Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the quarterly period ended:

September 30, 2014

Commission File Number: 001-35302

 

 

Entegra Financial Corp.

(Exact name of Registrant as specified in its Charter)

 

 

 

North Carolina		45-2460660
(State of Incorporation)		(I.R.S. Employer Identification No.)
14 One Center Court,
Franklin, North Carolina		28734
(Address of principal executive offices)		(Zip Code)

(828) 524-7000

(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 Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).    Yes  x    No  ¨

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

 

Large accelerated filer		¨		Accelerated filer		¨
Non-accelerated filer		¨		Smaller reporting company		x

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: On November 10, 2014, 6,546,375 shares of the issuer’s common stock (no par value), were issued and outstanding.

 

 

 

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ENTEGRA FINANCIAL CORP. AND SUBSIDIARIES

FORM 10-Q

TABLE OF CONTENTS

 

				Page No.
PART I. FINANCIAL INFORMATION
Item 1.		Financial Statements			3
		Consolidated Balance Sheets – September 30, 2014 and December 31, 2013			3
		Consolidated Statements of Income – Three and Nine Months Ended September 30, 2014 and 2013			4
		Consolidated Statements of Comprehensive Income (Loss) – Three and Nine Months Ended September  30, 2014 and 2013			5
		Consolidated Statements of Changes in Shareholders’ Equity – Nine Months Ended September  30, 2014 and 2013			6
		Consolidated Statements of Cash Flows – Nine Months Ended September 30, 2014 and 2013			7
		Notes to Consolidated Financial Statements			9
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			42
Item 3.		Quantitative and Qualitative Disclosures about Market Risk			66
Item 4.		Controls and Procedures			68
PART II. OTHER INFORMATION					69
Item 1.		Legal Proceedings			69
Item 1A.		Risk Factors			69
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			69
Item 3.		Defaults Upon Senior Securities			69
Item 4.		Mine Safety Disclosures			69
Item 5.		Other Information			69
Item 6.		Exhibits			70
		Signatures			71

 

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Item 1. Financial Statements

 

ENTEGRA FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

 

		September 30, 2014				December 31, 2013
		(Unaudited)				(Audited)
Assets
Cash and due from banks		$	6,973			$	9,080
Interest-earning deposits			77,120				25,236
Cash and cash equivalents			84,093				34,316
Investments - available for sale			187,959				155,484
Investments - held to maturity (fair value of $26,564 and $20,098 at September 30, 2014 and December 31, 2013, respectively)			25,536				20,988
Other investments, at cost			4,012				3,659
Loans held for sale			12,427				5,688
Loans receivable			530,021				521,874
Allowance for loan losses			(11,772	)			(14,251	)
Fixed assets, net			13,139				13,006
Real estate owned			6,167				10,506
Interest receivable			3,007				2,673
Bank owned life insurance			20,302				19,961
Net deferred tax asset			2,434				4,210
Real estate held for investment			2,543				2,489
Loan servicing rights			2,064				1,883
Other assets			2,508				2,068
Total assets		$	884,440			$	784,554
Liabilities and Equity
Liabilities:
Deposits		$	710,673			$	684,226
Federal Home Loan Bank advances			40,000				40,000
Junior subordinated notes			14,433				14,433
Post employment benefits			9,850				10,199
Accrued interest payable			2,267				2,023
Other liabilities			2,888				1,155
Total liabilities			780,111				752,036
Commitments and contingencies (Note 10)
Equity:
Preferred stock - no par value, 10,000,000 shares authorized; none issued and outstanding			—				—
Common stock - no par value, 50,000,000 shares authorized; 6,546,375 and 0 shares issued and outstanding as of September 30, 2014 and December 31, 2013, respectively			—				—
Additional paid in capital			63,733				—
Retained earnings			44,635				39,994
Accumulated other comprehensive loss			(4,039	)			(7,476	)
Total equity			104,329				32,518
Total liabilities and equity		$	884,440			$	784,554

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

 

 

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ENTEGRA FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Dollars in thousands, except per share data)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013				2014				2013
Interest income:
Interest and fees on loans		$	6,694			$	6,794			$	21,072			$	20,972
Taxable securities			1,024				939				2,976				2,427
Tax-exempt securities			85				92				270				277
Interest-earning deposits			21				5				49				22
Other			89				15				136				52
Total interest and dividend income			7,913				7,845				24,503				23,750
Interest expense:
Deposits			1,362				1,420				4,051				4,418
Federal Home Loan Bank advances			178				158				526				517
Junior subordinated notes			207				123				382				367
Total interest expense			1,747				1,701				4,959				5,302
Net interest income			6,166				6,144				19,544				18,448
Provision for loan losses			16				564				27				2,152
Net interest income after provision for loan losses			6,150				5,580				19,517				16,296
Noninterest income:
Servicing income (expense), net			66				(48	)			492				(144	)
Mortgage banking			177				399				660				1,836
Gain (loss) on sale of investments, net			273				(2	)			652				96
Other than temporary impairment on cost method investment			—				—				(76	)			—
Overdraft fees			261				287				769				852
Interchange fees			295				268				836				746
Bank owned life insurance			131				141				389				412
Other			229				168				639				602
Total noninterest income			1,432				1,213				4,361				4,400
Noninterest expenses:
Compensation and employee benefits			2,936				2,811				8,974				8,565
Net occupancy			655				609				1,964				1,890
Federal deposit insurance			275				425				971				1,267
Professional and advisory			149				196				529				416
Data processing			272				221				774				666
Net cost of operation of real estate owned			590				1,084				2,034				3,574
Other			716				701				2,128				1,990
Total noninterest expenses			5,593				6,047				17,374				18,368
Income before taxes			1,989				746				6,504				2,328
Income tax expense			107				46				1,863				475
Net income		$	1,882			$	700			$	4,641			$	1,853
Earnings per share - basic and diluted		$	0.29				n/a			$	0.71				n/a
Average shares outstanding - basic and diluted			6,546,375				n/a				6,546,375				n/a

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

 

 

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ENTEGRA FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

(Dollars in thousands)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013				2014				2013
Net income		$	1,882			$	700			$	4,641			$	1,853
Other comprehensive income (loss):
Change in unrealized holding gains and losses on securities available for sale			(505	)			(1,650	)			3,939				(7,947	)
Reclassification adjustment for securities gains realized in net income			(273	)			2				(652	)			(96	)
Amortization of unrealized loss on securities transferred to held to maturity			50				—				150				—
Change in deferred tax valuation allowance attributable to unrealized gains and losses on investment securities available for sale			(278	)			(420	)			1,315				(2,652	)
Other comprehensive income (loss), before tax			(1,006	)			(2,068	)			4,752				(10,695	)
Income tax effect related to items of other comprehensive income (loss)			278				518				(1,315	)			3,177
Other comprehensive income (loss), after tax			(728	)			(1,550	)			3,437				(7,518	)
Comprehensive income (loss)		$	1,154			$	(850	)		$	8,078			$	(5,665	)

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

 

 

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ENTEGRA FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Unaudited)

Nine Months Ended September 30, 2014 and September 30, 2013

(Dollars in thousands)

 

		Common Stock				Additional Paid in Capital				Retained Earnings				Accumulated Other Comprehensive Income (loss)				Total
Balance, January 1, 2013		$	—			$	—			$	40,409			$	1,885			$	42,294
Net income			—				—				1,853				—				1,853
Other comprehensive loss, net of tax			—				—				—				(7,518	)			(7,518	)
Balance, September 30, 2013		$	—			$	—			$	42,262			$	(5,633	)		$	36,629
Balance, January 1, 2014		$	—			$	—			$	39,994			$	(7,476	)		$	32,518
Net income			—				—				4,641				—				4,641
Other comprehensive income, net of tax			—				—				—				3,437				3,437
Issuance of common stock			—				65,464				—				—				65,464
Common stock issuance costs			—				(1,731	)			—				—				(1,731	)
Balance, September 30, 2014		$	—			$	63,733			$	44,635			$	(4,039	)		$	104,329

The accompanying notes are an integral part of the consolidated financial statements

 

 

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ENTEGRA FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Dollars in thousands)

 

		Nine Months Ended September 30,
		2014				2013
Operating activities:
Net income		$	4,641			$	1,853
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation			652				632
Security amortization, net			817				1,199
Provision for loan losses			27				2,152
Provision for real estate owned			1,508				2,387
Deferred income tax expense			1,713				475
Net increase (decrease) in deferred loan fees			302				(195	)
Gain on sales of securities available for sale			(652	)			(96	)
Other than temporary impairment on cost method investment			76				—
Income on bank owned life insurance, net			(389	)			(412	)
Mortgage banking income, net			(660	)			(1,836	)
Net realized loss on sale of real estate owned			49				121
Loans originated for sale			(22,228	)			(54,062	)
Proceeds from sale of loans originated for sale			16,113				56,584
Net change in operating assets and liabilities:
Interest receivable			(334	)			(98	)
Loan servicing rights			(181	)			106
Other assets			(440	)			(673	)
Postemployment benefits			(349	)			(495	)
Accrued interest payable			244				436
Other liabilities			863				1,138
Net cash provided by operating activities		$	1,772			$	9,216

 

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ENTEGRA FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited), continued

(Dollars in thousands)

 

		Nine Months Ended September 30,
		2014				2013
Investing activities:
Activity for investments available for sale:
Purchases		$	(72,408	)		$	(93,129	)
Maturities/calls and principal repayments			19,600				28,938
Sales			18,833				4,180
Net (increase) decrease in loans			(10,930	)			28,270
Proceeds from sale of real estate owned			3,157				6,690
Real estate cost capitalized			(59	)			(118	)
Purchase of fixed assets			(885	)			(418	)
Purchase of other investments, at cost			(562	)			—
Redemptions of other investments, at cost			209				388
Net cash used in investing activities		$	(43,045	)		$	(25,199	)
Financing activities:
Net increase in deposits		$	26,447			$	7,755
Net increase in escrow deposits			870				741
Proceeds from FHLB advances			—				1,000
Repayment of FHLB advances			—				(1,000	)
Proceeds from sale of common stock			63,733				—
Net cash provided by financing activities		$	91,050			$	8,496
Increase (decrease) in cash and cash equivalents			49,777				(7,487	)
Cash and cash equivalents, beginning of period		$	34,316			$	25,362
Cash and cash equivalents, end of period		$	84,093			$	17,875
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest on deposits and other borrowings		$	4,715			$	5,350
Income taxes			150				—
Noncash investing and financing activities:
Real estate acquired in satisfaction of mortgage loans		$	1,516			$	8,141
Loans originated for disposition of real estate owned			1,249				1,186
Transfer of investment securities available for sale to held to maturity			4,399				—

 

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ENTEGRA FINANCIAL CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1. ORGANIZATION AND BASIS OF PRESENTATION

Organization

Entegra Financial Corp. (the “Company”) was incorporated on May 31, 2011 and became the holding company for Macon Bank, Inc. (the “Bank”) on September 30, 2014 upon the completion of Macon Bancorp’s merger with and into the Company, pursuant to which Macon Bancorp converted from the mutual to stock form of organization. The Company’s primary operation is its investment in the Bank. The Company also owns 100% of the common stock of Macon Capital Trust I, a Delaware statutory trust formed in 2003 to facilitate the issuance of trust preferred securities. The Bank is a North Carolina state-chartered savings bank and has a wholly owned subsidiary, Macon Services, Inc., which owns a real estate investment property. The consolidated financials are presented in these financial statements.

The Bank operates as a community-focused retail bank, originating primarily real estate based mortgage, consumer and commercial loans and accepting deposits from consumers and small businesses.

Estimates

The preparation of consolidated financial statements requires management to make estimates and assumptions that 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.

Material estimates that are particularly susceptible to significant change, in the near term, relate to the determination of the allowance for loan losses and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowance for loan losses and the valuation of foreclosed real estate, management obtains independent appraisals for significant properties.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the Company, the Bank, and its wholly owned subsidiary. The accounts of Macon Capital Trust I are not consolidated with the Company. In consolidation all significant intercompany accounts and transactions have been eliminated.

Reclassification

Certain amounts in the prior years’ financial statements may have been reclassified to conform to the current year’s presentation. The reclassifications had no significant effect on our results of operation or financial condition as previously reported.

Basis of Presentation

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP, for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements and should be read in conjunction with our Registration Statement on Form S-1, as amended, filed with the SEC on July 18, 2014. In the opinion of management, these interim financial statements present fairly, in all material respects, the Company’s consolidated financial position and results of operations for each of the interim periods presented. Results of operations for interim periods are not necessarily indicative of the results of operations that may be expected for a full year or any future period.

Recent Accounting Standards Updates

In January 2014, the Financial Accounting Standards Board (“FASB”) amended the Receivables topic of the Accounting Standards Codification. The amendments are intended to resolve diversity in practice with respect to when a creditor should reclassify a collateralized consumer mortgage loan to real estate owned. In addition, the amendments require a creditor to reclassify a collateralized consumer mortgage loan to REO upon obtaining legal title to the real estate collateral, or the borrower voluntarily conveying its interest in the real estate collateral to the creditor to satisfy the loan through a deed in lieu of foreclosure or similar legal agreement. As an emerging growth company, the amendments will be effective for the Company for annual periods beginning after December 15, 2014,

 

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and interim periods within annual periods beginning after December 15, 2015. For non-emerging growth companies, the amendments will be effective for annual periods, and interim periods within those annual periods beginning after December 15, 2014. Early implementation of the guidance is permitted. In implementing this guidance, assets that are reclassified from real estate to loans are measured at the carrying value of the real estate at the date of adoption. Assets reclassified from loans to real estate are measured at the lower of the net amount of the loan receivable or the fair value of the real estate less costs to sell at the date of adoption. The Company will apply the amendments prospectively. The Company does not expect these amendments to have a material effect on its financial statements.

In August 2014, the FASB issued guidance that is intended to define management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern and to provide related footnote disclosures. In connection with preparing financial statements, management will need to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the organization’s ability to continue as a going concern within one year after the date that the financial statements are issued. The amendments will be effective for the Company for annual periods ending after December 15, 2016, and for annual and interim periods thereafter. The Company does not expect these amendments to have a material effect on its financial statements.

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

NOTE 2. STOCK CONVERSION AND CHANGE IN CORPORATE FORM

 

On January 23, 2014, the Board of Directors of Macon Bancorp adopted a Plan of Conversion (the “Plan of Conversion”) which provided for the reorganization of Macon Bancorp from a North Carolina chartered mutual holding company into a stock holding company, Entegra Financial Corp., incorporated under the laws of the State of North Carolina (the “Conversion”).

In connection with the Conversion, the Company sold 6,546,375 shares of common stock at an offering price of $10.00 per share and received gross sales proceeds of $65.5 million. The Company recognized $1.7 million in reorganization and stock issuance costs as of September 30, 2014 which have been deducted from the gross sales proceeds. Of the $63.7 million in net sales proceeds, $44.6 million, or approximately 70%, was contributed to the capital of the Bank upon completion of the Conversion on September 30, 2014.

 

Common Stock Offering Summary
(Dollars in thousands)
Gross proceeds		$	65,464
Issuance costs			(1,731	)
Net proceeds		$	63,733
Contributed to bank subsidiary		$	44,581
Retained by the Company			19,152
		$	63,733

On September 30, 2014, liquidation accounts were established by the Company and the Bank for the benefit of eligible depositors of the Bank as defined in the Plan of Conversion. Each eligible depositor will have a pro rata interest in the liquidation accounts for each of his or her deposit accounts based upon the proportion that the balance of each such account bears to the balance of all deposit accounts of the Bank as of the dates specified in the Plan of Conversion. The liquidation accounts will be maintained for the benefit of eligible depositors who continue to maintain their deposit accounts in the Bank. The liquidation accounts will be reduced annually to the extent that eligible depositors reduce their qualifying deposits. In the unlikely event of a complete liquidation of the Bank or the Company or both, and only in such event, eligible depositors who continue to maintain accounts will be entitled to receive a distribution from the liquidation accounts before any distribution may be made with respect to common stock. Neither the Company nor the Bank may declare or pay a cash dividend if the effect thereof would cause its equity to be reduced below either the amount required for the liquidation accounts or the regulatory capital requirements imposed by the Company’s or the Bank’s regulators.

 

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NOTE 3. INVESTMENT SECURITIES

 

The amortized cost and estimated fair values of securities available for sale as of September 30, 2014 and December 31, 2013 are summarized as follows:

 

		September 30, 2014
		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
		(Dollars in thousands)
Agency		$	34,108			$	6			$	(339	)		$	33,775
Municipal			23,443				150				(333	)			23,260
Mortgage-backed			131,923				282				(1,864	)			130,341
Mutual fund			586				—				(3	)			583
		$	190,060			$	438			$	(2,539	)		$	187,959

 

		December 31, 2013
		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
		(Dollars in thousands)
Agency		$	22,977			$	—			$	(1,078	)		$	21,899
Municipal			26,963				114				(1,475	)			25,602
Mortgage-backed			110,431				574				(3,590	)			107,415
Mutual fund			576				—				(8	)			568
		$	160,947			$	688			$	(6,151	)		$	155,484

 

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The amortized cost and estimated fair values of securities held to maturity (“HTM”) as of September 30, 2014 and December 31, 2013 are summarized as follows:

 

		September 30, 2014
		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
		(Dollars in thousands)
Agency		$	21,141			$	858			$	—			$	21,999
Municipal			4,395				173				(3	)			4,565
		$	25,536			$	1,031			$	(3	)		$	26,564

 

		December 31, 2013
		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
		(Dollars in thousands)
Agency		$	20,988			$	—			$	(890	)		$	20,098

During the nine months ended September 30, 2014 and year ended December 31, 2013, the Bank transferred the following investment securities from available for sale to held to maturity:

 

		At Date of Transfer
		During the Nine Months Ended
		September 30, 2014
		(Dollars in thousands)
Book value		$	4,473
Market value			4,399
Unrealized loss		$	74

 

		At Date of Transfer
		During the Year Ended
		December 31, 2013
		(Dollars in thousands)
Book value		$	23,000
Market value			20,954
Unrealized loss		$	2,046

There were no transfers of investment securities from available for sale to held to maturity during the three months ended September 30, 2014.

 

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Information pertaining to the activity for the three month and nine month periods ended September 30, 2014 and 2013 of unrealized losses related to HTM securities previously recognized in other comprehensive income (“OCI”) is summarized below:

 

		For the three months ended September 30								For the nine months ended September 30
(Dollars in thousands)		2014				2013				2014				2013
Beginning unrealized loss related to HTM securities previously recognized in OCI		$	1,986			$	—			$	2,012			$	—
Additions for transfers to HTM			—				—				74				—
Amortization of unrealized losses on HTM securities previously recognized in OCI			(50	)			—				(150	)			—
Ending unrealized loss in OCI related to HTM securities previously recognized in OCI		$	1,936			$	—			$	1,936			$	—

Information pertaining to securities with gross unrealized losses at September 30, 2014 and December 31, 2013, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:

 

		September 30, 2014
		Less Than 12 Months								More Than 12 Months								Total
		Fair Value				Unrealized Losses				Fair Value				Unrealized Losses				Fair Value				Unrealized Losses
		(Dollars in thousands)
Held to Maturity:
Municipal		$	585			$	3			$	—			$	—			$	585			$	3
Available for Sale:
Agency		$	14,078			$	68			$	13,729			$	271			$	27,807			$	339
Municipal			3,242				56				13,185				277				16,427				333
Mortgage-backed			42,913				293				45,667				1,571				88,580				1,864
Mutual fund			586				3				—				—				586				3
		$	61,404			$	423			$	72,581			$	2,119			$	133,985			$	2,542

 

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		December 31, 2013
		Less Than 12 Months								More Than 12 Months								Total
		Fair Value				Unrealized Losses				Fair Value				Unrealized Losses				Fair Value				Unrealized Losses
		(Dollars in thousands)
Held to Maturity:
Agency		$	20,098			$	890			$	—			$	—			$	20,098			$	890
Available for Sale:
Agency		$	21,899			$	1,078			$	—			$	—			$	21,899			$	1,078
Municipal			18,653				1,201				2,409				274				21,062				1,475
Mortgage-backed			73,836				2,655				9,926				935				83,762				3,590
Mutual fund			568				8				—				—				568				8
		$	135,054			$	5,832			$	12,335			$	1,209			$	147,389			$	7,041

Information pertaining to the number of securities with unrealized losses is detailed in the table below. Management of the Company believes all unrealized losses as of September 30, 2014 and December 31, 2013 represent temporary impairment. The unrealized losses have resulted from temporary changes in the interest rate market and not as a result of credit deterioration. We do not intend to sell and it is not likely that we will be required to sell any of the securities referenced in the table below before recovery of their amortized cost.

 

		September 30, 2014
		Less Than 12 Months				More Than 12 Months				Total
Agency securities			8				5				13
Municipal securities			9				28				37
Mortgage-backed			34				25				59
Mutual fund			1				—				1
			52				58				110
		December 31, 2013
		Less Than 12 Months				More Than 12 Months				Total
Agency securities			17				—				17
Municipal securities			43				5				48
Mortgage-backed			40				8				48
Mutual fund			1				—				1
			101				13				114

 

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For the three and nine months ended September 30, 2014 and 2013 the Company had proceeds from sales of securities available for sale and their corresponding gross realized gains and losses as detailed below:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013				2014				2013
		(Dollars in thousands)
Gross proceeds		$	3,408			$	50			$	18,833			$	4,180
Gross realized gains			301				—				680				98
Gross realized losses			(28	)			(2	)			(28	)			(2	)

The Bank had securities pledged against deposits of approximately $10.8 million and $6.8 million at September 30, 2014 and December 31, 2013, respectively.

The amortized cost and estimated fair value of investments in debt securities at September 30, 2014, by contractual maturity, is shown below. Mortgage-backed securities have not been scheduled because expected maturities will differ from contractual maturities when borrowers have the right to prepay the obligations.

 

		Available for Sale
		Amortized Cost				Fair Value
		(Dollars in thousands)
Over 1 year through 5 years		$	16,164			$	16,092
After 5 years through 10 years			23,436				23,093
Over 10 years			18,537				18,433
			58,137				57,618
Mortgage-backed securities			131,923				130,341
Total		$	190,060			$	187,959
		Held to Maturity
		Amortized Cost				Fair Value
		(Dollars in thousands)
Over 10 years		$	25,536			$	26,564
Total		$	25,536			$	26,564

 

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NOTE 4. LOANS RECEIVABLE

 

Loans receivable as of September 30, 2014 and December 31, 2013 are summarized as follows:

 

		September 30, 2014				December 31, 2013
		(Dollars in thousands)
Real estate mortgage loans:
One-to four-family residential		$	230,245			$	225,520
Commercial real estate			172,350				155,633
Home equity loans and lines of credit			56,577				56,836
Residential construction			8,257				8,952
Other construction and land			51,644				64,927
Total real estate loans			519,073				511,868
Commercial and industrial			10,919				8,285
Consumer			3,236				3,654
Total commercial and consumer			14,155				11,939
Loans receivable, gross			533,228				523,807
Less: Net deferred loan fees			(1,631	)			(1,933	)
Unamortized discount			(1,576	)			—
Loans receivable, net		$	530,021			$	521,874

The Bank had $116.4 million and $107.1 million of loans pledged as collateral to secure funding with the Federal Home Loan Bank of Atlanta (“FHLB”) at September 30, 2014 and December 31, 2013, respectively. The Bank also had $90.7 million and $97.7 million of loans pledged as collateral to secure funding with the Federal Reserve Bank (“FRB”) Discount Window at September 30, 2014 and December 31, 2013, respectively.

During January 2014, the Bank purchased the remaining participation balance of certain commercial real estate loans from the Federal Deposit Insurance Corporation (“FDIC”). The Bank had previously originated the loans and sold a 50% participation to an institution that was subsequently taken into receivership by the FDIC. At the date of purchase, the outstanding loan balance purchased was $9.3 million and the loans were purchased at a total discount of $2.6 million. Subsequent to the transaction, $2.8 million of the participation balance purchased was repaid, resulting in the Bank recognizing approximately $0.6 million of the initial discount, in addition to recognizing $0.3 million of previously collected but deferred interest. In addition, the Bank restructured a $1.8 million loan in the second quarter of 2014 and recognized $0.2 million of the discount in interest income.

 

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The following tables present the activity related to the discount on purchased loans for the three and nine month periods ended September 30, 2014 and 2013:

 

		For the three months ended September 30								For the nine months ended September 30
(Dollars in thousands)		2014				2013				2014				2013
Discount on purchased loans, beginning of period		$	1,665			$	—			$	—			$	—
Additional discount for new purchases			—				—				2,607				—
Accretion			(89	)							(276	)
Interest income recognized for repayments and restructurings			—				—				(755	)			—
Discount on purchased loans, end of period		$	1,576			$	—			$	1,576			$	—

NOTE 5. ALLOWANCE FOR LOAN LOSSES

 

The following tables present, by portfolio segment, the changes in the allowance for loan losses for the three months ended September 30, 2014 and 2013, the nine months ended September 30, 2014 and 2013, and the year ended December 31, 2013:

 

		Three Months Ended September 30, 2014
		One-to four Family Residential				Commercial Real Estate				Home Equity and Lines of Credit				Residential Construction				Other Construction and Land				Commercial				Consumer				Total
		(Dollars in thousands)
Beginning balance		$	3,182			$	2,846			$	1,146			$	487			$	3,257			$	304			$	339			$	11,561
Provision			65				(43	)			215				82				(343	)			118				(78	)			16
Charge-offs			109				3				26				—				10				3				59				210
Recoveries			165				6				5				—				113				4				112				405
Ending balance		$	3,303			$	2,806			$	1,340			$	569			$	3,017			$	423			$	314			$	11,772
		Three Months Ended September 30, 2013
		One-to four Family Residential				Commercial Real Estate				Home Equity and Lines of Credit				Residential Construction				Other Construction and Land				Commercial				Consumer				Total
		(Dollars in thousands)
Beginning balance		$	4,364			$	2,587			$	2,014			$	430			$	3,707			$	337			$	247			$	13,686
Provision			233				443				(113	)			88				(188	)			(25	)			126				564
Charge-offs			505				341				26				65				189				—				154				1,280
Recoveries			74				44				2				98				59				7				56				340
Ending balance		$	4,166			$	2,733			$	1,877			$	551			$	3,389			$	319			$	275			$	13,310

 

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		Nine Months Ended September 30, 2014
		One-to four Family Residential				Commercial Real Estate				Home Equity and Lines of Credit				Residential Construction				Other Construction and Land				Commercial				Consumer				Total
		(Dollars in thousands)
Beginning balance		$	3,693			$	4,360			$	1,580			$	501			$	3,516			$	336			$	265			$	14,251
Provision			47				106				78				68				(213	)			56				(115	)			27
Charge-offs			625				2,001				357				—				485				128				122				3,718
Recoveries			188				341				39				—				199				159				286				1,212
Ending balance		$	3,303			$	2,806			$	1,340			$	569			$	3,017			$	423			$	314			$	11,772
		Nine Months Ended September 30, 2013
		One-to four Family Residential				Commercial Real Estate				Home Equity and Lines of Credit				Residential Construction				Other Construction and Land				Commercial				Consumer				Total
		(Dollars in thousands)
Beginning balance		$	4,620			$	2,973			$	2,002			$	429			$	4,059			$	379			$	412			$	14,874
Provision			360				1,312				271				204				142				(68	)			(69	)			2,152
Charge-offs			1,146				1,677				417				193				910				17				410				4,770
Recoveries			332				125				21				111				98				25				342				1,054
Ending balance		$	4,166			$	2,733			$	1,877			$	551			$	3,389			$	319			$	275			$	13,310
		Year Ended December 31, 2013
		One-to four Family Residential				Commercial Real Estate				Home Equity and Lines of Credit				Residential Construction				Other Construction and Land				Commercial				Consumer				Total
		(Dollars in thousands)
Beginning balance		$	4,620			$	2,973			$	2,002			$	429			$	4,059			$	379			$	412			$	14,874
Provision			(77	)			3,471				316				154				430				(57	)			121				4,358
Charge-offs			1,283				2,209				760				193				1,512				17				675				6,649
Recoveries			433				125				22				111				539				31				407				1,668
Ending balance		$	3,693			$	4,360			$	1,580			$	501			$	3,516			$	336			$	265			$	14,251

The following tables present, by portfolio segment and reserving methodology, the allocation of the allowance for loan losses and the gross investment in loans as of September 30, 2014 and December 31, 2013:

 

		September 30, 2014
		One-to four Family Residential				Commercial Real Estate				Home Equity and Lines of Credit				Residential Construction				Other Construction and Land				Commercial				Consumer				Total
		(Dollars in thousands)
Allowance for loan losses
Individually evaluated for impairment		$	816			$	158			$	31			$	—			$	178			$	12			$	—			$	1,195
Collectively evaluated for impairment			2,487				2,648				1,309				569				2,839				411				314				10,577
Balance, end of period		$	3,303			$	2,806			$	1,340			$	569			$	3,017			$	423			$	314			$	11,772
Loans Receivable
Individually evaluated for impairment		$	9,946			$	18,718			$	2,050			$	—			$	6,331			$	347			$	—			$	37,392
Collectively evaluated for impairment			220,299				153,632				54,527				8,257				45,313				10,572				3,236				495,836
		$	230,245			$	172,350			$	56,577			$	8,257			$	51,644			$	10,919			$	3,236			$	533,228

 

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		December 31, 2013
		One-to four Family Residential				Commercial Real Estate				Home Equity and Lines of Credit				Residential Construction				Other Construction and Land				Commercial				Consumer				Total
		(Dollars in thousands)
Allowance for loan losses
Individually evaluated for impairment		$	1,152			$	2,329			$	168			$	—			$	318			$	101			$	—			$	4,068
Collectively evaluated for impairment			2,541				2,031				1,412				501				3,198				235				265				10,183
Balance, end of year		$	3,693			$	4,360			$	1,580			$	501			$	3,516			$	336			$	265			$	14,251
Loans Receivable
Individually evaluated for impairment		$	9,865			$	20,943			$	1,612			$	—			$	7,119			$	531			$	—			$	40,070
Collectively evaluated for impairment			215,655				134,690				55,224				8,952				57,808				7,754				3,654				483,737
		$	225,520			$	155,633			$	56,836			$	8,952			$	64,927			$	8,285			$	3,654			$	523,807

Portfolio Quality Indicators

The Bank’s portfolio grading analysis estimates the capability of the borrower to repay the contractual obligations of the loan agreements as scheduled. The Bank’s internal credit risk grading system is based on experiences with similarly graded loans, industry best practices, and regulatory guidance. Credit risk grades are refreshed each quarter, at which time management analyzes the resulting information, as well as other external statistics and factors, to track loan performance.

The Bank’s internally assigned grades pursuant to the Board-approved lending policy are as follows:

 

•

Pass (1-5) – Acceptable loans with any identifiable weaknesses appropriately mitigated.

 

•

Special Mention (6) – Potential weakness or identifiable weakness present without appropriate mitigating factors; however, loan continues to perform satisfactorily with no material delinquency noted. This may include some deterioration in repayment capacity and/or loan-to-value of securing collateral.

 

•

Substandard (7) – Significant weakness that remains unmitigated, most likely due to diminished repayment capacity, serious delinquency, and/or marginal performance based upon restructured loan terms.

 

•

Doubtful (8) – Significant weakness that remains unmitigated and collection in full is highly questionable or improbable.

 

•

Loss (9) – Collectability is unlikely resulting in immediate charge-off.

Description of segment and class risks

Each of our portfolio segments and the classes within those segments are subject to risks that could have an adverse impact on the credit quality of our loan portfolio. Management has identified the most significant risks as described below which are generally similar among our segments and classes. While the list in not exhaustive, it provides a description of the risks that management has determined are the most significant.

One-to four family residential

We centrally underwrite each of our one-to four family residential loans using credit scoring and analytical tools consistent with the Board-approved lending policy and internal procedures based upon industry best practices and regulatory directives. Loans to be sold to secondary market investors must also adhere to investor guidelines. We also evaluate the value and marketability of that collateral. Common risks to each class of non-commercial loans, including one-to-four family residential, include risks that are not specific to individual transactions such as general economic conditions within our markets, particularly unemployment and potential declines in real estate values. Personal events such as death, disability or change in marital status also add risk to non-commercial loans.

 

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Commercial real estate

Commercial mortgage loans are primarily dependent on the ability of our customers to achieve business results consistent with those projected at loan origination resulting in cash flow sufficient to service the debt. To the extent that a customer’s business results are significantly unfavorable versus the original projections, the ability for our loan to be serviced on a basis consistent with the contractual terms may be at risk. While these loans are secured by real property and possibly other business assets such as inventory or accounts receivable, it is possible that the liquidation of the collateral will not fully satisfy the obligation. Other commercial real estate loans consist primarily of loans secured by multifamily housing and agricultural loans. The primary risk associated with multifamily loans is the ability of the income-producing property that collateralizes the loan to produce adequate cash flow to service the debt. High unemployment or generally weak economic conditions may result in our customer having to provide rental rate concessions to achieve adequate occupancy rates. The performance of agricultural loans are highly dependent on favorable weather, reasonable costs for seed and fertilizer, and the ability to successfully market the product at a profitable margin. The demand for these products is also dependent on macroeconomic conditions that are beyond the control of the borrower.

Home equity and lines of credit

Home equity loans are often secured by first or second liens on residential real estate, thereby making such loans particularly susceptible to declining collateral values. A substantial decline in collateral value could render our second lien position to be effectively unsecured. Additional risks include lien perfection inaccuracies and disputes with first lienholders that may further weaken our collateral position. Further, the open-end structure of these loans creates the risk that customers may draw on the lines in excess of the collateral value if there have been significant declines since origination.

Residential construction and other construction and land

Residential mortgage construction loans are typically secured by undeveloped or partially developed land with funds to be disbursed as home construction is completed contingent upon receipt and satisfactory review of invoices and inspections. Declines in real estate values can result in residential mortgage loan borrowers having debt levels in excess of the collateral’s current market value. Non-commercial construction and land development loans can experience delays in completion and/or cost overruns that exceed the borrower’s financial ability to complete the project. Cost overruns can result in foreclosure of partially completed collateral with unrealized value and diminished marketability. Commercial construction and land development loans are dependent on the supply and demand for commercial real estate in the markets we serve as well as the demand for newly constructed residential homes and building lots. Deterioration in demand could result in significant decreases in the underlying collateral values and make repayment of the outstanding loans more difficult for our customers.

Commercial

We centrally underwrite each of our commercial loans based primarily upon the customer’s ability to generate the required cash flow to service the debt in accordance with the contractual terms and conditions of the loan agreement. We strive to gain a complete understanding of our borrower’s businesses including the experience and background of the principals. To the extent that the loan is secured by collateral, which is a predominant feature of the majority of our commercial loans, or other assets including accounts receivable and inventory, we gain an understanding of the likely value of the collateral and what level of strength it brings to the loan transaction. To the extent that the principals or other parties are obligated under the note or guaranty agreements, we analyze the relative financial strength and liquidity of each guarantor. Common risks to each class of commercial loans include risks that are not specific to individual transactions such as general economic conditions within our markets, as well as risks that are specific to each transaction including volatility or seasonality of cash flows, changing demand for products and services, personal events such as death, disability or change in marital status, and reductions in the value of our collateral.

 

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Consumer

The consumer loan portfolio includes loans secured by personal property such as automobiles, marketable securities, other titled recreational vehicles including boats and motorcycles, as well as unsecured consumer debt. The value of underlying collateral within this class is especially volatile due to potential rapid depreciation in values since date of loan origination in excess of principal repayment.

The following tables present the recorded investment in gross loans, by loan grade, as of September 30, 2014 and December 31, 2013.

 

September 30, 2014
Loan Grade		One-to Four- Family Residential				Commercial Real Estate				Home Equity and Lines of Credit				Residential Construction				Other Construction and Land				Commercial				Consumer				Total
		(Dollars in thousands)
1		$	—			$	69			$	—			$	—			$	—			$	—			$	20			$	89
2			—				—				—				—				—				100				—				100
3			64,834				14,777				6,019				27				5,339				485				469				91,950
4			60,412				32,826				10,356				3,453				7,617				2,776				490				117,930
5			43,012				87,523				10,368				1,914				19,989				5,846				180				168,832
6			6,944				20,737				1,092				1,116				2,507				1,164				2				33,562
7			7,399				16,418				1,812				—				8,659				548				—				34,836
		$	182,601			$	172,350			$	29,647			$	6,510			$	44,111			$	10,919			$	1,161			$	447,299
Ungraded Loan Exposure:
Performing		$	46,088			$	—			$	26,598			$	1,682			$	7,255			$	—			$	2,075			$	83,698
Nonperforming			1,556				—				332				65				278				—				—				2,231
Subtotal		$	47,644			$	—			$	26,930			$	1,747			$	7,533			$	—			$	2,075			$	85,929
Total		$	230,245			$	172,350			$	56,577			$	8,257			$	51,644			$	10,919			$	3,236			$	533,228

 

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December 31, 2013
Loan Grade		One-to Four- Family Residential				Commercial Real Estate				Home Equity and Lines of Credit				Residential Construction				Other Construction and Land				Commercial				Consumer				Total
		(Dollars in thousands)
1		$	—			$	—			$	—			$	—			$	—			$	176			$	—			$	176
2			—				—				—				—				—				100				—				100
3			73,574				11,960				6,720				607				6,241				598				477				100,177
4			64,548				28,164				12,250				2,670				14,489				1,000				231				123,352
5			41,272				72,975				11,625				1,555				25,926				4,232				855				158,440
6			10,362				18,167				1,578				1,723				4,331				1,495				14				37,670
7			10,503				24,346				1,953				—				9,626				590				1				47,019
		$	200,259			$	155,612			$	34,126			$	6,555			$	60,613			$	8,191			$	1,578			$	466,934
Ungraded Loan Exposure:
Performing		$	25,261			$	21			$	22,710			$	2,397			$	4,314			$	94			$	2,076			$	56,873
Nonperforming			—				—				—				—				—				—				—				—
Subtotal		$	25,261			$	21			$	22,710			$	2,397			$	4,314			$	94			$	2,076			$	56,873
Total		$	225,520			$	155,633			$	56,836			$	8,952			$	64,927			$	8,285			$	3,654			$	523,807

Delinquency Analysis of Loans by Class

The following tables include an aging analysis of the recorded investment of past-due financing receivables by class as of September 30, 2014 and December 31, 2013. The Bank does not accrue interest on loans greater than 90 days past due.

 

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		September 30, 2014
		30-59 Days Past Due				60-89 Days Past Due				90 Days and Over Past Due				Total Past Due				Current				Total Loans Receivable
		(Dollars in thousands)
One-to four-family residential		$	6,641			$	1,692			$	1,973			$	10,306			$	219,939			$	230,245
Commercial real estate			4,754				711				880				6,345				166,005				172,350
Home equity and lines of credit			228				263				939				1,430				55,147				56,577
Residential construction			222				—				65				287				7,970				8,257
Other construction and land			1,407				1,444				331				3,182				48,462				51,644
Commercial			36				—				—				36				10,883				10,919
Consumer			65				3				—				68				3,168				3,236
Total		$	13,353			$	4,113			$	4,188			$	21,654			$	511,574			$	533,228
		December 31, 2013
		30-59 Days Past Due				60-89 Days Past Due				90 Days and Over Past Due				Total Past Due				Current				Total Loans Receivable
		(Dollars in thousands)
One-to four-family residential		$	5,539			$	669			$	2,587			$	8,795			$	216,725			$	225,520
Commercial real estate			4,746				53				722				5,521				150,112				155,633
Home equity and lines of credit			313				29				350				692				56,144				56,836
Residential construction			120				—				—				120				8,832				8,952
Other construction and land			499				185				970				1,654				63,273				64,927
Commercial			—				35				—				35				8,250				8,285
Consumer			18				9				—				27				3,627				3,654
Total		$	11,235			$	980			$	4,629			$	16,844			$	506,963			$	523,807

Impaired Loans

The following table presents investments in loans considered to be impaired and related information on those impaired loans as of September 30, 2014 and December 31, 2013.

 

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		September 30, 2014												December 31, 2013
		Recorded Balance				Unpaid Principal Balance				Specific Allowance				Recorded Balance				Unpaid Principal Balance				Specific Allowance
		(Dollars in thousands)
Loans without a valuation allowance
One-to four-family residential		$	4,745			$	5,243			$	—			$	4,158			$	4,539			$	—
Commercial real estate			16,166				18,659				—				8,567				9,518				—
Home equity and lines of credit			1,821				1,955				—				1,102				1,262				—
Residential construction			—				—				—				—				—				—
Other construction and land			4,438				5,073				—				5,455				6,464				—
Commercial			16				16				—				—				—				—
		$	27,186			$	30,946			$	—			$	19,282			$	21,783			$	—
Loans with a valuation allowance
One-to four-family residential		$	5,201			$	5,201			$	816			$	5,707			$	5,707			$	1,152
Commercial real estate			2,552				2,552				158				12,376				12,376				2,329
Home equity and lines of credit			229				229				31				510				510				168
Residential construction			—				—				—				—				—				—
Other construction and land			1,893				1,893				178				1,664				1,664				318
Commercial			331				331				12				531				531				101
		$	10,206			$	10,206			$	1,195			$	20,788			$	20,788			$	4,068
Total
One-to four-family residential		$	9,946			$	10,444			$	816			$	9,865			$	10,246			$	1,152
Commercial real estate			18,718				21,211				158				20,943				21,894				2,329
Home equity and lines of credit			2,050				2,184				31				1,612				1,772				168
Residential construction			—				—				—				—				—				—
Other construction and land			6,331				6,966				178				7,119				8,128				318
Commercial			347				347				12				531				531				101
		$	37,392			$	41,152			$	1,195			$	40,070			$	42,571			$	4,068

 

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Lost interest income on impaired loans was $0.1 million for the three months ended September 30, 2014 and 2013. Lost interest income on impaired loans for the nine months ended September 30, 2014 and 2013 was $0.3 million and $0.3 million, respectively. The following table presents average impaired loans by class segment for the periods indicated.

 

		Three months ended September 30																Nine months ended September 30
		2014								2013								2014								2013
		Average Investment in Impaired Loans				Interest Income Recognized				Average Investment in Impaired Loans				Interest Income Recognized				Average Investment in Impaired Loans				Interest Income Recognized				Average Investment in Impaired Loans				Interest Income Recognized
		(Dollars in thousands)
Loans without a valuation allowance
One-to four-family residential		$	4,793			$	41			$	6,458			$	65			$	4,918			$	119			$	6,493			$	195
Commercial real estate			16,208				167				7,568				99				16,140				521				7,626				298
Home equity and lines of credit			1,832				13				511				5				1,891				39				511				15
Residential construction			—				—				—				—				—				—				—				52
Other construction and land			4,615				58				1,587				17				4,748				177				1,598				52
Commercial			17				—				346				5				18				—				349				15
		$	27,465			$	279			$	16,470			$	191			$	27,715			$	856			$	16,577			$	627
Loans with a valuation allowance
One-to four-family residential		$	5,214			$	53			$	3,356			$	18			$	5,242			$	162			$	3,486			$	49
Commercial real estate			2,559				28				4,825				60				2,574				84				4,884				182
Home equity and lines of credit			229				3				857				7				229				9				856				21
Residential construction			—				—				—				—				—				—				—				—
Other construction and land			1,902				24				4,852				62				1,920				71				5,027				184
Commercial			332				5				—				—				336				15				—				—
		$	10,236			$	113			$	13,890			$	147			$	10,301			$	341			$	14,253			$	436
Total
One-to four-family residential		$	10,007			$	94			$	9,814			$	83			$	10,160			$	281			$	9,979			$	244
Commercial real estate			18,767				195				12,393				159				18,714				605				12,510				480
Home equity and lines of credit			2,061				16				1,368				12				2,120				48				1,367				36
Residential construction			—				—				—				—				—				—				—				52
Other construction and land			6,517				82				6,439				79				6,668				248				6,625				236
Commercial			349				5				346				5				354				15				349				15
		$	37,701			$	392			$	30,360			$	338			$	38,016			$	1,197			$	30,830			$	1,063

Nonperforming Loans and Assets

The following table summarizes the balances of nonperforming loans and assets as of September 30, 2014 and December 31, 2013. Certain loans classified as Troubled Debt Restructurings (“TDRs”) and impaired loans may be on non-accrual status even though they are not contractually delinquent.

 

		September 30, 2014				December 31, 2013
		(Dollars in thousands)
One-to four-family residential		$	3,095			$	2,794
Commercial real estate			7,136				10,212
Home equity loans and lines of credit			1,061				350
Residential construction			65				—
Other construction and land			1,014				2,068
Commercial			16				190
Consumer			—				13
Non-performing loans		$	12,387			$	15,627
Real estate owned			6,167				10,506
Non-performing assets		$	18,554			$	26,133

 

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Troubled Debt Restructurings (TDR)

The following tables summarize TDR loans as of the dates indicated:

 

		September 30, 2014
		Performing				Nonperforming				Total
		TDR’s				TDR’s				TDR’s
		(Dollars in thousands)
One-to-four family residential		$	5,725			$	717			$	6,442
Commercial real estate			8,979				5,798				14,777
Home equity and lines of credit			444				—				444
Residential construction			—				—				—
Other construction and land			5,677				615				6,292
Commercial			331				16				347
		$	21,156			$	7,146			$	28,302

 

		December 31, 2013
		Performing				Nonperforming				Total
		TDR’s				TDR’s				TDR’s
		(Dollars in thousands)
One-to-four family residential		$	5,786			$	643			$	6,429
Commercial real estate			10,690				694				11,384
Home equity and lines of credit			510				—				510
Residential construction			—				—				—
Other construction and land			5,688				638				6,326
Commercial			341				—				341
		$	23,015			$	1,975			$	24,990

 

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Loan modifications that were considered TDR’s during the three and nine months ended September 30, 2014 and 2013 are summarized in the tables below:

 

		Three Months Ended September 30, 2014												Nine Months Ended September 30, 2014
(Dollars in thousands)		Number of Loans				Pre-modification Outstanding Recorded Investment				Post-modification Outstanding Recorded Investment				Number of Loans				Pre-modification Outstanding Recorded Investment				Post-modification Outstanding Recorded Investment
Below market interest rate:
One-to-four family residential			—			$	—			$	—				2			$	409			$	326
Commercial real estate			1				280				280				1				280				280
Home equity loans and lines of credit			—				—				—				1				50				40
Other construction and land			1				151				151				1				151				151
			2			$	431			$	431				5			$	890			$	797
Extended payment terms:
Other construction and land			—			$	—			$	—				2			$	720				596
Commercial real estate			—				—				—				7				6,770				5,332
Commercial			—				—				—				1				18				12
			—			$	—			$	—				10			$	7,508			$	5,940
		Three Months Ended September 30, 2013												Nine Months Ended September 30, 2013
(Dollars in thousands)		Number of Loans				Pre-modification Outstanding Recorded Investment				Post-modification Outstanding Recorded Investment				Number of Loans				Pre-modification Outstanding Recorded Investment				Post-modification Outstanding Recorded Investment
Below market interest rate:
One-to four-family residential			—			$	—			$	—				3			$	486			$	398
Commercial real estate			—				—				—				2				1,802				1,604
Home equity loans and lines of credit			—				—				—				2				263				151
			—			$	—			$	—				7			$	2,551			$	2,153
Extended payment terms:
Other construction and land			1			$	199			$	157				1			$	199			$	157
Commercial real estate			1				478				215				1				478				215

 

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The following table summarizes TDRs that defaulted during the three and nine month periods ending September 30, 2014 and 2013 and which were modified as TDRs within the previous 12 months.

 

		During the Three Months Ended September 30, 2014								During the Three Months Ended September 30, 2013
		Number of Loans				Recorded Investment				Number of Loans				Recorded Investment
Below market interest rate:
One-to-four family residential			—			$	—				—			$	—
Home equity and lines of credit			1				50				—				—
			1			$	50				—			$	—
Extended payment terms:
Commercial real estate			—			$	—				—			$	—
		During the Nine Months Ended September 30, 2014								During the Nine Months Ended September 30, 2013
		Number of Loans				Post-modification Outstanding Recorded Investment				Number of Loans				Post-modification Outstanding Recorded Investment
Below market interest rate:
One-to-four family residential			1			$	135				—			$	—
Home equity and lines of credit			1				50				—				—
			2			$	185				—			$	—
Extended payment terms:
Commercial real estate			1			$	215				—			$	—

 

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NOTE 6. REAL ESTATE OWNED

 

The following table summarizes real estate owned and changes in the valuation allowance for real estate owned for the three and nine months ended September 30, 2014 and 2013.

 

		September 30,				December 31,
(Dollars in thousands)		2014				2013
Real estate owned, gross		$	7,464			$	16,066
Less: Valuation allowance			1,297				5,560
Real estate owned, net		$	6,167			$	10,506

 

		Three Months Ended September 30,								Nine Months Ended September 30,
(Dollars in thousands)		2014				2013				2014				2013
Valuation allowance, beginning		$	2,661			$	4,742			$	5,560			$	3,635
Provision charged to expense			411				548				1,508				2,387
Reduction due to disposal			(1,775	)			(627	)			(5,771	)			(1,359	)
Valuation allowance, ending		$	1,297			$	4,663			$	1,297			$	4,663

NOTE 7. LOAN SERVICING

 

Loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of mortgage and other loans serviced for others as of September 30, 2014 and December 31, 2013 is detailed below.

 

September 30, 2014				December 31, 2013
(Dollars in thousands)
$	241,625			$	255,475

The following summarizes the activity in the balance of loan servicing rights for the three and nine months ended September 30, 2014 and 2013:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013				2014				2013
		(Dollars in thousands)
Loan servicing rights, beginning of period		$	2,089			$	2,009			$	1,883			$	1,908
Capitalization from loans sold			68				139				278				649
Fair value adjustment			(93	)			(207	)			(97	)			(616	)
Loan servicing rights, end of period		$	2,064			$	1,941			$	2,064			$	1,941

The Bank held custodial escrow deposits of $1.5 million and $0.6 million for loan servicing accounts at September 30, 2014 and December 31, 2013, respectively.

 

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NOTE 8. DEPOSITS

The following table summarizes deposit balances and interest expense by type of deposit as of and for the nine months ended September 30, 2014 and 2013 and the year ended December 31, 2013.

 

		As of and for the																Year-ended
		Nine months ended September 30,																December 31,
		2014								2013								2013
(Dollars in thousands)		Balance				Interest Expense				Balance				Interest Expense				Balance				Interest Expense
Noninterest-bearing demand		$	82,381			$	—			$	69,821			$	—			$	70,127			$	—
Interest-bearing demand			88,669				108				79,870				99				81,645				134
Money Market			188,141				753				181,177				853				183,504				1,122
Savings			28,115				27				26,237				28				25,593				36
Certificates of Deposit			323,367				3,163				325,748				3,438				323,357				4,534
		$	710,673			$	4,051			$	682,853			$	4,418			$	684,226			$	5,826

NOTE 9. JUNIOR SUBORDINATED DEBT

 

The Company issued $14.4 million of junior subordinated notes to its wholly owned subsidiary, Macon Capital Trust I, to fully and unconditionally guarantee the trust preferred securities issued by the Trust. These notes qualify as Tier I capital for the Company. The notes accrue and pay interest quarterly at a rate per annum, reset quarterly, equal to 90-day LIBOR plus 2.80% (3.03% at September 30, 2014). The notes mature on March 30, 2034.

The Company has the right to redeem the notes, in whole or in part, on or after March 30, 2009 at a price equal to 100% of the principal amount plus accrued and unpaid interest. In addition, the Company may redeem the notes in whole (but not in part) upon the occurrence of a capital disqualification event, an investment company event, or a tax event at a specified redemption price as defined in the indenture.

The Company also may, at its option, defer the payment of interest on the notes for a period up to 20 consecutive quarters, provided that interest will also accrue on the deferred payments of interest. As of September 30, 2014 and December 31, 2013, the Company has deferred payments of interest on the notes for 16 and 13 consecutive quarters in the aggregate amount of $1.9 million and $1.6 million, respectively.

 

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NOTE 10. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

 

The following table summarizes the components of accumulated other comprehensive income (loss) and changes in those components as of and for the three and nine months ended September 30, 2014 and 2013.

 

		Three Months Ended September 30, 2014
		Available for Sale Securities				Held to Maturity Securities Transferred from AFS				Deferred Tax Valuation Allowance on AFS				Total
		(Dollars in thousands)
Balance, beginning of period		$	(818	)		$	(1,226	)		$	(1,267	)		$	(3,311	)
Change in deferred tax valuation allowance attributable to net unrealized losses on investment securities available for sale			—				—				(278	)			(278	)
Change in net unrealized holding losses on securities available for sale			(505	)			—				—				(505	)
Reclassification adjustment for net securities gains realized in net income			(273	)			—				—				(273	)
Transfer of net unrealized loss from available for sale to held to maturity			—				—				—				—
Amortization of unrealized gains and losses on securities transferred to held to maturity			—				50				—				50
Income tax expense			298				(20	)			—				278
Balance, end of period		$	(1,298	)		$	(1,196	)		$	(1,545	)		$	(4,039	)
		Three Months Ended September 30, 2013
		(Dollars in thousands)
Balance, beginning of period		$	(2,470	)		$	—			$	(1,613	)		$	(4,083	)
Change in deferred tax valuation allowance attributable to unrealized gains on investment securities available for sale			—				—				(420	)			(420	)
Change in unrealized holding gains on securities available for sale			(1,650	)			—				—				(1,650	)
Reclassification adjustment for net securities gains realized in net income			2				—				—				2
Income tax benefit			518				—				—				518
Balance, end of period		$	(3,600	)		$	—			$	(2,033	)		$	(5,633	)
		Nine Months Ended September 30, 2014
		(Dollars in thousands)
Balance, beginning of period		$	(3,374	)		$	(1,242	)		$	(2,860	)		$	(7,476	)
Change in deferred tax valuation allowance attributable to net unrealized losses on investment securities available for sale			—				—				1,315				1,315
Change in net unrealized holding losses on securities available for sale			3,939				—				—				3,939
Reclassification adjustment for net securities gains realized in net income			(652	)			—				—				(652	)
Transfer of net unrealized loss from available for sale to held to maturity			74				(74	)			—				—
Amortization of unrealized gains and losses on securities transferred to held to maturity			—				150				—				150
Income tax expense			(1,285	)			(30	)			—				(1,315	)
Balance, end of period		$	(1,298	)		$	(1,196	)		$	(1,545	)		$	(4,039	)
		Nine Months Ended September 30, 2013
		(Dollars in thousands)
Balance, beginning of period		$	1,266			$	—			$	619			$	1,885
Change in deferred tax valuation allowance attributable to unrealized gains on investment securities available for sale			—				—				(2,652	)			(2,652	)
Change in unrealized holding gains on securities available for sale			(7,947	)			—				—				(7,947	)
Reclassification adjustment for net securities gains realized in net income			(96	)			—				—				(96	)
Income tax benefit			3,177				—				—				3,177
Balance, end of period		$	(3,600	)		$	—			$	(2,033	)		$	(5,633	)

 

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The following table shows the line items in the consolidated Statements of Income affected by amounts reclassified from accumulated other comprehensive income (loss):

 

		Three months ended September 30,								Nine months ended September 30,
		2014				2013				2014				2013
		(Dollars in thousands)								(Dollars in thousands)
Gain on sale of investments, net		$	273			$	(2	)		$	652			$	96
Tax effect			—				—				—				—
Impact, net of tax			273				(2	)			652				96
Interest income - taxable securities			50				—				150				—
Tax effect			—				—				—				—
Impact, net of tax			50				—				150				—
Total reclassifications, net of tax		$	323			$	(2	)		$	802			$	96

NOTE 11. COMMITMENTS AND CONTINGENCIES

 

To accommodate the financial needs of its customers, the Bank makes commitments under various terms to lend funds. These commitments include revolving credit agreements, term loan commitments and short-term borrowing agreements. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held includes first and second mortgages on one-to-four family dwellings, accounts receivable, inventory, and commercial real estate. Certain lines of credit are unsecured.

The following summarizes the Bank’s approximate commitments to fund lines of credit at September 30, 2014:

 

		September 30, 2014
		(Dollars in thousands)
Home equity lines		$	67,134
Consumer and other lines			2,491
		$	69,625

 

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As of September 30, 2014, the Company had outstanding commitments to originate mortgage loans as follows:

 

		September 30, 2014
		Amount				Range of Rates
		(Dollar in thousands)
Fixed		$	740			4.125% to 4.500%
Variable			259			3.125% to 4.750%
		$	999

The allowance for unfunded commitments was $0.1 million at September 30, 2014 and December 31, 2013.

The Bank is exposed to loss as a result of its obligation for representations and warranties on loans sold to Fannie Mae and maintained a reserve of $0.3 million as of September 30, 2014 and December 31, 2013.

In the normal course of business, the Company is periodically involved in litigation. In the opinion of the Company’s management, none of this litigation is expected to have a material adverse effect on the accompanying consolidated financial statements.

NOTE 12. FAIR VALUE DISCLOSURES

 

We use fair value measurements when recording and disclosing certain financial assets and liabilities. Securities available-for-sale, mortgage servicing rights and mortgage derivatives are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record other assets at fair value on a nonrecurring basis, such as loans held for sale, impaired loans and real estate owned.

Fair value is the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market in an orderly transaction between market participants at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction. In determining fair value, we use various valuation approaches, including market, income and cost approaches. The fair value standard establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing an asset or liability, which is developed, based on market data we have obtained from independent sources. Unobservable inputs reflect our estimate of assumptions that market participants would use in pricing an asset or liability, which are developed based on the best information available in the circumstances.

The fair value hierarchy gives the highest priority to unadjusted quoted market prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). The fair value hierarchy is broken down into three levels based on the reliability of inputs as follows:

 

•

Level 1: valuation is based upon unadjusted quoted market prices for identical instruments traded in active markets.

 

•

Level 2: valuation is based upon quoted market prices for similar instruments traded in active markets, quoted market prices for identical or similar instruments traded in markets that are not active and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by market data.

 

•

Level 3: valuation is derived from other valuation methodologies, including discounted cash flow models and similar techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in determining fair value.

 

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A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

Fair value estimates are made at a specific point of time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale the Company’s entire holdings of a particular financial instrument. Because no active market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, current interest rates and prepayment trends, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in any of these assumptions used in calculating fair value also would affect significantly the estimates. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of these estimates.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value on a recurring basis:

Securities

We obtain fair values for debt securities from a third-party pricing service, which utilizes several sources for valuing fixed-income securities. The market evaluation sources for debt securities include observable inputs rather than significant unobservable inputs and are classified as Level 2. The service provider utilizes pricing models that vary by asset class and include available trade, bid and other market information. Generally, the methodologies include broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs.

Included in securities are investments in an exchange traded bond fund and U.S. Treasury bonds which are valued by reference to quoted market prices and considered a Level 1 security.

Loan Servicing Rights

Loan servicing rights are carried at fair value as determined by a third party valuation firm. The valuation model utilizes a discounted cash flow analysis using discount rates and prepayment speed assumptions used by market participants. The Company classifies loan servicing right fair value measurements as Level 3.

Derivative Instruments

Derivative instruments include interest rate lock commitments and forward sale commitments. These instruments are valued based on the change in the value of the underlying loan between the commitment date and the end of the period. The Company classifies these instruments as Level 3.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value on a nonrecurring basis:

Loans Held for Sale

Loans held for sale are carried at the lower of cost or fair value. The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. Loans held for sale carried at fair value are classified as Level 2.

Impaired Loans

Impaired loans are carried at the lower of recorded investment or fair value. The fair value of impaired loans is estimated using either the value of the collateral (less selling costs if repayment is expected from liquidation of the collateral) or discounted cash flows. Appraisals may be discounted based on our historical knowledge, changes in market conditions from the time of appraisal or our knowledge of the borrower and the borrower’s business. Impaired loans carried at fair value are classified as Level 3.

Real Estate Owned

Real estate owned, obtained in partial or total satisfaction of a loan is recorded at the lower of recorded investment in the loan or fair value less cost to sell. Subsequent to foreclosure, these assets are carried at the lower of the

 

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amount recorded at acquisition date or fair value less cost to sell. Accordingly, it may be necessary to record nonrecurring fair value adjustments. Fair value, when recorded, is generally based upon appraisals by approved, independent, state certified appraisers. Like impaired loans, appraisals may be discounted based on our historical knowledge, changes in market conditions from the time of appraisal or other information available to us. Real estate owned carried at fair value is classified as Level 3.

In addition to financial instruments recorded at fair value in our financial statements, fair value accounting guidance requires disclosure of the fair value of all of an entity’s assets and liabilities that are considered financial instruments. The majority of our assets and liabilities are considered financial instruments. Many of these instruments lack an available trading market as characterized by a willing buyer and willing seller engaged in an exchange transaction. Also, it is our general practice and intent to hold our financial instruments to maturity and to not engage in trading or sales activities. For fair value disclosure purposes, we substantially utilize the fair value measurement criteria as required and explained above. In cases where quoted fair values are not available, we use present value methods to determine the fair value of our financial instruments.

Following is a description of valuation methodologies used for the disclosure of the fair value of financial instruments not carried at fair value:

Cash and Cash Equivalents

The carrying amount of such instruments is deemed to be a reasonable estimate of fair value.

Loans

The fair value of variable rate performing loans is based on carrying values adjusted for credit risk. The fair value of fixed rate performing loans is estimated using discounted cash flow analyses, utilizing interest rates currently being offered for loans with similar terms, adjusted for credit risk. The fair value of nonperforming loans is based on their carrying values less any specific reserve. A prepayment assumption is used to estimate the portion of loans that will be repaid prior to their scheduled maturity. No adjustment has been made for the illiquidity in the market for loans as there is no active market for many of the Company’s loans on which to reasonably base this estimate.

Bank Owned Life Insurance

Fair values approximate net cash surrender values.

Other Investments. at Cost

No ready market exists for this stock and it has no quoted market value. However, redemption of this stock has historically been at par value. Accordingly, the carrying amount is deemed to be a reasonable estimate of fair value.

Deposits

The fair values disclosed for demand deposits are equal to the amounts payable on demand at the reporting date. The fair value of certificates of deposit are estimated by discounting the amounts payable at the certificate rates using the rates currently offered for deposits of similar remaining maturities.

Advances from the FHLB

The fair values disclosed for fixed rate long-term borrowings are determined by discounting their contractual cash flows using current interest rates for long-term borrowings of similar remaining maturities. The carrying amounts of variable rate long-term borrowings approximate their fair values.

Junior Subordinated Notes

The carrying amount approximates fair value because the debt is variable rate tied to LIBOR.

Accrued Interest Receivable and Payable

Since these financial instruments will typically be received or paid within three months, the carrying amounts of such instruments are deemed to be a reasonable estimate of fair value.

Loan Commitments

Estimates of the fair value of these off-balance sheet items are not made because of the short-term nature of these arrangements and the credit standing of the counterparties.

 

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Assets and Liabilities Recorded at Fair Value on a Recurring Basis

Below is a table that presents information about certain assets and liabilities measured at fair value on a recurring basis as of September 30, 2014 and December 31, 2013.

 

		September 30, 2014
		Level 1				Level 2				Level 3				Total
		(Dollars in thousands)
Securities available for sale:
U.S. government agencies		$	1,493			$	32,282			$	—			$	33,775
Municipal securities			—				23,260				—				23,260
Mortgage-backed securities			—				130,341				—				130,341
Mutual fund			583				—				—				583
			2,076				185,883				—				187,959
Loan servicing rights			—				—				2,064				2,064
Forward sales commitments			—				—				34				34
Interest rate lock commitments			—				—				8				8
Total assets		$	2,076			$	185,883			$	2,106			$	190,065

 

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		December 31, 2013
		Level 1				Level 2				Level 3				Total
		(Dollars in thousands)
Securities available for sale:
U.S. government agencies		$	—			$	21,899			$	—			$	21,899
Municipal securities			—				25,602				—				25,602
Mortgage-backed securities			—				107,415				—				107,415
Mutual fund			568				—				—				568
			568				154,916				—				155,484
Loan servicing rights			—				—				1,883				1,883
Forward sales commitments			—				—				12				12
Total assets		$	568			$	154,916			$	1,895			$	157,379
Interest rate lock commitments		$	—			$	—			$	7			$	7
Total liabilities		$	—			$	—			$	7			$	7

The following table presents the changes in assets measured at fair value on a recurring basis for which we have utilized Level 3 inputs to determine fair value as of and for the three and nine months ended September 30, 2014 and 2013:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013				2014				2013
		(Dollars in thousands)
Balance at beginning of period		$	2,156			$	2,009			$	1,888			$	1,908
Loan servicing right activity, included in servicing income, net
Capitalization from loans sold			68				139				278				649
Fair value adjustment			(93	)			(207	)			(97	)			(616	)
Mortgage derivative gains included in Other income			(25	)			—				37				—
Balance at end of period		$	2,106			$	1,941			$	2,106			$	1,941

 

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Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

Below is a table that presents information about certain assets and liabilities measured at fair value on a nonrecurring basis as of September 30, 2014 and December 31, 2013. There were no loans held for sale carried at fair value at either September 30, 2014 or December 31, 2013.

 

		September 30, 2014
		Level 1				Level 2				Level 3				Total
		(Dollars in thousands)
Loans held for sale		$	—			$	—			$	—			$	—
Impaired loans			—				—				36,197				36,197
Real estate owned			—				—				6,167				6,167
Total assets		$	—			$	—			$	42,364			$	42,364

 

		December 31, 2013
		Level 1				Level 2				Level 3				Total
		(Dollars in thousands)
Loans held for sale		$	—			$	—			$	—			$	—
Impaired loans			—				—				36,002				36,002
Real estate owned			—				—				10,506				10,506
Total assets		$	—			$	—			$	46,508			$	46,508

The following table provides information describing the unobservable inputs used in Level 3 fair value measurements at September 30, 2014.

 

		Valuation Technique		Unobservable Input		General Range
Impaired loans		Discounted Appraisals		Collateral discounts and estimated selling cost		0 – 30%
		Present value of cash flows		Default rates		0 – 10%
Real estate owned		Discounted Appraisals		Collateral discounts and estimated selling cost		0 – 30%
Loan servicing rights		Discounted Cash Flows		Prepayment speed		7 – 25%
				Discount rate		12%
Forward sales commitments and interest rate lock commitments		Change in market price of underlying loan		Value of underlying loan		95% – 105%

 

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The approximate carrying and estimated fair value of financial instruments are summarized below:

 

						Fair Value Measurements at September 30, 2014
		Carrying Amount				Total				Level 1				Level 2				Level 3
Assets:
Cash and equivalents		$	84,093			$	84,093			$	84,093			$	—			$	—
Securities available for sale			187,959				187,959				2,076				185,883				—
Securities held to maturity			25,536				26,564				—				26,564				—
Loans held for sale			12,427				13,411				—				13,411				—
Loans receivable, net			530,021				535,198				—				—				535,198
Real estate owned			6,167				6,167				—				—				6,167
Other investments, at cost			4,012				4,012				—				4,012				—
Interest receivable			3,007				3,007				—				—				3,007
Bank owned life insurance			20,302				20,302				—				—				20,302
Loan servicing rights			2,064				2,064				—				—				2,064
Forward sales commitments			34				34				—				—				34
Interest rate lock commitments			8				8				—				—				8
Liabilities:
Demand deposits		$	387,306			$	387,306			$	—			$	—			$	387,306
Certificate deposits			323,367				326,745				—				—				326,745
Federal Home Loan Bank advances			40,000				41,891				—				—				41,891
Junior subordinated debentures			14,433				14,433				—				—				14,433
Accrued interest payable			2,267				2,267				—				—				2,267

 

						Fair Value Measurements at December 31, 2013
		Carrying Amount				Total				Level 1				Level 2				Level 3
		(Dollars in thousands)
Assets:
Cash and equivalents		$	34,316			$	34,316			$	34,316			$	—			$	—
Securities available for sale			155,484				155,484				568				154,916				—
Securities held to maturity			20,988				20,098				—				20,098				—
Loans held for sale			5,688				6,151				—				6,151				—
Loans receivable, net			507,623				526,395				—				—				526,395
Real estate owned			10,506				10,506				—				—				10,506
Federal Home Loan Bank stock			2,724				2,724				—				2,724				—
Interest receivable			2,673				2,673				—				—				2,673
Bank owned life insurance			19,961				19,961				—				—				19,961
Mortgage servicing rights			1,883				1,883				—				—				1,883
Forward sales commitments			12				12				—				—				12
Liabilities:
Demand deposits		$	360,869			$	360,869			$	—			$	—			$	360,869
Certificate deposits			323,357				327,280				—				—				327,280
Federal Home Loan Bank advances			40,000				41,845				—				—				41,845
Junior subordinated debentures			14,433				14,433				—				—				14,433
Accrued interest payable			2,023				2,023				—				—				2,023
Interest rate lock commitments			7				7				—				—				7

 

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NOTE 13. REGULATORY MATTERS

 

The Company and the Bank are subject to various regulatory capital requirements administered by their respective federal and state banking regulators. Failure to satisfy minimum capital requirements may result in certain mandatory and additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. On April 21, 2014, the Bank entered into a memorandum of understanding (the “Memorandum of Understanding”) with the FDIC and the North Carolina Commissioner of Banks (the “Commissioner,” and together with the FDIC, the “Bank Supervisory Authorities”), which replaced the consent order entered into in 2012. In 2012, Macon Bancorp entered into a written agreement (the “Written Agreement”) with the FRB. For additional information about the Memorandum of Understanding and the Written Agreement, see “Supervision and Regulation – Regulatory Agreements” on page 112 of our Registration Statement.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital to average assets (as defined).

Following are the required and actual capital amounts and ratios for the Bank:

 

		Actual								For Capital Adequacy Purposes								To meet the Requirements of the Memorandum of Understanding
(Dollars in thousands)		Amount				Ratio				Amount				Ratio				Amount				Ratio
As of September 30, 2014:
Tier I Leverage Capital		$	104,197				12.04	%		$	34,608				³4	%		$	69,217				³8	%
Tier 1 Risk-based Capital		$	104,197				19.93	%		$	20,916				³4	%			N/A				N/A
Total Risk-based Capital		$	110,799				21.19	%		$	41,831				³8	%		$	57,518				³11	%
As of December 31, 2013:
Tier I Leverage Capital		$	54,775				7.02	%		$	31,190				³4	%		$	62,380				³8	%
Tier 1 Risk-based Capital		$	54,775				10.70	%		$	20,484				³4	%			N/A				N/A
Total Risk-based Capital		$	61,274				11.97	%		$	40,968				³8	%		$	56,331				³11	%

 

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Following are the required and actual capital amounts and ratios for the Company:

 

		Actual								For Capital Adequacy Purposes
(Dollars in thousands)		Amount				Ratio				Amount				Ratio
As of September 30, 2014:
Tier I Leverage Capital		$	122,160				14.12	%		$	34,613				³4	%
Tier I Risk-based Capital		$	122,160				23.34	%		$	20,922				³4	%
Total Risk Based Capital		$	128,763				24.60	%		$	41,844				³8	%
As of December 31, 2013:
Tier I Leverage Capital		$	53,806				6.90	%		$	31,190				³4	%
Tier I Risk-based Capital		$	53,806				10.52	%		$	20,459				³4	%
Total Risk Based Capital		$	60,297				11.79	%		$	40,917				³8	%

NOTE 14. SUBSEQUENT EVENTS

 

In preparing these consolidated financial statements, the Company has evaluated events and transactions for potential recognition or disclosure through the date the financial statements were issued.

 

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

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements, which can be identified by the use of words such as “estimate,” “project,” “believe,” “intend,” “anticipate,” “plan,” “seek,” “expect,” “will,” “may” and words of similar meaning. These forward-looking statements include, but are not limited to:

 

•

statements of our goals, intentions and expectations;

 

•

statements regarding our business plans, prospects, growth and operating strategies;

 

•

statements regarding the asset quality of our loan and investment portfolios; and

 

•

estimates of our risks and future costs and benefits.

These forward-looking statements are based on our current beliefs and expectations and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. The Company is under no duty to and do not undertake any obligation to update any forward-looking statements after the date of this Quarterly Report on Form 10-Q.

The following factors, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements:

 

•

our failure to comply with the terms of the Memorandum of Understanding and Written Agreement (the “Regulatory Agreements”);

 

•

the effect of the requirements of the Regulatory Agreements to which we are subject and any further regulatory actions;

 

•

our failure to secure the timely termination of the Regulatory Agreements;

 

•

our failure to obtain regulatory approval to bring current and resume ongoing interest payments on our trust preferred securities prior to December 30, 2015;

 

•

the occurrence of an ownership change under applicable tax rules that could limit our ability to utilize losses to offset future taxable income;

 

•

general economic conditions, either nationally or in our market areas, that are worse than expected;

 

•

credit quality deterioration which could cause an increase in the provision for credit losses;

 

•

competition among depository and other financial institutions;

 

•

inflation and changes in the interest rate environment that reduce our margins or reduce the fair value of financial instruments;

 

•

adverse changes in the securities markets;

 

•

changes in laws or government regulations or policies affecting financial institutions, including changes in regulatory fees and capital requirements;

 

•

our ability to enter new markets successfully and capitalize on growth opportunities;

 

•

our ability to successfully integrate acquired entities, if any;

 

•

changes in consumer spending, borrowing and savings habits;

 

•

changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, FASB, the SEC and the PCAOB;

 

•

changes in our key personnel, and our compensation and benefit plans;

 

•

changes in our financial condition or results of operations that reduce capital available to pay dividends; and

 

•

changes in the financial condition or future prospects of issuers of securities that we own.

See also those risk factors identified in the section headed “Risk Factors,” beginning on page 16 of the Registration Statement.

Critical Accounting Policies and Estimates

Our critical accounting policies involving significant judgments and assumptions used in the preparation of the Consolidated Financial Statements as of September 30, 2014 have remained unchanged from the disclosures presented in our Registration Statement.

 

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The Jumpstart Our Business Startups Act (“JOBS Act”) contains provisions that, among other things, reduce certain reporting requirements for qualifying public companies. As an “emerging growth company” we have elected to use the extended transition period to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies. Accordingly, our financial statements may not be comparable to the financial statements of public companies that comply with such new or revised accounting standards. As of September 30, 2014 and December 31, 2013, there was not a significant difference in the presentation of our financial statements as compared to other public companies as a result of this transition guidance.

Overview

Entegra Financial Corp. (the “Company”) was incorporated on May 31, 2011 and became the holding company for Macon Bank, Inc. (the “Bank”), on September 30, 2014 upon the completion of Macon Bancorp’s conversion from the mutual to stock form of organization and merger with the Company. In connection with the conversion, the Company sold 6,546,375 shares of common stock at an offering price of $10.00 per share and received gross sales proceeds of $65.5 million. The Company recognized $1.7 million in reorganization and stock issuance costs as of September 30, 2014 which have been deducted from the gross sales proceeds. Of the $63.7 million in net sales proceeds, $44.6 million, or approximately 70%, was contributed to the capital of the Bank upon completion of the conversion on September 30, 2014.

We provide a full range of financial services through offices located in Cherokee, Henderson, Jackson, Macon, Polk and Transylvania counties, North Carolina. We provide full service retail and commercial banking products as well as wealth management services through a third party.

We earn revenue primarily from interest on loans and securities, and fees charged for financial services provided to our customers. Offsetting these revenues are the cost of deposits and other funding sources, provisions for loan losses and other operating costs such as salaries and employee benefits, data processing, occupancy and tax expense.

Our mission is to become the financial services provider of choice within the markets that we serve. We plan to do this by delivering exceptional service and value. Our strategic plan focuses on growth by expanding into contiguous markets with higher growth potential, while diversifying the current loan portfolio.

During the nine months ended September 30, 2014, we continued to execute on our key strategic initiatives of stabilizing the loan portfolio and improving asset quality, while generating earnings and increasing capital. Our focus throughout the remainder of 2014 will be on loan growth to increase our net interest income, implementing opportunities to increase fee income, improving asset quality and closely monitoring operating expenses. We strive to be well-positioned for changes in both the economy and interest rates, regardless of the timing or direction of these changes. Management regularly assesses our balance sheet, capital, liquidity and operational infrastructure in order to be positioned to take advantage of opportunities for growth as they may arise.

Our results of operations are significantly affected by general economic and competitive conditions in our market areas and nationally, as well as changes in interest rates, sources of funding, government policies and actions of regulatory authorities. Future changes in applicable laws, regulations or government policies may materially affect our financial condition and results of operations.

The following discussion and analysis is presented on a consolidated basis and focuses on the major components of the Company’s operations and significant changes in its results of operations for the periods presented. For further information, refer to the Consolidated Financial Statements and notes thereto included in our Registration Statement on Form S-1.

Earnings Summary

Net income for the three months ended September 30, 2014 was $1.9 million compared to $0.7 million for the same period in 2013. Net income for the nine months ended September 30, 2014 was $4.6 million compared to $1.9 million for the same period in 2013. The increase in net income for each period was primarily related to a reduction in the provision for loan losses and real estate owned related expenses, combined with by an increase in net interest income.

 

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Net interest income increased $22 thousand, or 0.4%, to $6.2 million for the three months ended September 30, 2014 and increased $1.1 million, or 5.9%, to $19.5 million for the nine months ended September 30, 2014 compared to the same periods in 2013. The improvement in net interest income for the nine month period was primarily the result of the favorable resolution and restructuring of two commercial loans, which resulted in the recognition of approximately $1.1 million of deferred interest and discounts.

Explanation of Use of Non-GAAP Financial Measures

In addition to the results of operations presented in accordance with GAAP, management uses, and this Quarterly Report contains or references, certain non-GAAP financial measures, such as core efficiency ratio and core income. Management believes these non-GAAP financial measures provide information useful to investors in understanding our underlying operational performance and performance trends as they facilitate comparisons with the performance of other financial institutions. Although management believes that these non-GAAP financial measures enhance investors’ understanding of our business and performance, these non-GAAP financial measures should not be considered an alternative to GAAP.

The following table shows the differences between income before taxes calculated in accordance with GAAP and income before taxes calculated on a non-GAAP basis for the periods indicated:

 

		For the three months ended September 30,								For the nine months ended September 30,
		2014				2013				2014				2013
		(Dollars in thousands)
Income before taxes - GAAP		$	1,989			$	746			$	6,504			$	2,328
Adjustments to income before taxes:
Provision for loan losses			16				564				27				2,152
Gain (loss) on sale of investments, net			(273	)			2				(652	)			(96	)
Other than temporary impairment			—				—				76				—
Net cost of operation of real estate owned			590				1,084				2,034				3,574
Net adjustment to income before taxes			333				1,650				1,485				5,630
Core income before taxes - non-GAAP		$	2,322			$	2,396			$	7,989			$	7,958

 

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The following table shows the differences between the efficiency ratio calculated in accordance with GAAP and the core efficiency ratio calculated on a non-GAAP basis for the periods indicated:

 

		For the three months ended September 30,								For the nine months ended September 30,
		2014				2013				2014				2013
		(Dollars in thousands)
Efficiency ratio - GAAP			73.61	%			82.19	%			72.68	%			80.39	%
Non interest expense - GAAP		$	5,593			$	6,047			$	17,374			$	18,368
Adjustments to non interest expense:
Net cost of operation of real estate owned			(590	)			(1,084	)			(2,034	)			(3,574	)
Core noninterest expense - non-GAAP		$	5,003			$	4,963			$	15,340			$	14,794
Non interest income - GAAP		$	1,432			$	1,213			$	4,361			$	4,400
Adjustments to non interest income:
Gain (loss) on sale of investments, net			(273	)			2				(652	)			(96	)
Other than temporary impairment			—				—				76				—
Core noninterest income - non-GAAP		$	1,159			$	1,215			$	3,785			$	4,304
Net interest income - GAAP		$	6,166			$	6,144			$	19,544			$	18,448
Net adjustment to efficiency ratio			-5.31	%			-14.75	%			-6.92	%			-15.37	%
Core efficiency ratio - non-GAAP			68.30	%			67.44	%			65.76	%			65.02	%

Financial Condition At September 30, 2014 and December 31, 2013

Total assets increased $99.9 million, or 12.7%, to $884.4 million at September 30, 2014 from $784.6 million at December 31, 2013. This increase in assets was comprised primarily of investment securities, which increased $37.0 million, or 21.0%, as deposit growth outpaced loan demand. Cash and cash equivalents increased $49.8 million, or 145.1%, to $84.1 million at September 30, 2014 which is primarily due to the $63.7 million in net proceeds received upon the completion of our common stock offering on September 30, 2014.

Loans receivable increased $8.1 million, or 1.6%, to $530.0 million at September 30, 2014 from $521.9 million at December 31, 2013.

Total liabilities increased $28.1 million, or 3.7%, to $780.1 million at September 30, 2014 from $752.0 million at December 31, 2013, due primarily to strong growth in deposits which increased $26.4 million, or 3.9% to $710.7 million at September 30, 2014 from $684.2 million at December 31, 2013. We did not incur any additional borrowings or indebtedness during the nine months ended September 30, 2014.

Total equity increased $71.8 million, or 220.8%, to $104.3 million at September 30, 2014 from $32.5 million at December 31, 2013. This substantial increase was primarily the result of $63.7 million in net proceeds raised in our common stock offering, a $3.4 million decrease in accumulated other comprehensive loss related to an improvement in net unrealized holding gains and losses on securities available for sale, and $4.6 million of net income for the period.

Cash and Cash Equivalents

Total cash and cash equivalents increased $49.8 million, or 145.1%, to $84.1 million at September 30, 2014 from $34.3 million at December 31, 2013 which is primarily due to the $63.7 million in net proceeds received upon the completion of our common stock offering on September 30, 2014, partially offset by cash used to invest in loans and investment securities. The cash proceeds from the stock offering were not invested as of September 30, 2014 and we continue to hold higher than normal levels of liquidity in anticipation of rising interest rates.

 

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Investment Securities

Our investment securities portfolio is classified as both “available-for-sale” and “held-to-maturity”. Available-for-sale securities are carried at fair value. The following table shows the amortized cost and fair value for our available for sale investment portfolio at the dates indicated.

 

		At September 30,								At December 31,
		2014								2013
		Amortized Cost				Fair value				Amortized Cost				Fair value
		(Dollars in thousands)
Investment securities available-for-sale:
U.S. Government and agency securities:
U.S. Government and agency obligations		$	20,608			$	20,522			$	3,557			$	3,492
U.S. Government structured agency obligations			12,000				11,760				19,420				18,407
U.S. Treasury Notes & Bonds			1,500				1,493				—				—
Municipal obligations			23,443				23,260				26,963				25,602
Mortgage-backed securities:
U.S. Government agency			103,249				101,984				88,818				86,224
SBA securities			19,162				18,964				18,472				18,162
Collateralized mortgage obligations			9,512				9,393				3,141				3,029
Mutual funds			586				583				576				568
Total securities available-for-sale		$	190,060			$	187,959			$	160,947			$	155,484

Available for sale investment securities increased $32.5 million, or 20.9%, to $188.0 million at September 30, 2014 from $155.5 million at December 31, 2013. The increase is primarily related to an increase in deposits over the same period which outpaced loan demand, partially offset by the reclassification of $4.4 million of municipal securities from available for sale to held to maturity during the first nine months of 2014.

Held to maturity investment securities are carried at amortized cost. The following table shows the amortized cost and fair value for our held-to-maturity investment portfolio as of the most recent quarter and year end.

 

		At September 30,								At December 31,
		2014								2013
		Amortized Cost				Fair value				Amortized Cost				Fair value
		(Dollars in thousands)
Investment securities held-to-maturity:
U.S. Government structured agency obligations		$	21,141			$	21,999			$	20,988			$	20,098
Municipal obligations			4,395				4,565				—				—
Total securities held-to-maturity		$	25,536			$	26,564			$	20,988			$	20,098

Held-to-maturity investment securities increased $4.5 million, or 21.7%, to $25.5 million at September 30, 2014 from $21.0 million at December 31, 2013 primarily as a result of reclassification of municipal securities from available-for-sale to held-to-maturity as mentioned above. The reclassification will remain in effect until the investments are called or mature. We reclassified these securities to minimize the impact of future interest rate changes on accumulated other comprehensive income (loss). The difference between the book values and fair values at the date of the transfer will continue to be reported in a separate component of accumulated other comprehensive income (loss), and will be amortized into income over the remaining life of the security as an adjustment of yield in a manner consistent with the amortization of a premium. Concurrently, the revised book values of the transferred securities (represented by the market value on the date of transfer) are being amortized back to their par values over the remaining life of the securities as an adjustment of yield in a manner consistent with the amortization of a discount.

 

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Loans

The following table presents our loan portfolio composition and the corresponding percentage of total loans as of the dates indicated. Other construction and land loans include residential acquisition and development loans, commercial undeveloped land and one- to four-family improved and unimproved lots. Commercial real estate includes non-residential owner occupied and non-owner occupied real estate, multi-family, and owner-occupied investment property. Commercial business loans include unsecured commercial loans and commercial loans secured by business assets.

 

		At September 30, 2014								At December 31, 2013
		Amount				Percent				Amount				Percent
		(Dollars in thousands)
Real estate loans:
One- to four-family residential		$	230,245				43.2	%		$	225,520				43.1	%
Commercial			172,350				32.3				155,633				29.7
Home equity loans and lines of credit			56,577				10.6				56,836				10.8
Residential construction			8,257				1.5				8,952				1.7
Other construction and land			51,644				9.7				64,927				12.4
Commercial			10,919				2.1				8,285				1.6
Consumer			3,236				0.6				3,654				0.7
Total loans, gross		$	533,228				100.0	%		$	523,807				100.0	%
Less:
Deferred loan fees, net			1,631								1,933
Unamortized discount			1,576								—
Total loans, net		$	530,021							$	521,874
Percentage of total assets			59.9	%							66.5	%

Net loans increased by $8.1 million, or 1.6%, to $530.0 million at September 30, 2014 from $521.9 million at December 31, 2013. During 2014, we began to experience an improvement in loan demand, primarily in residential and commercial real estate loans. We believe that economic conditions in our primary market area are continuing to improve, albeit at a moderate pace, and that these improving conditions are contributing to an increase in loan demand.

Delinquent Loans

The accrual of interest on loans is discontinued at the time a loan becomes 90 days delinquent or when it becomes probable that all principal and interest will not be collected, whichever occurs first, unless the loan is well secured and in the process of collection. All interest accrued but not collected for loans that are placed on nonaccrual is reversed. Interest payments received on nonaccrual loans are generally applied as a direct reduction to the principal outstanding until the loan is returned to accrual status. Interest payments received on nonaccrual loans may be recognized as income on a cash basis if recovery of the remaining principal is reasonably assured. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Interest payments applied to principal while the loan was on nonaccrual may be recognized in income over the remaining life of the loan after the loan is returned to accrual status.

 

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If a loan is modified in a TDR, the loan is generally placed on non-accrual until there is a period of satisfactory payment performance by the borrower (either immediately before or after the restructuring), generally six consecutive months, and the ultimate collectability of all amounts contractually due is not in doubt.

The following table sets forth certain information with respect to our loan portfolio delinquencies at the dates indicated. We have no loans past due 90 days and over that are still accruing interest.

 

		Delinquent loans
		30-59 Days Amount				60-89 Days Amount				90 Days and over Amount				Total Amount
		(Dollars in thousands)
At September 30, 2014
Real estate loans:
One-to four-family residential		$	6,641			$	1,692			$	1,973			$	10,306
Commercial			4,754				711				880				6,345
Home equity loans and lines of credit			228				263				939				1,430
Residential construction			222				—				65				287
Other construction and land			1,407				1,444				331				3,182
Commercial			36				—				—				36
Consumer			65				3				—				68
Total loans		$	13,353			$	4,113			$	4,188			$	21,654
% of total loans, net			2.52	%			0.78	%			0.79	%			4.09	%
At December 31, 2013
Real estate loans:
One-to four-family residential		$	5,539			$	669			$	2,587			$	8,795
Commercial			4,746				53				722				5,521
Home equity loans and lines of credit			313				29				350				692
Residential construction			120				—				—				120
Other construction and land			499				185				970				1,654
Commercial			—				35				—				35
Consumer			18				9				—				27
Total loans		$	11,235			$	980			$	4,629			$	16,844
% of total loans, net			2.15	%			0.19	%			0.89	%			3.23	%

Delinquent loans increased $4.8 million, or 28.6%, to $21.7 million at September 30, 2014 from $16.8 million at December 31, 2013. Included in the delinquent loans at September 30, 2014 are several loans that are part of a total $5.5 million loan relationship secured by a restaurant, lodge, vacation rentals and land that became delinquent in the second quarter of 2014. This relationship was classified as “substandard” at September 30, 2014.

 

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Non-Performing Assets

Non-performing loans include all loans past due 90 days and over, certain impaired loans (some of which may be contractually current), and TDR loans that have not yet established a satisfactory period of payment performance (some of which may be contractually current). Non-performing assets include non-performing loans and REO. The table below sets forth the amounts and categories of our non-performing assets at the dates indicated.

 

		At September 30,				At December 31,
		2014				2013
		(Dollars in thousands)
Non-accrual loans:
Real estate loans:
One-to four-family residential		$	3,095			$	2,794
Commercial			7,136				10,212
Home equity loans and lines of credit			1,061				350
Residential construction			65				—
Other construction and land			1,014				2,068
Commercial			16				190
Consumer			—				13
Total non-performing loans		$	12,387			$	15,627
REO:
One- to four-family residential		$	362			$	1,076
Commercial real estate			1,239				2,988
Residential construction			—				210
Other construction and land			4,566				6,232
Total real estate owned		$	6,167			$	10,506
Total non-performing assets		$	18,554			$	26,133
Troubled debt restructurings still accruing		$	21,156			$	23,015
Ratios:
Non-performing loans to total loans, net			2.34	%			2.99	%
Non-performing assets to total assets			2.10	%			3.33	%

Non-performing loans decreased $3.2 million, or 20.7%, to $12.4 million at September 30, 2014 from $15.6 million at December 31, 2013. The largest decrease in the non-performing classification was in commercial real estate loans which declined $3.1 million, or 30.1%. Several commercial real estate relationships returned to accrual status during this period upon demonstration of sustained payment performance and cash flow coverage. Real estate owned decreased $4.3 million, or 41.3%, to $6.2 million at September 30, 2014 from $10.5 million at December 31, 2013, as disposals and writedowns exceeded additions during the nine month period. The decrease in non-performing assets reflects the overall improving economy in our primary market area which has resulted in fewer foreclosures and problem assets.

 

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Classification of Loans

The following table sets forth amounts of classified and criticized loans at the dates indicated. As indicated in the table, loans classified as “doubtful” or “loss” are charged off immediately.

 

		At September 30,				At December 31,
		2014				2013
		(Dollars in thousands)
Classified loans:
Substandard		$	34,836			$	47,019
Doubtful			—				—
Loss			—				—
Total classified loans:			34,836				47,019
As a % of total loans, net			6.57	%			9.01	%
Special mention			33,562				37,670
Total criticized loans		$	68,398			$	84,689
As a % of total loans, net			12.90	%			16.23	%

Total classified loans decreased $12.2 million, or 25.9 %, to $34.8 million at September 30, 2014 from $47.0 million at December 31, 2013. Total criticized loans decreased $16.3 million, or 19.2%, to $68.4 million at September 30, 2014 from $84.7 million at December 31, 2013. These reductions reflect an improving economy and an increasing number of criticized loans being paid off or upgraded as a consequence of improvements in our borrowers’ cash flows and payment performance. Management continues to dedicate significant resources to monitoring and resolving classified and criticized loans.

Allowance for Loan Losses

The allowance for loan losses reflects our estimates of probable losses inherent in our loan portfolio at the balance sheet date. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of our loans in light of historical experience, the nature and volume of our loan portfolio, adverse situations that may affect our borrowers’ abilities to repay, the estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The methodology for determining the allowance for loan losses has two main components: the evaluation of individual loans for impairment and the evaluation of certain groups of homogeneous loans with similar risk characteristics.

A loan is considered impaired when it is probable that we will be unable to collect all principal and interest payments due according to the original contractual terms of the loan. We individually evaluate all loans classified as “substandard” or nonaccrual. If the impaired loan is considered collateral dependent, a charge-off is taken based upon the appraised value of the property (less an estimate of selling costs if foreclosure or sale of the property is anticipated). If the impaired loan is not collateral dependent, a specific reserve is established based upon an estimate of the future discounted cash flows after consideration of modifications and the likelihood of future default and prepayment.

The allowance for homogenous loans consists of a base loss reserve and a qualitative reserve. The base loss reserve utilizes a weighted average loss rate for the last 16 quarters, with the most recent four quarters weighted more heavily than the least recent four quarters. The loss rates for the base loss reserve are segmented into 13 loan categories and contain loss rates ranging from approximately 0% to 15%.

 

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The qualitative reserve adjusts the weighted average loss rates utilized in the base loss reserve for trends in the following internal and external factors:

 

•

Non-accrual and classified loans

 

•

Collateral values

 

•

Loan concentrations

 

•

Economic conditions – including unemployment rates, building permits, and a regional economic index.

Qualitative reserve adjustment factors as a percentage of historical loss rates range from -10% for a favorable trend to +30% for a highly unfavorable trend. These factors are subject to adjustment as economic conditions change.

 

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The following table sets forth activity in our allowance for loan losses at the dates and for the periods indicated.

 

		At or for the three months								At or for the nine months
		ended September 30,								ended September 30,
		2014				2013				2014				2013
		(Dollars in thousands)								(Dollars in thousands)
Balance at beginning of period		$	11,561			$	13,686			$	14,251			$	14,874
Charge-offs:
Real Estate:
One- to four-family residential			109				505				625				1,146
Commercial			3				341				2,001				1,677
Home equity loans and lines of credit			26				26				357				417
Residential construction			—				65				—				193
Other construction and land			10				189				485				910
Commercial			3				—				128				17
Consumer			59				154				122				410
Total charge-offs			210				1,280				3,718				4,770
Recoveries:
Real Estate:
One- to four-family residential			165				74				188				332
Commercial			6				44				341				125
Home equity loans and lines of credit			5				2				39				21
Residential construction			—				98				—				111
Other construction and land			113				59				199				98
Commercial			4				7				159				25
Consumer			112				56				286				342
Total recoveries			405				340				1,212				1,054
Net charge-offs (recoveries)			(195	)			940				2,506				3,716
Provision for loan losses			16				564				27				2,152
Balance at end of period		$	11,772			$	13,310			$	11,772			$	13,310
Ratios:
Net charge-offs to average loans outstanding (annualized)			-0.14	%			0.72	%			0.62	%			0.92	%
Allowance to non-performing loans at period end			95.04	%			164.20	%			95.04	%			164.20	%
Allowance to total loans, net at period end			2.22	%			2.55	%			2.22	%			2.55	%

Net charge-offs/recoveries for the quarter ended September 30, 2014 improved by $1.1 million, to net recoveries of $0.2 million compared to net charge-offs of $0.9 million for the corresponding period in the prior year. For the nine months ended September 30, 2014 net charge-offs decreased $1.2 million, or 32.6%, compared to the corresponding period in the prior year. A $1.7 million charge-off was recorded on our largest lending relationship during the first quarter of 2014, and was responsible for a significant portion of the $3.7 million of charge-offs recorded during the nine months ended September 30, 2014. This expected loss was previously reserved for at December 31, 2013,

 

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resulting in no impact on the provision for loan losses during the first nine months of 2014. The overall historical loss rate used in our allowance for loan losses calculation continues to decline as previous quarters with larger loss rates are eliminated from the calculation as time passes. Our coverage ratio of non-performing loans remained strong, increasing slightly from 91.19% at December 31, 2013 to 95.04% at September 30, 2014.

Real Estate Owned (REO)

The table below summarizes the balances and activity in REO at the dates and for the periods indicated.

 

		September 30,				December 31,
		2014				2013
		(Dollars in thousands)
One- to four-family residential		$	362			$	1,076
Commercial			1,239				2,988
Residential construction			—				210
Other construction and land			4,566				6,232
Total		$	6,167			$	10,506

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013				2014				2013
		(Dollars in thousands)								(Dollars in thousands)
Balance, beginning of period		$	7,485			$	16,172			$	10,506			$	19,755
Additions			454				5,194				1,516				8,141
Disposals			(1,427	)			(4,124	)			(4,406	)			(7,876	)
Writedowns			(411	)			(548	)			(1,508	)			(2,387	)
Other			66				1,057				59				118
Balance, end of period		$	6,167			$	17,751			$	6,167			$	17,751

REO decreased $4.3 million, or 41.3%, to $6.2 million at September 30, 2014 from $10.5 million at December 31, 2013, and decreased $11.6 million, or 65.3%, to $6.2 million at September 30, 2014 from $17.8 million at September 30, 2013. We have experienced a significant decrease in the number and dollar amount of additions to REO, and have had moderate success in liquidating REO. Our policy continues to be to aggressively market REO for sale, including recording write-downs when necessary.

Net Deferred Tax Assets

Deferred income tax assets and liabilities are determined using the asset and liability method and are reported net in the Consolidated Balance Sheets. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax basis of assets and liabilities and recognizes enacted changes in tax rate and laws. When deferred tax assets are recognized, they are subject to a valuation allowance based on management’s judgment as to whether realization is more likely than not. In determining the need for a valuation allowance, we considered the following sources of taxable income:

 

•

Future reversals of existing taxable temporary differences;

 

•

Future taxable income exclusive of reversing temporary differences and carry forwards;

 

•

Taxable income in prior carryback years; and

 

•

Tax planning strategies that would, if necessary, be implemented.

As a result of the analysis above, we concluded that a valuation allowance was necessary as of September 30, 2014 and December 31, 2013. The recorded balance of net deferred tax assets at September 30, 2014 and December 31, 2013 of $2.4 million and $4.2 million respectively, represents the amount of tax planning strategies available to the

 

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Company. We maintained a valuation allowance of $20.5 million and $22.6 million against our deferred tax asset as of September 30, 2014 and December 31, 2013, respectively. The tax planning strategies utilized include converting tax free municipal income to taxable income, the intention and ability to hold securities with an unrealized loss, and the ability to create taxable gains on certain insurance policies.

Deposits

The following table presents deposits by category and percentage of total deposits as of the dates indicated.

 

		As of								As of
		September 30, 2014								December 31, 2013
		Balance				Percent				Balance				Percent
		(Dollars in thousands)
Deposit type:
Savings accounts		$	28,115				4.0	%		$	25,593				3.7	%
Time deposits			314,194				44.1				311,830				45.7
Brokered CDs			9,173				1.3				11,527				1.7
Money market accounts			188,141				26.5				183,504				26.8
Interest-bearing demand accounts			88,669				12.5				81,645				11.9
Noninterest-bearing demand accounts			82,381				11.6				70,127				10.2
Total deposits		$	710,673				100.0	%		$	684,226				100.0	%

As noted in the table above, we have experienced deposit growth across all categories, with the exception of brokered deposits, which we expect to completely eliminate by September 2015.

Junior Subordinated Notes

We had $14.4 million in junior subordinated notes outstanding at September 30, 2014 and December 31, 2013 payable to an unconsolidated subsidiary. These notes accrue interest at 2.80% above the 90-day LIBOR, adjusted quarterly. The effective interest rate was 3.03% and 3.04% at September 30, 2014 and December 31, 2013, respectively. Because of restrictions in the Written Agreement, we have been deferring payment of dividends for 16 consecutive quarters. At September 30, 2014, we have deferred payments of interest on the notes in the amount of $1.9 million.

Equity

Total equity increased $71.8 million, or 220.8%, to $104.3 million at September 30, 2014 from $32.5 million at December 31, 2013. This substantial increase was primarily the result of $63.7 million in net proceeds raised in our common stock offering, a $3.4 million increase in accumulated other comprehensive income related to an improvement in net unrealized holding gains and losses on securities available for sale, and $4.6 million of net income for the period.

 

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Comparison of Operating Results for the Three Months Ended September 30, 2014 and September 30, 2013.

General. Net income increased $1.2 million, or 168.9%, to $1.9 million for the three months ended September 30, 2014, compared to net income of $0.7 million for the three months ended September 30, 2013. On a pre-tax basis, income increased $1.2 million, or 166.6%, to $2.0 million for the three months ended September 30, 2014 compared to $0.7 million for the three months ended September 30, 2013. These increases were primarily attributable to a decrease in the provision for loan losses of $0.5 million and a decrease in non-interest expense of $0.5 million. The increase in after-tax income was partially offset by an increase in income tax expense of $0.1 million primarily due to alternative minimum tax payments made during the three months ended September 30, 2014.

Net Interest Income. Net interest income before provision for loan losses increased slightly to $6.2 million for the three months ended September 30, 2014, compared to $6.1 million for the same period in 2013. The tax-equivalent net interest margin decreased from 3.41% for the quarter ended September 30, 2013 to 3.04% for the same period in 2014. The decline in the margin was primarily the result of a significant increase of $48.5 million in the average balance of cash held in interest-bearing accounts compared to the same period in 2013. The increase in the average balance of cash held in interest bearing-accounts is attributable to our oversubscribed common stock offering in the third quarter of 2014 during which the collected funds were not invested in higher yielding assets.

 

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The following table sets forth the average balances of assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets on a tax-equivalent basis, the total dollar amounts of interest expense on average interest-bearing liabilities, and the resulting annualized average tax-equivalent yields and cost for the periods indicated. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.

 

		For the three months ended
		September 30,
		2014												2013
		Average Outstanding Balance				Interest				Yield/ Rate				Average Outstanding Balance				Interest				Yield/ Rate
		(Dollars in thousands)
Interest-earning assets:
Loans, including loans held for sale		$	539,301			$	6,677				4.91	%		$	524,142			$	6,778				5.13	%
Loans, tax exempt (1)			2,010				25				4.93				1,665				24				5.78
Investments - taxable			199,832				1,024				2.03				174,543				939				2.13
Investment tax exempt (1)			7,930				129				6.44				8,771				139				6.31
Interest earning deposits			58,086				21				0.14				9,600				5				0.21
Other investments, at cost			3,837				89				9.20				3,099				15				1.92
Total interest-earning assets			810,996				7,965				3.90				721,820				7,901				4.34
Noninterest-earning assets			50,884												47,722
Total assets		$	861,880											$	769,542
Interest-bearing liabilities:
Savings accounts		$	27,702			$	9				0.13	%		$	25,974			$	10				0.15	%
Certificates of deposit			327,384				1,054				1.28				324,782				1,099				1.34
Money market accounts			188,547				254				0.53				180,399				277				0.61
Interest bearing transaction accounts			88,825				45				0.20				78,665				34				0.17
Total interest bearing deposits			632,458				1,362				0.85				609,820				1,420				0.92
FHLB advances			40,001				178				1.77				27,253				158				2.30
Junior subordinated debentures			14,433				207				5.69				14,433				123				3.38
Total interest-bearing liabilities			686,892				1,747				1.01				651,506				1,701				1.04
Noninterest-bearing deposits			120,206												71,435
Other non interest bearing liabilities			12,451												6,913
Total liabilities			819,549												729,854
Total equity			42,331												39,688
Total liabilities and net worth		$	861,880											$	769,542
Tax-equivalent net interest income						$	6,218											$	6,200
Net interest-earning assets (2)		$	124,104											$	70,314
Average interest-earning assets to interest-bearing liabilities			1.18												1.11
Tax-equivalent net interest rate spread (3)											2.89	%											3.31	%
Tax-equivalent net interest margin (4)											3.04	%											3.41	%

 

(1)	Tax exempt loans and investments are calculated giving effect to a 34% federal tax rate.

(2)	Net interest-earning assets represents total interest-earning assets less total interest-bearing liabilities.

(3)	Tax-equivalent net interest rate spread represents the difference between the tax equivalent yield on average interest-earning assets and the cost of average interest-bearing liabilities.

(4)	Tax-equivalent net interest margin represents tax equivalent net interest income divided by average total interest-earning assets.

 

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The following table presents the effects of changing rates and volumes on our net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to change in volume (changes in volume multiplied by prior rate). The total column represents the sum of the prior columns. For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately, based on changes due to rate and the changes due to volume.

 

		For the three months ended September 30, 2014 compared to the three months ended September 30, 2013
		Change due to
		Volume				Rate				Total
		(Dollars in thousands)
Interest-earning assets:
Loans, including loans held for sale (1)		$	191			$	(292	)		$	(101	)
Loans, tax exempt (2)			5				(4	)			1
Investment - taxable			131				(46	)			85
Investments - tax exempt (2)			(13	)			3				(10	)
Interest-earning deposits			18				(2	)			16
Other investments, at cost			4				70				74
Total interest-earning assets			336				(271	)			65
Interest-bearing liabilities:
Savings accounts		$	(1	)		$	2			$	1
Certificates of deposit			(9	)			54				45
Money market accounts			(12	)			35				23
Interest bearing transaction accounts			(5	)			(6	)			(11	)
FHLB advances			(62	)			42				(20	)
Junior subordinated debentures			—				(84	)			(84	)
Total interest-bearing liabilities			(89	)			43				(46	)
Change in tax-equivalent net interest income		$	247			$	(228	)		$	19

 

(1)	Non-accrual loans are included in the above analysis.

(2)	Interest income on tax exempt loans and investments are adjusted for based on a 34% federal tax rate

Net interest income before provision for loan losses increased slightly to $6.2 million for the three months ended September 30, 2014, compared to $6.1 million for the same period in 2013. As indicated in the table above, an increase in net interest earned of $247 thousand attributable to an improvement in volume was almost entirely offset by a $228 thousand reduction in net interest earned attributable to a reduction in rates.

The increase in tax-equivalent net interest income of $247 thousand due to volume was primarily due to the effect of higher average loan and taxable investment balances which increased $15.5 million and $25.3 million, respectively, for the three months ended September 30, 2014 as compared to the same period in 2013. The increase in average loan and investment balances was partially offset by higher average FHLB advance balances which increased $12.7 million over the same periods.

 

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The decrease in tax-equivalent net interest income of $228 thousand due to rate was primarily due to the impact of lower average loan yields which decreased 22 basis points to 4.91% in the quarter ended September 30, 2014 as compared to 5.13% in the three months ending September 30, 2013. The decrease in average loan yields was partially offset by the impact of lower average deposit yields which decreased 7 basis points to 0.85% in the quarter ended September 30, 2014 as compared to 0.92% in the three months ending September 30, 2013. In addition, a reduction in average rates on FHLB advances from 2.30% during the three months ended September 30, 2013 to 1.77% for the three months ended September 30, 2014 also contributed to the increase in this component of net interest income. The lower average FHLB advance rates were due to a restructuring of the advances during 2013 that lengthened the maturities and lowered the rates.

Our tax-equivalent net interest rate spread decreased by 42 basis points to 2.89% for the three months ended September 30, 2014 compared to 3.31% for the three months ended September 30, 2013, and our tax-equivalent net interest margin decreased 37 basis points to 3.04% for the three months ended September 30, 2014, compared to 3.41% for the three months ended September 30, 2013. The primary cause of these decreases was an asset-sensitive balance sheet which resulted in a 44 basis point decrease in the yield on earning assets, driven primarily by lower loan yields and a significant increase of $48.5 million in the average balance of cash held in interest-bearing accounts attributable to our oversubscribed common stock offering in the third quarter of 2014, during which the collected funds were not invested in higher yielding assets.

Provision for Loan Losses. During the three months ended September 30, 2014, the provision for loan losses was $16 thousand compared to $0.6 million for the same period in the prior year. The decrease in the provision for loan losses was the result of an improvement in asset quality as compared to the prior year, and a continued reduction in historical and projected loan losses, which has favorably impacted our allowance for loan loss model.

Noninterest Income. The following table summarizes the components of noninterest income and the corresponding change between the three month periods ended September 30, 2014 and 2013:

 

		Three Months Ended September 30,
		2014				2013				Change
		(Dollars in thousands)
Servicing income (expense), net		$	66			$	(48	)		$	114
Mortgage banking			177				399				(222	)
Gain (loss) on sale of investments, net			273				(2	)			275
Overdraft fees			261				287				(26	)
Interchange fees			295				268				27
Bank owned life insurance			131				141				(10	)
Other			229				168				61
Total		$	1,432			$	1,213			$	219

The $0.1 million net increase in servicing income was primarily the result of an increase in the fair value of the corresponding mortgage servicing rights. The fair value of our mortgage servicing rights has risen in recent quarters due to a decrease in expected prepayment speeds.

Mortgage banking income declined $0.2 million, or 55.6%, consistent with an industry-wide slowdown in refinancing activity.

Net gains on sales of investments increased $0.3 million for the three months ended September 30, 2014 compared to the three months ended September 30, 2013. The increase in net gains on sales of investments is due to the sale of investments for gross proceeds of $3.4 million for the three months ended September 30, 2014 compared to $0.1 million for the three months ended September 30, 2013.

 

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Noninterest Expense. The following table summarizes the components of noninterest expense and the corresponding change between the three months ended September 30, 2014 and 2013:

 

		Three Months Ended September 30,
		2014				2013				Change
		(Dollars in thousands)
Compensation and employee benefits		$	2,936			$	2,811			$	125
Net occupancy			655				609				46
Federal deposit insurance			275				425				(150	)
Professional and advisory			149				196				(47	)
Data processing			272				221				51
Net cost of operation of real estate owned			590				1,084				(494	)
Other			716				701				15
Total noninterest expenses		$	5,593			$	6,047			$	(454	)

Compensation and employee benefits increased by $0.1 million, or 4.4%, for the three months ended September 30, 2014 compared to the three months ended September 30, 2013. This additional expense resulted primarily from an increase in the number of full-time equivalent employees to 187 at September 30, 2014, as compared to 183 at the end of September 30, 2013, in response to anticipated growth.

FDIC deposit insurance decreased $0.2 million, or 35.3%, for the three months ended September 30, 2014 compared to the three months ended September 30, 2013 as a result of a reduction in our assessment rates due to an improving risk profile.

The net cost of operation of real estate owned decreased $0.5 million, or 45.6%, for the three months ended September 30, 2014 compared to the three months ended September 30, 2013. This reduction reflects recent decreases in our levels of real estate owned.

Income Taxes. We recorded $0.1 million of income tax expense for the three months ended September 30, 2014, reflecting alternative minimum tax payments made during the period offset by an increase in our allowable net deferred tax asset based on the available tax planning strategies, compared to $46 thousand in the three months ended September 30, 2013. Several of our tax planning strategies are sensitive to changes in interest rates, and we may be required to further reduce our net deferred tax asset in the future should interest rates materially change. We continue to be in a net operating loss position for federal and state income tax purposes and do not have a material current tax liability or receivable.

Comparison of Results of Operations for the Nine Months Ended September 30, 2014 and September 30, 2013

Net income increased $2.8 million, or 150.5%, to $4.6 million for the nine months ended September 30, 2014, compared to net income of $1.9 million for the nine months ended September 30, 2013. On a pre-tax basis, income increased $4.2 million, or 179.4%, to $6.5 million for the nine months ended September 30, 2014 compared to $2.3 million for the nine months ended September 30, 2013. These increases were primarily due to an increase in net interest income of $1.1 million and decreases in non-interest expense of $1.0 million and the provision for loan losses of $2.1 million. The increase in after-tax income was partially offset by an increase in income tax expense of $1.4 million due to an increase in the valuation allowance for our deferred tax asset as a result of a reduction in the amount of tax planning strategies available to us.

Net Interest Income. Net interest income before provision for loan losses increased by $1.1 million, or 5.9%, to $19.5 million for the nine months ended September 30, 2014, compared to $18.4 million for the nine months ended September 30, 2013. This improvement was the result of an increase in loan yields of 6 basis points and a reduction in rates on interest-bearing liabilities of 10 basis points for the nine months ended September 30, 2014 compared to the same period during 2013. The improved loan yields were primarily the result of the favorable resolution and restructuring of two commercial loans, which resulted in the recognition of approximately $1.1 million of deferred interest and discounts.

 

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The following table sets forth the average balances of assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets on a tax-equivalent basis, the total dollar amounts of interest expense on average interest-bearing liabilities, and the resulting annualized average tax-equivalent yields and cost for the periods indicated. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.

 

		For the nine months ended
		September 30,
		2014												2013
		Average												Average
		Outstanding												Outstanding
		Balance				Interest				Yield/ Rate				Balance				Interest				Yield/ Rate
						(Dollars in thousands)
Interest-earning assets:
Loans, including loans held for sale		$	532,891			$	21,022				5.27	%		$	536,424			$	20,923				5.21	%
Loans, tax exempt (1)			1,979				76				5.12				1,692				74				5.87
Investments - taxable			185,116				2,976				2.15				158,967				2,427				2.04
Investment tax exempt (1)			8,476				409				6.45				8,771				420				6.40
Interest earning deposits			35,982				49				0.18				13,046				22				0.23
Other investments, at cost			3,643				136				4.99				3,181				52				2.19
Total interest-earning assets			768,087				24,668				4.29				722,081				23,918				4.43
Noninterest-earning assets			49,630												49,255
Total assets		$	817,717											$	771,336
Interest-bearing liabilities:
Savings accounts		$	26,717				27				0.14	%		$	25,588				28				0.15
Certificates of deposit			326,280				3,163				1.30				329,923				3,438				1.39
Money market accounts			185,650				753				0.54				181,492				853				0.63
Interest bearing transaction accounts			83,708				108				0.17				76,516				99				0.17
Total interest bearing deposits			622,355				4,051				0.87				613,519				4,418				0.96
FHLB advances			40,002				526				1.76				26,210				517				2.64
Junior subordinated debentures			14,433				382				3.54				14,433				367				3.40
Total interest-bearing liabilities			676,790				4,959				0.98				654,162				5,302				1.08
Noninterest-bearing deposits			88,878												67,204
Other non interest bearing liabilities			12,488												8,509
Total liabilities			778,156												729,875
Total equity			39,561												41,461
Total liabilities and net worth		$	817,717											$	771,336
Tax-equivalent net interest income						$	19,709											$	18,616
Net interest-earning assets (2)		$	91,297											$	67,919
Average interest-earning assets to interest-bearing liabilities			1.13												1.10
Tax-equivalent net interest rate spread (3)											3.31	%											3.34	%
Tax-equivalent net interest margin (4)											3.43	%											3.45	%

 

(1)	Tax exempt loans and investments are calculated giving effect to a 34% federal tax rate.

(2)	Net interest-earning assets represents total interest-earning assets less total interest-bearing liabilities.

(3)	Tax-equivalent net interest rate spread represents the difference between the tax equivalent yield on average interest-earning assets and the cost of average interest-bearing liabilities.

(4)	Tax-equivalent net interest margin represents tax equivalent net interest income divided by average total interest-earning assets.

 

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The following table presents the effects of changing rates and volumes on our net interest income for the period indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to change in volume (changes in volume multiplied by prior rate). The total column represents the sum of the prior columns. For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately, based on changes due to rate and the changes due to volume.

 

		For the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013
		Change due to
		Volume				Rate				Total
		(Dollars in thousands)
Interest-earning assets:
Loans, including loans held for sale (1)		$	(139	)		$	238			$	99
Loans, tax exempt (2)			12				(10	)			2
Investment - taxable			415				134				549
Investments - tax exempt (2)			(14	)			3				(11	)
Other investments, at cost			32				(5	)			27
Interest-earning deposits			9				75				84
Total interest-earning assets		$	315			$	435			$	750
Interest-bearing liabilities:
Savings accounts		$	(1	)		$	2			$	1
Certificates of deposit			38				237				275
Money market accounts			(19	)			119				100
Interest bearing transaction accounts			(9	)			—				(9	)
FHLB advances			(217	)			208				(9	)
Junior subordinated debentures			—				(15	)			(15	)
Total interest-bearing liabilities		$	(208	)		$	551			$	343
Change in tax-equivalent net interest income		$	107			$	986			$	1,093

 

(1)	Non-accrual loans are included in the above analysis.

(2)	Interest income on tax exempt loans and investments are adjusted for based on a 34% federal tax rate

Tax-equivalent net interest income increased by $1.1 million, or 5.9%, to $19.7 million for the nine months ended September 30, 2014, from $18.6 million for the nine months ended September 30, 2013. As indicated in the table above, the increase resulted from additional interest earned of $1.0 million attributable to an improvement in rates and an increase of $0.1 million attributable to volume.

The increase in tax-equivalent net interest income due to rates was primarily due to the impact of higher average loan yields which increased to 5.27% in the nine months ended September 30, 2014 as compared to 5.21% in the nine months ending September 30, 2013. This increase in loan yields reflects the impact of the aforementioned favorable resolution and restructuring of two commercial loans, which contributed substantially all of the 6 basis point increase in loan yields. In addition, lower average rates on FHLB advances of 1.76% for the nine months ended September 30, 2014, as compared to 2.64% for the same period in the prior fiscal year, also contributed to the increase in net interest income. The lower average FHLB advance rates were due to a restructuring of the advances during 2013 that lengthened the maturities and lowered the rates. An 9 basis point reduction in average deposit yields to 0.87% for the nine months ended September 30, 2014, from 0.96% for the comparable period ended September 30, 2013 also contributed to the increase in the component of tax-equivalent net interest income attributable to rates.

 

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The increase in tax-equivalent net interest income of $0.1 million due to volume was primarily due to the effect of higher average taxable investment balances which increased $26.1 million for the nine months ended September 30, 2014 compared to the same period in 2013. The improvement related to the higher average balance in taxable investments was partially offset by higher average FHLB advance balances which increased $13.8 million over the same periods. Although average loan balances decreased when comparing the first nine months of 2014 to the same period in 2013, we have experienced loan growth during the first nine months of 2014.

Our tax-equivalent net interest rate spread remained mostly flat, decreasing by 3 basis points to 3.31% for the nine months ended September 30, 2014 compared to 3.34% for the nine months ended September 30, 2013. Our tax-equivalent net interest margin also remained relatively unchanged, decreasing by 2 basis points to 3.43% from 3.45% over the same periods.

Provision for Loan Losses. During the nine months ended September 30, 2014, the provision for loan losses was $27 thousand compared to $2.2 million for the same period in the prior fiscal year. The decrease in the provision for loan losses was the result of an improvement in asset quality, and a continued reduction in historical and projected loan losses which has favorably impacted our allowance for loan loss model.

Noninterest Income. The following table summarizes the components of noninterest income and the corresponding change between the nine month periods ended September 30, 2014 and 2013:

 

		Nine Months Ended September 30,
		2014				2013				Change
		(Dollars in thousands)
Servicing income (expense), net		$	492			$	(144	)		$	636
Mortgage banking			660				1,836				(1,176	)
Gain on sale of investments, net			652				96				556
Other than temporary impairment			(76	)			—				(76	)
Overdraft fees			769				852				(83	)
Interchange fees			836				746				90
Bank owned life insurance			389				412				(23	)
Other			639				602				37
Total		$	4,361			$	4,400			$	(39	)

The $0.6 million net increase in servicing income was primarily the result of an increase in the fair value of the corresponding mortgage servicing rights. The fair value of our mortgage servicing rights has risen in recent quarters due to a decrease in expected prepayment speeds.

Mortgage banking income declined $1.2 million, or 64.1%, consistent with an industry-wide slowdown in refinancing activity.

Net gains on sales of investments increased $0.6 million for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. The increase in net gains on sales of investments is due to the sale of investments for gross proceeds of $18.8 million for the nine months ended September 30, 2014 compared to $4.2 million for the nine months ended September 30, 2013.

We also recorded an other than temporary impairment of $76 thousand on a Small Business Investment Company investment fund during the nine months ended September 30, 2014.

 

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Noninterest Expense. The following table summarizes the components of noninterest expense and the corresponding change between the nine months ended September 30, 2014 and 2013:

 

		Nine Months Ended September 30,
		2014				2013				Change
		(Dollars in thousands)
Compensation and employee benefits		$	8,974			$	8,565			$	409
Net occupancy			1,964				1,890				74
Federal deposit insurance			971				1,267				(296	)
Professional and advisory			529				416				113
Data processing			774				666				108
Net cost of operation of real estate owned			2,034				3,574				(1,540	)
Other			2,128				1,990				138
Total noninterest expenses		$	17,374			$	18,368			$	(994	)

Compensation and employee benefits increased by $0.4 million, or 4.8%, for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. This additional expense resulted from an increase in the number of full-time equivalent employees to 187 at the end of September 30, 2014, as compared to 177 at the end of September 30, 2013, in response to anticipated growth.

FDIC deposit insurance decreased $0.3 million, or 23.4%, for the nine months ended September 30, 2014 compared to the same period in 2013 as a result of a reduction in our assessment rates due to an improving risk profile.

The net cost of operation of real estate owned decreased $1.5 million, or 43.1%, for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. This reduction reflects recent decreases in our levels of real estate owned.

Income Taxes. We recorded $1.9 million of income tax expense for the nine months ended September 30, 2014, reflecting a decrease in our allowable net deferred tax asset based on the available tax planning strategies, compared to $0.5 million in the nine months ended September 30, 2013. Several of our tax planning strategies are sensitive to changes in interest rates, and we may be required to further reduce our net deferred tax asset in the future should interest rates materially change. We continue to be in a net operating loss position for federal and state income tax purposes and do not have a material current tax liability or receivable.

Liquidity and Capital Resources

Liquidity is the ability to meet current and future financial obligations. Our primary sources of funds consist of deposit inflows, loan repayments, advances from the FHLB, proceeds from the sale of loans originated for sale, and principal repayments and the sale of available-for-sale securities. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. Our Asset/Liability Management Committee, under the direction of our Chief Operating Officer, is responsible for establishing and monitoring our liquidity targets and strategies in order to ensure that sufficient liquidity exists for meeting the borrowing needs and deposit withdrawals of our customers as well as unanticipated contingencies. We believe that we have enough sources of liquidity to satisfy our short- and long-term liquidity needs as of September 30, 2014.

We regularly monitor and adjust our investments in liquid assets based upon our assessment of expected loan demand, expected deposit flows and borrowing maturities, yields available on interest-earning deposits and securities, and the objectives of our asset/liability management program. Excess liquid assets are invested generally in FHLB and FRB interest-earning deposits and investment securities and are also used to pay off short-term borrowings. At September 30, 2014, cash and cash equivalents totaled $84.1 million. Included in this total is $75.5 million held at FRB and $1.6 million held at the FHLB in interest-earning assets.

 

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Our cash flows are derived from operating activities, investing activities and financing activities as reported in our Consolidated Statements of Cash Flows included in our Consolidated Financial Statements. The following summarizes the most significant sources and uses of liquidity during the nine months ended September 30, 2014 and 2013:

 

		Nine Months Ended September 30,
		2014				2013
Operating activities:
Loans originated for sale		$	(22,228	)		$	(54,062	)
Proceeds from loans originated for sale			16,113				56,584
Investing activities:
Purchases of investments		$	(72,408	)		$	(93,129	)
Maturities and principal repayments of investments			19,600				28,938
Sales of investments			18,833				4,180
Net (increase) decrease in loans			(10,930	)			28,270
Proceeds from sales of real estate owned			3,157				6,690
Financing activities:
Net increase in deposits		$	26,447			$	7,755
Proceeds from sale of common stock			63,733				—

At September 30, 2014, we had $1.0 million in outstanding commitments to originate mortgage loans. In addition to commitments to originate mortgage loans, we had $67.1 million in unused lines of credit for home equity loans and other lines of credit and $2.5 million for consumer lines.

Depending on market conditions, we may be required to pay higher rates on our deposits or other borrowings than we currently pay on certificates of deposit. Based on historical experience and current market interest rates, we anticipate that following their maturity we will retain a large portion of our retail certificates of deposit with maturities of one year or less as of September 30, 2014.

In addition to loans, we invest in securities that provide a source of liquidity, both through repayments and as collateral for borrowings. Our securities portfolio includes both callable securities (which allow the issuer to exercise call options) and mortgage-backed securities (which allow borrowers to prepay loans). Accordingly, a decline in interest rates would likely prompt issuers to exercise call options and borrowers to prepay higher-rate loans, so producing higher than otherwise scheduled cash flows.

Liquidity management is both a daily and long-term function of management. If we require more funds than we are able to generate locally, we have borrowing agreements with the FHLB and the FRB discount window. The following summarizes our borrowing capacity as of September 30, 2014:

 

				Total Capacity				Used Capacity				Unused Capacity
FHLB		Loans		$	100,734			$	40,000			$	60,734
Unpledged Marketable Securities		Investments			203,089				10,755				192,334
FRB		Loans			50,848				—				50,848
				$	354,671			$	50,755			$	303,916

The Bank is subject to various regulatory capital requirements, including a risk-based capital measure. The risk-based guidelines and framework under prompt corrective action provisions include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items

 

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to broad risk categories. Under the Memorandum of Understanding, the Bank is required to maintain a Tier I leverage capital ratio of not less than 8% and a total risk-based capital ratio of not less than 11%. For additional information, see “Supervision and Regulation – Regulatory Agreements” on page 112 of our Registration Statement. The following table summarizes the required and actual capital ratios of the Bank as of the dates indicated:

 

		Actual								For Capital Adequacy Purposes								To meet the Requirements of the Memorandum of Understanding
(Dollars in thousands)		Amount				Ratio				Amount				Ratio				Amount				Ratio
As of September 30, 2014:
Tier I Leverage Capital		$	104,197				12.04	%		$	34,608				³4	%		$	69,217				³8	%
Tier 1 Risk-based Capital		$	104,197				19.93	%		$	20,916				³4	%			N/A				N/A
Total Risk-based Capital		$	110,799				21.19	%		$	41,831				³8	%		$	57,518				³11	%
As of December 31, 2013:
Tier I Leverage Capital		$	54,775				7.02	%		$	31,190				³4	%		$	62,380				³8	%
Tier 1 Risk-based Capital		$	54,775				10.70	%		$	20,484				³4	%			N/A				N/A
Total Risk-based Capital		$	61,274				11.97	%		$	40,968				³8	%		$	56,331				³11	%

 

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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

General

One of the most significant forms of market risk is interest rate risk because, as a financial institution, the majority of our assets and liabilities are sensitive to changes in interest rates. Interest rate fluctuations affect earnings by changing net interest income and other interest –sensitive income and expense levels. Interest rate changes affect EVE by changing the net present value of a bank’s future cash flows, and the cash flows themselves as rates change. Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value. However, excessive risk can threaten a bank’s earnings, capital, liquidity and solvency. Therefore, a principal part of our operations is to manage interest rate risk and limit the exposure of our net interest income to changes in market interest rates. The Board of Directors of the Bank have established an Asset/Liability Management Committee (“ALCO Committee”), which is responsible for evaluating the interest rate risk inherent in our assets and liabilities, for determining the level of risk that is appropriate, given our business strategy, operating environment, capital, liquidity and performance objectives, and for managing this risk consistent with the guidelines approved by the Board. Our ALCO Committee monitors and manages market risk through rate shock analyses, economic value of equity, or EVE, analyses and simulations in order to avoid unacceptable earnings and market value fluctuations due to changes in interest rates.

One of the primary ways we manage interest rate risk is by selling the majority of our long-term fixed rate mortgages to the secondary markets, obtaining commitments to sell at locked-in interest rates prior to issuing a loan commitment. From a funding perspective, we expect to satisfy the majority of our future requirements with retail deposit growth, including checking and savings accounts, money market accounts and certificates of deposit generated within our markets. Deposits, exclusive of brokered certificates of deposit, increased to $701.5 million at September 30, 2014, from $672.7 million at December 31, 2013. Brokered deposits declined $2.4 million, or 20.4%, to $9.2 million at September 30, 2014 from $11.5 million at December 31, 2013. If our funding needs exceed our deposits, we will utilize our excess funding capacity with the FHLB and the Federal Reserve.

We have taken the following steps to reduce our interest rate risk:

 

•

increased our personal and business checking accounts and our money market accounts, which are less rate-sensitive than certificates of deposit and which provide us with a stable, low-cost source of funds;

 

•

limited the fixed rate period on all loans within our portfolio

 

•

utilized our securities portfolio for positioning based on projected interest rate environments;

 

•

priced certificates of deposits to encourage customers to extend to longer terms;

 

•

utilized FHLB advances for positioning.

We have not conducted hedging activities, such as engaging in futures, options or swap transactions.

Economic Value of Equity (EVE)

EVE is the difference between the present value of an institution’s assets and liabilities (the institution’s EVE) that would change in the event of a range of assumed changes in market interest rates. EVE is used to monitor interest rate risk beyond the 12 month time horizon of rate shocks. The simulation model uses a discounted cash flow analysis and an option-based pricing approach to measure the interest rate sensitivity of EVE. The model estimates the economic value of each type of asset, liability and off-balance sheet contract using the current interest rate yield curve with instantaneous increases or decreases of 100 to 400 basis points in 100 basis point increments. A basis point equals one-hundredth of one percent, and 100 basis points equals one percent. An increase in interest rates from 3% to 4% would mean, for example, a 100 basis point increase in the “Change in Interest Rates” column below. Given the current relatively low level of market interest rates, an NPV calculation for an interest rate decrease of greater than 100 basis points has not been prepared.

 

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Certain shortcomings are inherent in the methodologies used in determining interest rate risk through changes in EVE. Modeling changes in EVE require making certain assumptions that may or may not reflect the manner in which actual yields and costs, or loan repayments and deposit decay, respond to changes in market interest rates. In this regard, the EVE information presented assumes that the composition of our interest-sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and assumes that a particular change in interest rates is reflected across the yield curve regardless of the duration or repricing of specific assets and liabilities. Accordingly, although the EVE information provides an indication of our interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on our net interest income and will differ from actual results.

Net Interest Income

In addition to an EVE analysis, we analyze the impact of changing rates on our net interest income. Using our balance sheet as of a given date, we analyze the repricing components of individual assets, and adjusting for changes in interest rates at 100 basis point increments, we analyze the impact on our net interest income. Changes to our net interest income are shown in the following table based on immediate changes to interest rates in 100 basis point increments.

The table below reflects the impact of an immediate increase in interest rates in 100 basis point increments on Net Interest Income (NII) and Economic Value of Equity (EVE).

 

				September 30, 2014								December 31, 2013
Change in Interest Rates (basis points)				% Change in Pretax Net Interest Income				% Change in Economic Value of Equity				% Change in Pretax Net Interest Income				% Change in Economic Value of Equity
	+400				15.4				(14.2	)			10.5				(24.2	)
	+300				10.7				(12.1	)			7.1				(21.1	)
	+200				6.3				(9.1	)			3.9				(15.7	)
	+100				2.4				(5.3	)			1.3				(9.1	)
	—				—				—				—				—
	-100				(6.3	)			2.3				(4.4	)			5.1

The results from the rate shock analysis on NII are consistent with having an asset sensitive balance sheet. Having an asset sensitive balance sheet means assets will reprice at a faster pace than liabilities during the short-term horizon. The implications of an asset sensitive balance sheet will differ depending upon the change in market rates. For example, with an asset sensitive balance sheet in a declining interest rate environment, the interest rate on assets will decrease at a faster pace than liabilities. This situation could result in a decrease in NII and operating income. Conversely, with an asset sensitive balance sheet in a rising interest rate environment, the interest rate on assets will increase at a faster pace than liabilities. This situation could result in an increase in NII and operating income. As indicated in the table above, a 200 basis point increase in rates would result in a 6.3% increase in NII as of September 30, 2014 as compared to a 3.9% increase in NII as of December 31, 2013.

The results from the rate shock analysis on EVE are consistent with a balance sheet whose assets have a longer maturity than its liabilities. Like most financial institutions, we generally invest in longer maturity assets as compared to our liabilities in order to earn a higher return on our assets than we pay on our liabilities. This is because interest rates generally increase as the time to maturity increases, assuming a normal, upward sloping yield curve. In a rising interest rate environment, this results in a negative EVE because higher interest rates will reduce the present value of longer term assets more than it will reduce the present value of shorter term liabilities, resulting in a negative impact on equity. As noted in the table above, our exposure to higher interest rates from an EVE or present value perspective has declined from December 31, 2013 to September 30, 2014. For example, a 200 basis point increase in rates would result in a 9.1% decrease in EVE as of September 30, 2014 as compared to a 15.7% decrease in EVE as of December 31, 2013.

 

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Item 4. CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

The Company’s management, including its Chief Executive Officer and Chief Financial Officer evaluated the effectiveness of its disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of September 30, 2014. Based upon that evaluation, the Companys’s Chief Executive Officer and Chief Financial Officer each concluded that as of September 30, 2014, the end of the period covered by this Quarterly Report on Form 10-Q, the Company maintained effective disclosure controls and procedures.

Changes in Internal Control over Financial Reporting

There have been no changes to the Company’s internal controls over financial reporting that occurred during the quarter ended September 30, 2014 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

 

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PART II. OTHER INFORMATION

 

Item 1.

Legal Proceedings

We are not involved in any material pending legal proceedings. In the ordinary course of operations, we are often involved in legal proceedings. In the opinion of management, except for the Regulatory Agreements, neither the Company nor the Bank is a party to, nor is their property the subject of, any material pending legal proceedings, other than ordinary routine litigation incidental to their business, nor has any such proceeding been terminated during the quarter ended September 30, 2014.

 

Item 1A.

Risk Factors

There have been no material changes to the risk factors that we have previously disclosed in the “Risk Factors” section in the Registration Statement on Form S-1 as filed with the SEC on July 18, 2014.

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

Not Applicable

 

Item 3.

Defaults Upon Senior Securities

As disclosed in the Registration Statement, the Company has, since December 30, 2010, deferred payment of dividends on trust preferred securities issued by its subsidiary, Macon Capital Trust I. As of the date of filing of this report, the amount of accrued and unpaid dividends is $1.9 million. The Company intends to seek regulatory approval to resume payment of dividends during the fourth quarter of 2014.

 

Item 4.

Mine Safety Disclosures

Not Applicable

 

Item 5.

Other Information

None

 

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Item 6. Exhibits

 

Exhibit No.		Description
2		Plan of Conversion, incorporated by reference to Exhibit 2 of the Registration Statement on Form S-1, filed with the SEC on March 18, 2014 (SEC File No. 333-194641).
3.1		Articles of Incorporation of Entegra Financial Corp., as amended and restated, incorporated by reference to Exhibit 3.1 of the Registration Statement on Form S-1, filed with the SEC on March 18, 2014 (SEC File No. 333-194641).
3.2		Bylaws of Entegra Financial Corp., as amended and restated, incorporated by reference to Exhibit 3.2 of the Registration Statement on Form S-1, filed with the SEC on March 18, 2014 (SEC File No. 333-194641).
4		Form of Common Stock Certificate of Entegra Financial Corp., incorporated by reference to Exhibit 4 of the Registration Statement on Form S-1/A, filed with the SEC on September 27, 2014 (SEC File No. 333-194641).
10.1		Employment and Change of Control Agreement, dated as of October 9, 2014, by and among Entegra Financial Corp., Macon Bank, Inc., and Roger D. Plemens, incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K, filed with the SEC on October 15, 2014 (SEC File No. 001-35302)*
10.2		Employment and Change of Control Agreement, dated as of November 1, 2014, by and among Entegra Financial Corp., Macon Bank, Inc., and Ryan M. Scaggs, incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K, filed with the SEC on November 6, 2014 (SEC File No. 001-35302)*
10.3		Employment and Change of Control Agreement, dated as of November 1, 2014, by and among Entegra Financial Corp., Macon Bank, Inc., and David A. Bright, incorporated by reference to Exhibit 10.2 of the Current Report on Form 8-K, filed with the SEC on November 6, 2014 (SEC File No. 001-35302)*
31.1		Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32		Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101		Financial Statements filed in XBRL format.

 

*	Management contract or compensatory plan, contract or arrangement.

 

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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.

 

Date: November 12, 2014				Entegra Financial Corp.
(Registrant)
						By:		/s/ David A. Bright
						Name:		David A. Bright
						Title:		Chief Financial Officer
								(Authorized Officer)

 

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EXHIBIT INDEX

 

Exhibit No.		Description
31.01		Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.02		Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.01		Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101		Financial Statements filed in XBRL format.

 

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