and nine months ended September 30, 2017, compared to none and $467,000 for the respective 2016 three and nine month periods. During the three and nine months ended September 30, 2017, the Bank did not sell any investment securities available-for-sale, compared to none and $40.6 million sold in the 2016 three and nine month periods. Proceeds from investment securities sales in 2016 were primarily used to fund growth of our loan portfolio.

 

During the three and nine months ended September 30, 2017, the Bank recorded net gains of $14,000 and $70,000, from the sale of OREO compared to net gains of $77,000 and $51,000 for the respective 2016 three and nine month periods, as the Bank continued its efforts of disposing of these nonperforming assets. See “Note 9. Other Real Estate Owned” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Other non-interest income was $435,000 and $1.5 million for the three and nine months ended September 30, 2017, compared to $477,000 and $1.6 million for the 2016 three and nine month periods. Other non-interest income includes revenue from BOLI investments. BOLI earnings were $132,000 and $403,000 for the three and nine months ended September 30, 2017, compared to $142,000 and $419,000 for the 2016 periods.

 

Other non-interest income also includes revenues of $93,000 and $321,000 for the three and nine months ended September 30, 2017, from gains and retained servicing fees on Small Business Administration (“SBA”) loans sold , compared to $148,000 and $434,000 for the 2016 three and nine month periods. During the first nine months of 2016, other non-interest income also included the receipt of a $230,000 non-recurring fee.

 

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Non-Interest Expense. Total non-interest expense was $8.7 million and $27.0 million for the three and nine months ended September 30, 2017, compared to $8.9 million and $27.1 million for the 2016 three and nine month periods. Non-interest expenses for the three and nine month periods of 2017 were impacted by merger-related expenses as discussed above.

 

Compensation and benefit expenses, the largest component of non-interest expense, were $5.1 million and $15.2 million for the three and nine months ended September 30, 2017, compared to $5.0 million and $15.0 million for the respective 2016 three and nine month periods. The nine months ended September 30, 2016 included $65,000 of severance costs associated with branch consolidations during the period.

 

Federal Deposit Insurance Corporation (the “FDIC”) insurance premiums were $156,000 and $461,000 for the three and nine months ended September 30, 2017, compared to $157,000 and $479,000 for the respective 2016 three and nine month periods. The amount of our quarterly FDIC insurance premiums is determined by an FDIC calculation method based on various risk based components, combined with growth in our balance sheet.

 

Premises and equipment expense remained relatively consistent at $1.3 million and $4.0 million for the three and nine months ended September 30, 2017, compared to $1.3 million and $4.1 million for the 2016 three and nine month periods. During the first quarter of 2017, we consolidated two branch locations with other nearby facilities, and three branch locations were consolidated into other facilities in the first quarter of 2016.

 

Marketing expenses were reduced to $97,000 and $279,000 for the three and nine months ended September 30, 2017, from $151,000 and $569,000 for the respective 2016 three and nine month periods. During the prior fiscal year, we focused marketing efforts on enhancing our brand awareness throughout our footprint.

 

Data processing costs were $800,000 and $2.4 million for the three and nine months ended September 30, 2017, compared to $757,000 and $2.3 million for the 2016 three and nine month periods. Data processing costs fluctuate in conjunction with growth in the volume of loan and deposit accounts, combined with transaction activity volumes.

 

Total amortization of intangible assets, including MSRs and identifiable intangible assets, was $153,000 and $453,000 for the three and nine months ended September 30, 2017, compared to $137,000 and $402,000 for the 2016 three and nine month periods. Amortization of MSRs was $92,000 and $272,000 for the three and nine months ended September 30, 2017, compared to $66,000 and $189,000 for the 2016 three and nine month periods. The increase in the amortization of MSRs during the respective 2017 periods is primarily attributable to amortization expense associated with a $778,000 MSR portfolio purchased in the third quarter of 2016. Amortization of the core deposit intangible, which is the only identifiable intangible asset subject to amortization, was $60,000 and $181,000 for the three and nine months ended September 30, 2017, compared to $71,000 and $213,000 for the 2016 three and nine month periods. See “Note 11. Goodwill and Other Intangibles” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Total expenses attributable to the ongoing maintenance, property taxes, insurance and valuation adjustments for OREO properties were $2,000 and $272,000 for the three and nine months ended September 30, 2017, compared to $119,000 and $426,000 for the 2016 three and nine month periods. OREO valuation adjustments included therein were $15,000 and $192,000 for the three and nine months ended September 30, 2017, compared to none and $110,000 for the 2016 three and nine month periods. Management continuously analyzes the carrying value of OREO and makes valuation adjustments as necessary. See “Note 9. Other Real Estate Owned” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Other non-interest expense was $1.1 million and $3.9 million for the three and nine months ended September 30, 2017, compared to $1.3 million and $3.8 million for the 2016 three and nine month periods. Included in other non-interest expense for the three and six months ended September 30, 2017, is $109,000 and $387,000, respectively, of merger-related expenses discussed above. In addition, during the first quarter of 2017 and the first quarter of 2016, the Bank consolidated two and three existing branches, respectively, into nearby locations. Of the locations that were consolidated, four of the facilities are leased and one was owned. The Bank sold the owned location in first quarter of 2016 and realized an $85,000 pre-tax loss, which is included in other non-interest expense during that reporting period.

 

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Income tax expense totaled $1.4 million and $3.0 million for the three and nine months ended September 30, 2017, versus $947,000 and $2.2 million for the 2016 three and nine month periods. The effective income tax rates were 32.3% and 30.8% for the three and nine months ended September 30, 2017, compared to 33.3% and 30.6% for the for the 2016 three and nine month periods. The Bank’s investment in BOLI and tax-exempt municipal bonds contribute to more favorable effective income tax rates, which has been partially offset by the strong growth in the loan portfolio. See “Critical Accounting Policies” below for additional information.

 

Key Performance Ratios. Three of our key performance ratios are return on average assets (“ROA”), return on average equity (“ROE”) and the efficiency ratio. ROA improved to 1.09% and 0.88% for the three and nine months ended September 30, 2017, from 0.78% and 0.70% for the comparable 2016 three and nine month periods. ROE improved to 12.31% and 10.00% for the three and nine months ended September 30, 2017, from 8.52% and 7.69% for the comparable 2016 three and nine month periods. The efficiency ratio improved to 65.53% and 70.55% for the three and nine months ended September 30, 2017, from 73.84% and 77.31% for the comparable 2016 three and nine month periods. The efficiency ratio measures the proportion of net operating revenues that are absorbed by overhead expenses.

 

Liquidity and Capital Resources. Liquidity generally refers to the Bank's ability to generate adequate amounts of funds to meet its cash needs. Adequate liquidity guarantees that sufficient funds are available to meet deposit withdrawals, fund future loan commitments, maintain adequate reserve requirements, pay operating expenses, provide funds for debt service, and meet other general commitments. FDIC policy requires banks to maintain an average daily balance of liquid assets in an amount which it deems adequate to protect the safety and soundness of the Bank.

 

At September 30, 2017, the Bank had cash, deposits in other banks, investment securities and loans held for sale totaling $251.7 million, compared to $244.4 million at December 31, 2016. The Bank calculates its liquidity position under policy guidelines based on liquid assets in relationship to deposits and short-term borrowings. Based on its calculation guidelines, the Bank’s liquidity ratio was 19.8% at September 30, 2017, compared to 25.0% at December 31, 2016, which management believes is adequate.

 

The Bank believes it can meet liquidity needs with existing funding sources. The Bank's primary sources of funds are deposits, principal payments on loans and mortgage-backed securities, funds provided from operations, the ability to borrow from the FHLB of Atlanta and other lines of credit, and the availability of loans and investment securities available-for-sale. At September 30, 2017, the Bank had $265.0 million of credit availability with the FHLB, of which there was lendable collateral value totaling $222.9 million. Additional collateral would be required in order to access total borrowings up to the credit availability limit. In addition, at September 30, 2017, the Bank had additional capacity to borrow $116.9 million from the Federal Reserve Bank (“FRB”) Discount Window. At September 30, 2017, the Bank had $70.0 million of pre-approved, but unused lines of credit. See “Note 13. Borrowed Money” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial condition and results of operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company’s capital amounts and ratios are not significantly different from the Bank. The Bank was in compliance with all regulatory capital requirements at September 30, 2017, and December 31, 2016. See “Note 15. Regulatory Capital” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Contractual Obligations. In the normal course of business there are various outstanding contractual obligations of the Company that will require future cash outflows. Table 2 below reflects contractual obligations of the Company outstanding as of September 30, 2017.

 

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Table 2 – Contractual Obligations

 

   Payments Due by Period 
   Total  

Less Than 1

Year

   1-3 Years   3-5 Years  

More Than

5 Years

 
   (In thousands) 
Borrowed money (1)  $16,500   $5,000   $11,500   $-   $- 
Junior subordinated debentures (2)   10,310    -    -    -    10,310 
Lease obligations (3)   5,047    1,196    915    702    2,234 
Deposits (4)   945,288    846,467    77,438    21,383    - 
Total contractual obligations  $977,145   $852,663   $89,853   $22,085   $12,544 

 

(1)See “Note 13. Borrowed Money” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.
(2)See “Note 14. Junior Subordinated Debentures” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.
(3)See “Note 10. Premises and Equipment” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.
(4)See “Note 12. Deposits” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Critical Accounting Policies. The Company has identified the policies below as critical to its business operations and the understanding of its results of operations. The impact and any associated risks related to these policies on the Company’s business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect reported and expected financial results.

 

Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. Estimates affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Loan Impairment and Allowance for Loan and Lease Losses. A loan or lease is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or lease agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. The Bank uses several factors in determining if a loan is impaired. The internal asset classification procedures include a thorough review of significant lending relationships and include the accumulation of related data. This data includes loan and lease payment status, borrowers' financial data and borrowers' operating factors such as cash flows, operating income or loss, etc.

 

The ALLL is increased by charges to income and decreased by charge-offs, net of recoveries. Management's periodic evaluation of the adequacy of the ALLL is based on past loan and lease loss experience, known and inherent risks in loans and unfunded loan commitments, adverse situations that may affect a borrower's ability to repay, the estimated value of any underlying collateral, and current economic conditions. While management believes that it has established the ALLL in accordance with accounting principles generally accepted in the United States of America and has taken into account the views of its regulators and the current economic environment, there can be no assurance in the future that regulators or risks in its loans portfolio will not require additional adjustments to the ALLL.

 

Income Taxes. Deferred tax asset and liability balances are determined by application to temporary differences in the tax rate expected to be in effect when taxes will become payable or receivable. Temporary differences are differences between the tax basis of assets and liabilities and their reported amounts in the financial statements that will result in taxable or deductible amounts in future years. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.

 

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Off-Balance Sheet Arrangements. The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and involve elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The Company's exposure to credit loss in the event of non-performance by a party to a financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Table 3 below is a summary of the contractual amount of the Company’s exposure to off-balance sheet commitments.

 

Table 3 – Off Balance Sheet Arrangements

 

   September 30, 2017   December 31, 2016 
   (In Thousands) 
Commitments to originate loans  $104,825   $112,070 
Undrawn balances on lines of credit and credit reserves   56,811    54,186 
Standby letters of credit   655    487 
Total contractual obligations  $162,291   $166,743 

 

The reserve for unfunded commitments was $284,000 and $312,000 as of September 30, 2017 and December 31, 2016, respectively, which was recorded in other liabilities on the consolidated balance sheets.

 

Forward-Looking Statements. The Private Securities Litigation Reform Act of 1995 states that disclosure of forward-looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward-looking statements by corporate management. This Form 10-Q, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that involve risk and uncertainty. In order to comply with the terms of the safe harbor, the Company notes that a variety of risks and uncertainties could cause its actual results and experience to differ materially from anticipated results or other expectations expressed in the Company's forward-looking statements. There are risks and uncertainties that may affect the operations, performance, development, growth projections and results of the Company's business. They include, but are not limited to, difficulties and delays in integrating CARO’s and the Company’s businesses or fully realizing cost savings and other benefits; business disruption as a result of the Merger; customer acceptance of CARO products and services; potential difficulties encountered in expanding into a new market following the Merger; economic growth; interest rate movements; timely development of technology enhancements for products; services and operating systems; the impact of competitive products; services and pricing; customer requirements; regulatory changes and similar matters; and including without limitation other factors that could cause actual results to differ materially as discussed in documents filed by the Company with the Securities and Exchange Commission from time to time. Readers of this report are cautioned not to place undue reliance on forward-looking statements that are subject to influence by these risk factors and unanticipated events, as actual results may differ materially from management's expectations. The Company assumes no obligation and does not intend to update these forward-looking statements, except as required by law.

 

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Item 3. Quantitative and Qualitative Disclosures About Market Risk. The Company’s most significant market risk exposure is interest rate risk. The Company's primary goal in managing interest rate risk is to minimize the negative effect that changes in market interest rates have on earnings and capital. This goal is accomplished through the active management of the balance sheet. The goal of these activities is to structure the maturity and repricing of assets and liabilities to produce stable net interest income despite changing interest rates. The Company's overall interest rate risk position is governed by policies approved by the Board of Directors and guidelines established and monitored by the Bank’s Asset/Liability Management Committee (“ALCO”). To measure, monitor, and report on interest rate risk, the Company begins with two models: (1) net interest income (“NII) at risk, which measures the impact on NII over the next twelve and twenty-four months of immediate changes in interest rates and (2) net economic value of equity (“EVE”), which measures the impact on the present value of net assets of immediate changes in interest rates. NII at risk is designed to measure the potential short-term impact of changes in interest rates on NII. EVE is a long-term measure of interest rate risk to the Company's balance sheet, or equity. These models are subject to ALCO guidelines and are monitored regularly.

 

In calculating NII at risk, the Company begins with a base amount of NII that is projected over the next twelve and twenty four months, assuming the balance sheet is static and the yield curve remains unchanged over the period. The current yield curve is then “shocked,” or moved immediately, ±1.0 percent, ±2.0 percent, ±3.0 percent and ±4.0 percent in a parallel fashion, or at all points along the yield curve. New twelve and twenty four month NII projections are developed using the same balance sheet but with the new yield curves and these results are compared to the base scenario.

 

EVE at risk is based on the change in the present value of all assets and liabilities under different interest rate scenarios. The present value of existing cash flows with the current yield curve serves as the base case. The Company then applies an immediate parallel shock to that yield curve of ±1.0 percent, ±2.0 percent, ±3.0 percent and ±4.0 percent and recalculates the cash flows and related present values. Key assumptions used in the models described above include the timing of cash flows, the maturity and repricing of assets and liabilities, changes in market conditions, and interest rate sensitivities of the Company's non-maturity deposits with respect to interest rates paid and the level of balances. These assumptions are inherently uncertain and, as a result, the models cannot precisely calculate future NII or predict the impact of changes in interest rates on NII and EVE. Actual results could differ from simulated results due to the timing, magnitude and frequency of changes in interest rates and market conditions, changes in spreads and management strategies, among other factors. Projections of NII are assessed as part of the Company's forecasting process.

 

NII and EVE Analysis. Table 4 below presents the estimated exposure to NII for the next twelve months due to immediate changes in interest rates and the estimated exposure to EVE due to immediate changes in interest rates. All information is presented as of September 30, 2017.

 

Table 4 – NII and EVE Analysis

   September 30, 2017 
   Estimated Exposure
to NII
   Estimated Exposure to
EVE
 
Immediate change in interest rates:          
+ 4.0%   14.13%   8.28%
+ 3.0%   11.48    9.36 
+ 2.0%   7.46    9.37 
+ 1.0%   3.85    6.13 
No change        
- 1.0%   (6.96)   (12.14)

 

While the measures presented in the Table 4 are not a prediction of future NII or EVE valuations, they do suggest that if all other variables remained constant, immediate increases in interest rates at all points on the yield curve may produce higher NII in the short term. Other important factors that impact the levels of NII are balance sheet size and mix, interest rate spreads, the slope of the yield curve, the speed of interest rates changes, and management actions taken in response to the preceding conditions.

 

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Item 4.  Controls and Procedures. As of the end of the period covered by this report, management of the Company carried out an evaluation, under the supervision and with the participation of the Company’s principal executive officer and principal financial officer, of the effectiveness of the Company’s disclosure controls and procedures. Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s (the “SEC”) rules and forms. It should be noted that the design of the Company’s disclosure controls and procedures is based in part upon certain reasonable assumptions about the likelihood of future events, and there can be no reasonable assurance that any design of disclosure controls and procedures will succeed in achieving its stated goals under all potential future conditions, regardless of how remote, but the Company’s principal executive and financial officers have concluded that the Company’s disclosure controls and procedures are, in fact, effective at a reasonable assurance level. There have been no changes in the Company’s internal control over financial reporting, to the extent that elements of internal control over financial reporting are subsumed within disclosure controls and procedures, identified in connection with the evaluation described above that occurred during the Company’s last fiscal quarter, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

Item l. Legal Proceedings: The Company is currently not engaged in any material legal proceedings. From time to time, the Bank is a party to legal proceedings within the ordinary course of business wherein it enforces its security interest in loans, and other matters of similar nature.

 

Item 1A. Risk Factors: As previously discussed in this report, on November 1, 2017, the Company merged with and into CARO, with CARO as the surviving entity, subject to the terms and conditions set forth in an Agreement and Plan of Merger and Reorganization. In addition to the risk factors previously disclosed in the Company’s Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 2017, risk factors relating to the merger were also disclosed in the Company’s Quarterly Report on Form 10-Q for the Quarterly Period Ended June 30, 2017.

 

CARO’s and the Company’s respective businesses are subject to numerous risks and uncertainties, including the risks and uncertainties previously disclosed in the Company’s Quarterly Report on Form 10-Q for the Quarterly Periods Ended March 31, 2017 and June 30, 2017, respectively, and in CARO’s Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2016.

 

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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 following exhibits are filed herewith:

 

Number   Title
     
31.1   Rule 13a-14(a) Certification of Chief Executive Officer
     
31.2   Rule 13a-14(a) Certification of Chief Financial Officer
     
32   Section 1350 Certification
     
101   Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Statements of Financial Condition as of September 30, 2017 (unaudited) and December 31, 2016; (ii) Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2017 and 2016 (unaudited); (iii) Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2017 and 2016 (unaudited); (iv) Consolidated Statements of Changes in Stockholders’ Equity for the Nine Months Ended September 30, 2017 and 2016 (unaudited); (v) Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2017 and 2016 (unaudited); and (vi) Notes to Consolidated Financial Statements (unaudited) as of September 30, 2017 and December 31, 2016, and for the Three and Nine Months Ended September 30, 2017 and 2016.

 

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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    
(Successor to First South Bancorp, Inc.)    
     
/s/ Jerold L. Rexroad   /s/ William A. Gehman, III
Jerold L. Rexroad   William A. Gehman, III
President and Chief Executive Officer   Executive Vice President and Chief Financial Officer
Chief Executive Officer   Chief Financial Officer
(Principal Executive Officer)   (Principal Financial and Accounting Officer)
Date: November 9, 2017   Date: November 9, 2017

 

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