UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

 

x

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2015

 

or

 

o

Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from            to           

 

Commission file number 001-10897

 

Carolina Financial Corporation

(Exact name of registrant as specified in its charter)

 

Delaware		57-1039637
(State of Incorporation)		(I.R.S. Employer Identification No.)

 

288 Meeting Street, Charleston, South Carolina		29401
(Address of principal executive offices)		(Zip Code)

 

(843) 723-7700

(Issuer’s Telephone Number)

 

Securities registered pursuant to Section 12(b) of the Exchange Act: None

 

Securities registered under Section 12(g) of the Exchange Act:

 

Title of each class: Common Stock, $0.01 par value per share

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes o  No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.

Yes o  No x

 

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 o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x  No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

o

 

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

Yes o  No x

 

The aggregate market value of the voting and nonvoting common equity held by non-affiliates of the registrant (computed by reference to the price at which the stock was most recently sold) was $108,169,734 as of the last business day of the registrant’s most recently completed second fiscal quarter.

 

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

 

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

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

 

Class		Outstanding at March 14, 2016
Common Stock, $.01 par value per share		12,047,615 shares

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s Proxy Statement relating to the registrant’s Annual Meeting of Shareholders, to be held on May 3, 2016, are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated.

TABLE OF CONTENTS

 

		Page
PART 1
Item 1.	Business	1
Item 1A.	Risk Factors	21
Item 1B.	Unresolved Staff Comments	36
Item 2.	Properties	36
Item 3.	Legal Proceedings	36
Item 4.	Mine Safety Disclosures	36
PART II
Item 5.	Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters	37
Item 6.	Selected Financial Data	39
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	41
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	72
Item 8.	Financial Statements and Supplementary Data	73
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	138
Item 9A.	Controls and Procedures	138
Item 9B.	Other Information	138
PART III
Item 10	Director, Executive Officer and Corporate Governance	139
Item 11	Executive Compensation	139
Item 12	Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters	139
Item 13	Certain Relationships and Related Transactions	139
Item 14	Principal Accounting Fees and Services	139
Item 15.	Financial Statements and Exhibits	139
SIGNATURES
EXHIBIT INDEX

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K, including information included or incorporated by reference, contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 (the “Securities “Act”) and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). Forward-looking statements may relate to our financial condition, results of operation, plans, objectives, or future performance. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “believe,” “continue,” “assume,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties that could cause our actual results to differ from those anticipated in any forward-looking statements include, but are not limited to, those described below under “Item 1A- Risk Factors” and the following:

 

●

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

●

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

●

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

●

changes in interest rates, or changes in regulatory environment resulting in a decline in our mortgage production and a decrease in the profitability of our mortgage banking operations;

●

greater than expected losses due to higher credit losses generally and specifically because losses in the sectors of our loan portfolio secured by real estate are greater than expected due to economic factors, including, but not limited to, declining real estate values, increasing interest rates, increasing unemployment, or changes in payment behavior or other factors;

●

greater than expected losses due to higher credit losses because our loans are concentrated by loan type, industry segment, borrower type, or location of the borrower or collateral;

●

changes in the amount of our loan portfolio collateralized by real estate and weaknesses in the South Carolina, southeastern North Carolina and national real estate markets;

●

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

●

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

●

the rate of loan growth in recent or future years;

●

our ability to attract and retain key personnel;

●

our ability to retain our existing customers, including our deposit relationships;

●

significant increases in competitive pressure in the banking and financial services industries;

●

adverse changes in asset quality and resulting credit risk-related losses and expenses;

●

changes in the interest rate environment which could reduce anticipated or actual margins;

●

changes in political conditions or the legislative or regulatory environment, including, but not limited to, the Dodd-Frank Act and regulations adopted thereunder, changes in federal or state tax laws or interpretations thereof by taxing authorities and other governmental initiatives affecting the banking, mortgage banking, and financial service industries;

●

changes occurring in business conditions and inflation;

●

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

●

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

●

changes in deposit flows;

●

changes in technology;

●

changes in monetary and tax policies;

●

changes in accounting policies, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board and the Financial Accounting Standards Board;

●

loss of consumer confidence and economic disruptions resulting from terrorist activities or other military actions;

●

our expectations regarding our operating revenues, expenses, effective tax rates and other results of operations;

●

our anticipated capital expenditures and our estimates regarding our capital requirements;

●

our liquidity and working capital requirements;

●

competitive pressures among depository and other financial institutions;

●

the growth rates of the markets in which we compete;

●

our anticipated strategies for growth and sources of new operating revenues;

●

our current and future products, services, applications and functionality and plans to promote them;

●

anticipated trends and challenges in our business and in the markets in which we operate;

●

the evolution of technology affecting our products, services and markets;

●

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

●

management compensation and the methodology for its determination;

	●	our ability to compete in our industry and innovation by our competitors;
	●	increased cybersecurity risk, including potential business disruptions or financial losses;

●

acquisition integration risks, including potential deposit attrition, higher than expected costs, customer loss and business disruption, including, without limitation, potential difficulties in maintaining relationships with key personnel and other integration related matters, and the inability to identify and successfully negotiate and complete additional combinations with potential merger or acquisition partners or to successfully integrate such businesses into the Company, including the ability to realize the benefits and cost savings from, and limit any unexpected liabilities associated with, any such business combinations;

●

our ability to stay abreast of new or modified laws and regulations that currently apply or become applicable to our business; and

●

estimates and estimate methodologies used in preparing our consolidated financial statements and determining option exercise prices and stock-based compensation.

 

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

PART I

 

Item 1.  Business

 

General Overview

 

Carolina Financial Corporation is a Delaware corporation that was organized in February 1997 to serve as a bank holding company. It operates principally through CresCom Bank, a South Carolina state-chartered bank. CresCom Bank operates Crescent Mortgage Company and Carolina Service Corporation of Charleston as wholly-owned subsidiaries of CresCom Bank. Except where the context otherwise requires, the “Company”, “we”, “us” and “our” refer to Carolina Financial Corporation and its consolidated subsidiaries and the “Bank” refers to CresCom Bank.

 

We offer a variety of traditional community banking services to individuals and businesses. Our product line includes loans to small and medium-sized businesses, residential and commercial construction and development loans, commercial real estate loans, residential mortgage loans, residential lot loans, home equity loans, consumer loans and a variety of commercial and consumer demand, savings and time deposit products. We also offer online and bill payment services, wire transfer services, safe deposit box rentals, debit card and ATM card services, and the availability of a network of ATMs for our customers.

 

Crescent Mortgage Company, acquired by us in 2003, was founded in February 1993 as a wholesale and correspondent mortgage lender for community banks in the Southeastern United States. Today, Crescent Mortgage Company lends in 45 states and has partnered with community banks, credit unions, and mortgage brokers. Crescent Mortgage Company is based in Atlanta, Georgia.

 

Carolina Services Corporation of Charleston, a Delaware financial services company incorporated in 2002 to provide financial processing services to, and otherwise support the operations of, the Bank and Crescent Mortgage Company.

 

In December 2002 and October 2003, respectively, the Company formed Carolina Financial Capital Trust I and Carolina Financial Capital Trust II, which are special purpose subsidiaries organized in Delaware for the sole purpose of issuing an aggregate of $15 million of trust preferred securities.

 

On December 12, 2014, the Bank purchased 13 branches located in South Carolina and southeastern North Carolina from First Community Bank. In the transaction, the Bank acquired approximately $215.1 million of deposits, approximately $70.9 million of performing loans, and the bank facilities and certain other assets of the acquired branches.

 

On January 5, 2016, Carolina Financial Corporation announced the execution of a definitive agreement pursuant to which we will acquire Congaree Bancshares, Inc., the holding company of Congaree State Bank, in a cash and stock transaction with a total current value of approximately $16.3 million including the assumption of approximately $1.6 million in preferred stock.

 

Our main office is located at 288 Meeting Street, Charleston, South Carolina 29401.

 

Our Market Area

 

Our primary market areas are the South Carolina coast, including the Charleston (Charleston, Dorchester, and Berkeley Counties) and Myrtle Beach (Horry and Georgetown Counties) market areas, and the southeastern coastal region of North Carolina, including Bladen, Brunswick, Columbus and New Hanover Counties. We currently operate 27 branches: eight in the Charleston market, eight in the Myrtle Beach market, nine in southeastern North Carolina and two in other South Carolina markets. We also operate loan production offices in Greenville, South Carolina and Wilmington, North Carolina.

The following table presents, for each of our above-described primary market areas, the number of branches of CresCom Bank in the market area, the approximate amount of deposits with CresCom Bank in the market area as of June 30, 2015 and our approximate deposit market share in market area at June 30, 2015 (the latest date for which such data is available). This table does not include deposits held in Greenville, South Carolina branch, which opened on August 31, 2015 or those held in our Heath Springs, South Carolina branch.

 

		Number of				Deposits				Market
Market Name		Branches				(in millions)				Share
Charleston, South Carolina			8			$	518.5				4.60	%
Myrtle Beach, South Carolina			8			$	294.4				4.40	%
Southeastern North Carolina			9			$	188.1				2.49	%

 

The Charleston, South Carolina is heavily influenced by the diverse economic mix of the Charleston region. The region is home to the Port of Charleston, one of the busiest container ports along the Southeast and Gulf Coasts, as well as a number of national and international manufacturers, including Boeing South Carolina and Robert Bosch LLC. The region also benefits from a thriving tourism industry. In addition, a number of academic institutions are located within the region, including the Medical University of South Carolina, The Citadel, The College of Charleston, Charleston Southern University, Trident Technical College and The Charleston School of Law. Charleston also hosts military installations for the U.S. Navy, Marine Corps, U.S. Air Force, U.S. Army and U.S. Coast Guard.

 

The Myrtle Beach area, also known as the Grand Strand, is a 60-mile stretch of beaches extending south from the South Carolina/North Carolina state line to Pawley’s Island and is consistently ranked as one of the top vacation destinations in the country. The economy of the region is dominated by the tourism and retail industries. The Myrtle Beach-Conway-North Myrtle Beach market area is also home to Coastal Carolina University in Conway and Webster University in Myrtle Beach.

 

Our markets in southeastern North Carolina are contiguous to South Carolina and the Grand Strand. These markets are situated south and west of the Wilmington, North Carolina MSA. We currently maintain a loan production office in the Wilmington MSA, and we believe there are opportunities for future expansion in the market. Wilmington has a diversified economy and is a major resort area and a center for light manufacturing. The city also serves as the retail and medical center for the region. Companies in the Wilmington area produce fiber optic cables for the communications industry, aircraft engine parts, pharmaceuticals, nuclear fuel components and various textile products. This market area is home to several colleges including UNC-Wilmington.

 

In August 2015, we established a branch in the Greenville, South Carolina market. We had previously operated in Greenville through a loan production office. Greenville is located in the “Upstate” of South Carolina, which we believe represents a growing, business-friendly environment. Major industries in the Upstate include the automobile industry, which is concentrated primarily along the corridor between Greenville and Spartanburg around the BMW manufacturing facility in Greer, South Carolina. The Greenville Health System and Bon Secours St. Francis Health System represent the healthcare and pharmaceuticals industry in the area. The Upstate is also home to research and development facilities for Michelin, Fuji and General Electric and research centers to support the automotive, life sciences, plastics and photonics industries. The Upstate also benefits from being an academic center and is home to collegiate and university education facilities such as Clemson University, Furman University, Presbyterian College, University of South Carolina-Upstate, Anderson University, Lander University, Bob Jones University, Wofford College and Converse College, among others.

 

Our markets have experienced steady economic and population growth over the past 10 years, and we expect that the areas, as well as the business and tourism industries needed to support it, will continue to grow.

Competition

 

The banking business is highly competitive, and we experience competition in our market areas from many other financial institutions.  Competition among financial institutions is based on interest rates offered on deposit accounts, interest rates charged on loans, other credit and service charges relating to loans, the quality and scope of the services rendered, the convenience of banking facilities, and, in the case of loans to commercial borrowers, relative lending limits.  We compete with commercial banks, credit unions, savings institutions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as super-regional, national and international financial institutions that operate offices in our market areas and elsewhere.

 

We compete with these institutions both in attracting deposits and in making loans.  In addition, we have to attract our customer base from other existing financial institutions and from new residents.  Many of our competitors are well-established, larger financial institutions, such as SunTrust, Bank of America, Wells Fargo and BB&T.  These institutions offer some services, including extensive and established branch networks, that we do not provide.  In addition, many of our non-bank competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally insured banks.

 

Lending Activities

 

General. We emphasize a range of lending services, including commercial and residential real estate mortgage loans, real estate construction loans, commercial and industrial loans and consumer loans. Our customers are generally individuals and small to medium-sized businesses and professional firms that are located in or conduct a substantial portion of their business in our market areas. We have focused our lending activities primarily on the professional market, including doctors, dentists, small business to medium-sized owners and commercial real estate developers.

 

Certain credit risks are inherent in making loans. These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers. We attempt to mitigate repayment risks by adhering to internal credit policies and procedures. These policies and procedures include officer and customer lending limits, with approval processes for larger loans, documentation examination, and follow-up procedures for any exceptions to credit policies. Our loan approval policies provide for various levels of officer lending authority. When the amount of aggregate loans to a single borrower exceeds the maximum senior officer’s lending authority, the loan request will be considered by the management loan committee, or MLC, which is comprised of five members, all of whom are part of the senior management team of the Bank. The MLC meets weekly to approve loans with total loan commitments exceeding $1.0 million. The loan authority of the MLC is equal to two-thirds of the legal lending limit of the Bank which is equivalent to the in-house loan limit. Total credit exposure above the in-house limit requires approval by the majority of the board of directors. We do not make any loans to any director, executive officer of the Bank, or the related interests of each, unless the loan is approved by the full Board of Directors of the Bank and is on terms not more favorable than would be available to a person not affiliated with the Bank.

 

Our lending activities are subject to a variety of lending limits imposed by federal law. In general, the Bank is subject to a legal limit on loans to a single borrower equal to 15% of the Bank’s capital and unimpaired surplus. This legal lending limit will increase or decrease as the Bank’s level of capital increases or decreases. Based upon the capitalization of the Bank at December 31, 2015, the maximum amount we could lend to one borrower is $22.4 million. However, our internal lending limit without board approval at December 31, 2015 is $14.9 million. The board of directors will adjust the internal lending limit as deemed necessary to continue to mitigate risk and serve the Bank’s clients. We are able to sell participations in our larger loans to other financial institutions, which allow us to manage the risk involved in these loans and to meet the lending needs of our clients requiring extensions of credit in excess of these limits.

 

Real Estate Mortgage Loans. The principal component of our loan portfolio is loans secured by real estate mortgages. Real estate loans are subject to the same general risks as other loans and are particularly sensitive to fluctuations in the value of real estate. Fluctuations in the value of real estate, as well as other factors arising after a loan has been made, could negatively affect a borrower’s cash flow, creditworthiness, and ability to repay the loan. We obtain a security interest in real estate whenever possible, in addition to any other available collateral, in order to increase the likelihood of the ultimate repayment of the loan.

These loans generally fall into one of two categories:

 

●

Residential Mortgage Loans and Home Equity Loans. We generally originate and hold short-term and long-term first mortgages and traditional second mortgage residential real estate loans. Generally, we limit the loan-to-value ratio on our residential real estate loans to 90%. We offer fixed and adjustable rate residential real estate loans with terms of up to 30 years. We also offer a variety of lot loan options to consumers to purchase the lot on which they intend to build their home. The options available depend on whether the borrower intends to begin building within 12 months of the lot purchase or at an undetermined future date. We also offer traditional home equity loans and lines of credit. Our underwriting criteria for, and the risks associated with, home equity loans and lines of credit are generally the same as those for first mortgage loans. Home equity loans typically have terms of 10 years or less. We generally limit the extension of credit to 90% of the available equity of each property, although we may extend up to 100% of the available equity.

 

●

Commercial Real Estate. Commercial real estate loans generally have terms of five years or less, although payments may be structured on a longer amortization basis. We evaluate each borrower on an individual basis and attempt to determine their business risks and credit profile. We attempt to reduce credit risk in the commercial real estate portfolio by emphasizing loans on owner-occupied office and retail buildings where the loan-to-value ratio, established by independent appraisals, generally does not exceed 80%. We also generally require that a borrower’s cash flow exceed 120% of monthly debt service obligations. In order to ensure secondary sources of payment and liquidity to support a loan request, we typically review all of the personal financial statements of the principal owners and require their personal guarantees.

 

Real Estate Construction and Development Loans. We offer fixed and adjustable rate residential and commercial construction loan financing to builders and developers and to consumers who wish to build their own home. The term of construction and development loans generally is limited to 18 months, although payments may be structured on a longer amortization basis. Most loans will mature and require payment in full upon the sale of the property. We believe that construction and development loans generally carry a higher degree of risk than long-term financing of existing properties because repayment depends on the ultimate completion of the project and usually on the subsequent sale of the property. Specific risks include:

 

●

cost overruns;

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mismanaged construction;

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inferior or improper construction techniques;

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economic changes or downturns during construction;

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a downturn in the real estate market;

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rising interest rates which may prevent sale of the property; and

●

failure to sell completed projects in a timely manner.

 

We attempt to reduce risk associated with construction and development loans by obtaining personal guarantees and by keeping the maximum loan-to-value ratio at or below 65%-85% of the lesser of cost or appraised value, depending on the project type. Generally, we do not have interest reserves built into loan commitments but require periodic cash payments for interest from the borrower’s cash flow.

 

Commercial Loans. We make loans for commercial purposes in various lines of businesses, including the manufacturing industry, service industry, and professional service areas. Commercial loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or if they are secured, the value of the collateral may be difficult to assess and more likely to decrease than real estate.

 

Equipment loans typically will be made for a term of 10 years or less at fixed or variable rates, with the loan fully amortized over the term and secured by the financed equipment. Generally, we limit the loan-to-value ratio on these loans to 75% of cost. Working capital loans typically have terms not exceeding one year and usually are secured by accounts receivable, inventory, or personal guarantees of the principals of the business. For loans secured by accounts receivable or inventory, principal will typically be repaid as the assets securing the loan are converted into cash, and in other cases principal will typically be due at maturity. Trade letters of credit, standby letters of credit, and foreign exchange will generally be handled through a correspondent bank as agent for the Bank.

Our Charleston and Myrtle Beach markets have provided limited opportunities for us to develop a commercial and industrial (“C&I”) loan portfolio. The Company’s primary markets are generally concentrated in real estate lending. However, in order to diversify our lending portfolio, the Company began a syndicated loan program in 2014 to purchase nationally syndicated C&I loans to retain in the loan portfolio. These loans typically have terms of seven years and are tied to a floating rate index such as LIBOR or prime. To effectively manage this new line of lending, the Company hired an experienced senior lending executive with relevant experience to lead and manage this area of the loan portfolio and engaged a consulting firm that specializes in syndicated loans. The Company’s policy currently limits the syndicated loan portfolio not to exceed 75% of the Bank’s Tier 1 regulatory capital.

 

Consumer Loans. We make a variety of loans to individuals for personal and household purposes, including secured and unsecured installment loans and revolving lines of credit. Consumer loans are underwritten based on the borrower’s income, current debt level, past credit history, and the availability and value of collateral. Consumer rates are both fixed and variable, with negotiable terms. Our installment loans typically amortize over periods up to 72 months. Although we typically require monthly payments of interest and a portion of the principal on our loan products, we will offer consumer loans with a single maturity date when a specific source of repayment is available. Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and more likely to decrease in value than real estate.

 

Mortgage Banking Activities

 

As summarized below, our mortgage banking segment associated with Crescent Mortgage Company is comprised of two primary businesses: correspondent lending and loan servicing.

 

Correspondent Lending. Our mortgage banking operations are conducted mainly through the Bank’s wholesale mortgage origination subsidiary, Crescent Mortgage Company, which is headquartered in Atlanta, Georgia. These operations consist of the purchase of mortgage loans and table funded originations as well as the sale and servicing of a variety of residential mortgage loan products. Crescent Mortgage Company lends in 45 states and partners with over 2,000 community banks, credit unions, and quality mortgage brokers. Crescent Mortgage Company focuses on originating residential real estate loans, some of which conform to Federal Housing Administration (FHA), Veterans Affairs (VA) and Rural Development standards (RD). Loans originated that meet FHA standards qualify for the FHA’s insurance program whereas loans that meet VA and RD standards are guaranteed by their respective federal agencies.

 

Mortgage loans that do not qualify under these programs are commonly referred to as conventional loans. Conventional real estate loans could be conforming and non-conforming. Conforming loans are residential real estate loans that meet the standards for sale under the Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC) programs whereas loans that do not meet those standards are referred to as non-conforming residential real estate loans. In addition, Crescent Mortgage Company offers certain jumbo mortgage products which meet underwriting requirements of certain correspondent lenders. The Company’s strategy is to grow market share through superior service and competitive pricing and high quality mortgage products. Crescent Mortgage Company generally sells mortgages it acquires to a number of investors like FNMA and FHLMC or major banking correspondents.

 

Our mortgage banking profitability depends on maintaining sufficient volume of loan originations combined with maintaining a profitable margin upon ultimate sale. Changes in the level of interest rates, competition and the local economy affect the number of loans originated and the amount of loan sales and loan fees earned.

 

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

Deposit Products

 

We offer a full range of deposit services that are typically available in most banks and savings institutions, including checking accounts, commercial accounts, savings accounts and other time deposits of various types, ranging from daily money market accounts to longer-term certificates of deposit.  Transaction accounts and time deposits are tailored to and offered at rates competitive to those offered in our primary market areas.  In addition, we offer certain retirement accounts. We solicit accounts from individuals, businesses, associations, organizations and governmental authorities. We believe that our branch infrastructure will assist us in obtaining deposits from local customers in the future. Our retail customer deposits were $882.9 million at December 31, 2015, or 85.6% of our total deposits.

 

Emerging Growth Company

 

We qualify as an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). As an “emerging growth company,” we may take advantage of some or all of the reduced disclosure and other requirements that are otherwise applicable generally to public companies. These provisions include:

 

●

only two years of audited financial statements in addition to any required unaudited interim financial statements with correspondingly reduced “Management’s Discussion and Analysis of Financial Condition and Results of Operations” disclosure;

●

reduced disclosure about our executive compensation arrangements;

●

no requirement that we solicit non-binding advisory votes on executive compensation or golden parachute arrangements; and

●

exemption from the auditor attestation requirement in the assessment of our internal control over financial reporting.

 

As a result, the information that we provide to our stockholders may be different from the information that you might receive from other public reporting companies in which you hold equity interests.

 

Section 107 of the JOBS Act also provides that an emerging growth company can take advantage of the extended transition period provided in the Securities Act for complying with new or revised accounting standards. In other words, an emerging growth company can elect to delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this extended transition period for complying with new or revised accounting standards and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other companies.

 

We could remain an emerging growth company for up to five years, or until the earliest of (i) the last day of the first fiscal year in which our annual gross revenues exceed $1 billion, (ii) the date that we become a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our common stock held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, (iii) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three-year period and (iv) the last day of the fiscal year following the fifth anniversary of the date of the first sale of our common equity securities pursuant to an effective registration statement under the Securities Act, which would be December 2019. At this time, we expect to remain an “emerging growth company” for the foreseeable future.

 

Employees

 

As of March 14, 2016, we had 421 total employees, including 402 full-time employees.

SUPERVISION AND REGULATION

 

Both the Company and the Bank are subject to extensive state and federal banking laws and regulations that impose restrictions on and provide for general regulatory oversight of their operations.  These laws and regulations generally are intended to protect consumers and depositors and not stockholders.  The following summary is qualified by reference to the statutory and regulatory provisions discussed.  Changes in applicable laws or regulations may have a material effect on our business and prospects.  Our operations may be affected by legislative changes and the policies of various regulatory authorities.  We cannot predict the effect that fiscal or monetary policies, economic control or new federal or state legislation may have on our business and earnings in the future.

 

The following discussion is not intended to be a complete list of all the activities regulated by the banking laws or of the impact of those laws and regulations on our operations.  It is intended only to briefly summarize some material provisions.

 

Recent Legislative and Regulatory Initiatives to Address the Financial and Economic Crises

 

Markets in the United States and elsewhere experienced extreme volatility and disruption beginning in the latter half of 2007 from which they have not fully recovered. These circumstances exerted significant downward pressure on prices of equity securities and virtually all other asset classes, and resulted in substantially increased market volatility, severely constrained credit and capital markets, particularly for financial institutions, and caused an overall loss of investor confidence. Loan portfolio performances deteriorated at many institutions resulting from, among other factors, a weak economy and a decline in the value of the collateral supporting their loans. Dramatic slowdowns in the housing industry, due in part to falling home prices and increasing foreclosures and unemployment, have created strains on financial institutions. Many borrowers were unable to repay their loans, and the collateral securing these loans, in some cases, declined below the loan balance. In response to the challenges facing the financial services sector, the following regulatory and governmental actions were enacted.

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act

 

On July 21, 2010, President Obama signed into law The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which, among other things, changes the oversight and supervision of financial institutions, includes new minimum capital requirements, creates a new federal agency to regulate consumer financial products and services and implements changes to corporate governance and compensation practices. The Dodd-Frank Act is focused in large part on the financial services industry, particularly bank holding companies with consolidated assets of $50 billion or more, and contains a number of provisions that will affect us, including:

 

Minimum Leverage and Risk-Based Capital Requirements. Under the Dodd-Frank Act, the appropriate Federal banking agencies are required to establish minimum leverage and risk-based capital requirements on a consolidated basis for all insured depository institutions and bank holding companies, which can be no less than the currently applicable leverage and risk-based capital requirements for depository institutions. As a result, the Bank will be subject to at least the same capital requirements and must include the same components in regulatory capital.

 

Deposit Insurance Modifications. The Dodd-Frank Act modifies the FDIC’s assessment base upon which deposit insurance premiums are calculated. The new assessment base will equal our average total consolidated assets minus the sum of our average tangible equity during the assessment period. The Dodd-Frank Act also permanently raises the standard maximum insurance amount to $250,000.

 

Creation of New Governmental Authorities. The Dodd-Frank Act creates various new governmental authorities such as the Financial Stability Oversight Council and the Consumer Financial Protection Bureau, or CFPB, an independent regulatory authority housed within the Federal Reserve. The CFPB has broad authority to regulate the offering and provision of consumer financial products. The CFPB officially came into being on July 21, 2011, and rulemaking authority for a range of consumer financial protection laws (such as the Truth in Lending Act, the Electronic Funds Transfer Act and the Real Estate Settlement Procedures Act, among others) transferred from the Federal Reserve and other federal regulators to the CFPB on that date. The Dodd-Frank Act gives the CFPB authority to supervise and examine depository institutions with more than $10 billion in assets for compliance with these federal consumer laws. The authority to supervise and examine depository institutions with $10 billion or less in assets for compliance with federal consumer laws will remain largely with those institutions’ primary regulators. However, the CFPB may participate in examinations of these smaller institutions on a “sampling basis” and may refer potential enforcement actions against such institutions to their primary regulators. The CFPB also has supervisory and examination authority over certain nonbank institutions that offer consumer financial products. The Dodd-Frank Act identifies a number of covered nonbank institutions, and also authorizes the CFPB to identify additional institutions that will be subject to its jurisdiction. Accordingly, the CFPB may participate in examinations of the Bank, which currently has assets of less than $10 billion, and could supervise and examine our other direct or indirect subsidiaries that offer consumer financial products or services. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are stricter than those regulations promulgated by the CFPB, and state attorneys general are permitted to enforce consumer protection rules adopted by the CFPB against certain institutions.

The Dodd-Frank Act also authorized the CFPB to establish certain minimum standards for the origination of residential mortgages, including a determination of the borrower’s ability to repay. Under the Dodd-Frank Act, financial institutions may not make a residential mortgage loan unless they make a “reasonable and good faith determination” that the consumer has a “reasonable ability” to repay the loan. The Dodd-Frank Act allows borrowers to raise certain defenses to foreclosure but provides a full or partial safe harbor from such defenses for loans that are “qualified mortgages.” On January 10, 2013, the CFPB published final rules to, among other things, specify the types of income and assets that may be considered in the ability-to-repay determination, the permissible sources for verification, and the required methods of calculating the loan’s monthly payments. Since then the CFPB made certain modifications to these rules. The rules extend the requirement that creditors verify and document a borrower’s “income and assets” to include all “information” that creditors rely on in determining repayment ability. The rules also provide further examples of third-party documents that may be relied on for such verification, such as government records and check-cashing or funds-transfer service receipts. The rules took effect January 10, 2014. The rules also define “qualified mortgages,” imposing both underwriting standards - for example, a borrower’s debt-to-income ratio may not exceed 43% - and limits on the terms of their loans. Points and fees are subject to a relatively stringent cap, and the terms include a wide array of payments that may be made in the course of closing a loan. Certain loans, including interest-only loans and negative amortization loans, cannot be qualified mortgages.

 

Executive Compensation and Corporate Governance Requirements. The Dodd-Frank Act requires public companies to include, at least once every three years, a separate non-binding “say on pay” vote in their proxy statement by which stockholders may vote on the compensation of the company’s named executive officers. In addition, if such companies are involved in a merger, acquisition, or consolidation, or if they propose to sell or dispose of all or substantially all of their assets, stockholders have a right to an advisory vote on any golden parachute arrangements in connection with such transaction (frequently referred to as “say-on-golden parachute” vote). Other provisions of the Dodd-Frank Act may impact our corporate governance. For instance, the Dodd-Frank Act requires the SEC to adopt rules:

 

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prohibiting the listing of any equity security of a company that does not have an independent compensation committee; and

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requiring all exchange-traded companies to adopt clawback policies for incentive compensation paid to executive officers in the event of accounting restatements based on material non-compliance with financial reporting requirements.

 

The Dodd-Frank Act also authorizes the SEC to issue rules allowing stockholders to include their own nominations for directors in a company’s proxy solicitation materials. Many provisions of the Dodd-Frank Act require the adoption of additional rules to implement the changes. In addition, the Dodd-Frank Act mandates multiple studies that could result in additional legislative Action. Governmental intervention and new regulations under these programs could materially and adversely affect our business, financial condition and results of operations.

 

Basel Capital Standards

 

In December 2010, the Basel Committee on Banking Supervision, or BCBS, an international forum for cooperation on banking supervisory matters, announced the “Basel III” capital standards, which substantially revised the existing capital requirements for banking organizations. On July 2, 2013, the Federal Reserve adopted a final rule for the Basel III capital framework and, on July 9, 2013, the OCC also adopted a final rule and the FDIC adopted the same provisions in the form of an “interim” final rule. The rule applies to all national and state banks and savings associations and most bank holding companies and savings and loan holding companies, which we collectively refer to herein as “covered” banking organizations. In certain respects, the rule imposes more stringent requirements on “advanced approaches” banking organizations—those organizations with $250 billion or more in total consolidated assets, $10 billion or more in total foreign exposures, or that have opted in to the Basel II capital regime. The requirements in the rule began to phase in on January 1, 2014 for advanced approaches banking organizations, and on January 1, 2015 for other covered banking organizations, including the Company and the Bank. The requirements in the rule will be fully phased in by January 1, 2019.

The rule imposes new and higher risk-based capital and leverage requirements than those previously in place. Specifically, the following minimum capital requirements apply to us:

 

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a new Common Equity Tier 1 risk-based capital ratio of 4.5%;

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a Tier 1 risk-based capital ratio of 6% (increased from the former 4% requirement);

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a total risk-based capital ratio of 8% (unchanged from the former requirements); and

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a leverage ratio of 4%; and

 

Under the rule, Tier 1 capital is redefined to include two components: Common Equity Tier 1 capital and additional Tier 1 capital. The new and highest form of capital, Common Equity Tier 1 capital, consists solely of common stock (plus related surplus), retained earnings, accumulated other comprehensive income, and limited amounts of minority interests that are in the form of common stock. Additional Tier 1 capital includes other perpetual instruments historically included in Tier 1 capital, such as non-cumulative perpetual preferred stock. The rule permits bank holding companies with less than $15 billion in total consolidated assets to continue to include trust preferred securities and cumulative perpetual preferred stock issued before May 19, 2010 in Tier 1 capital, but not in Common Equity Tier 1 capital, subject to certain restrictions. Tier 2 capital consists of instruments that currently qualify in Tier 2 capital plus instruments that the rule has disqualified from Tier 1 capital treatment. Cumulative perpetual preferred stock, formerly includable in Tier 1 capital is now included only in Tier 2 capital. Accumulated other comprehensive income (“AOCI”) is presumptively included in Common Equity Tier 1 capital and often would operate to reduce this category of capital. The rules provided for a one-time opportunity at the end of the first quarter of 2015 for covered banking organization to opt-out of much of this treatment of AOCI. We made this opt-out election and, as a result, will retain the pre-existing treatment for AOCI.

 

In addition, in order to avoid restrictions on capital distributions or discretionary bonus payments to executives, a covered banking organization must maintain a “capital conservation buffer” on top of its minimum risk-based capital requirements. This buffer must consist solely of Tier 1 common equity, but the buffer applies to all three measurements (Common Equity Tier 1, Tier 1 capital and total capital). The capital conservation buffer will be phased in incrementally over time, becoming fully effective on January 1, 2019, and will consist of an additional amount of common equity equal to 2.5% of risk-based assets.

 

In general, the rule have had the effect of increasing capital requirements by increasing the risk weights on certain assets, including high volatility commercial real estate, certain loans past due 90 days or more or in nonaccrual status, mortgage servicing rights not includable in Common Equity Tier 1 capital, equity exposures, and claims on securities firms, that are used in the denominator of the three risk-based capital ratios.

 

Proposed Legislation and Regulatory Action

 

From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of the Company in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Company. A change in statutes, regulations or regulatory policies applicable to the Company or the Bank could have a material effect on the business of the Company.

Volcker Rule

 

Section 619 of the Dodd-Frank Act, known as the “Volcker Rule,” prohibits any bank, bank holding company, or affiliate (referred to collectively as “banking entities”) from engaging in two types of activities: “proprietary trading” and the ownership or sponsorship of private equity or hedge funds that are referred to as “covered funds.” Proprietary trading includes the purchase or sale of principal of any security, derivative, commodity future, or option on any such instrument for the purpose of benefitting from short-term price movements or realizing short-term profits. In December 2013, our primary federal regulators, the Federal Reserve and the FDIC, together with other federal banking agencies and the SEC and the Commodity Futures Trading Commission, finalized a regulation to implement the Volcker Rule.

 

Exceptions apply, however. Trading in U.S. Treasuries, obligations or other instruments issued by a government sponsored enterprise, state or municipal obligations, or obligations of the FDIC is permitted. A banking entity also may trade for the purpose of managing its liquidity, provided that it has a bona fide liquidity management plan. Trading activities as agent, broker or custodian; through a deferred compensation or pension plan; as trustee or fiduciary on behalf of customers; in order to satisfy a debt previously contracted; or in repurchase and securities lending agreements are permitted. Additionally, the Volcker Rule permits banking entities to engage in trading that takes the form of risk-mitigating hedging activities.

 

The covered funds that a banking entity may not sponsor or hold an ownership interest in are, with certain exceptions, funds that are exempt from registration under the Investment Company Act of 1940 because they either have 100 or fewer investors or are owned exclusively by “qualified investors” (generally, high net worth individuals or entities). Wholly-owned subsidiaries, joint ventures and acquisition vehicles, foreign pension or retirement funds, insurance company separate accounts (including bank-owned life insurance), public welfare investment funds, and entities formed by the FDIC for the purpose of disposing of assets are not covered funds, and a bank may invest in them. Most securitizations also are not treated as covered funds.

 

The regulation as issued on December 10, 2013, treated collateralized debt obligations backed by trust preferred securities as covered funds and accordingly subject to divestiture. In an interim final rule issued on January 14, 2014, the agencies exempted collateralized debt obligations, or CDOs, issued before May 19, 2010, that were backed by trust preferred securities issued before the same date by a bank with total consolidated assets of less than $15 billion or by a mutual holding company, and that the bank holding the CDO interest had purchased before December 10, 2013, from the Volcker Rule prohibition. This exemption does not extend to CDOs backed by trust-preferred securities issued by an insurance company.

 

Carolina Financial Corporation

 

The Company owns 100% of the outstanding capital stock of the Bank, and therefore is required to be and is registered as a bank holding company under the federal Bank Holding Company Act of 1956 (the “BHCA”). As a result, the Company is primarily subject to the supervision, examination and reporting requirements of the Board of Governors of the Federal Reserve (the “Federal Reserve”) under the BHCA and its regulations promulgated thereunder. Moreover, as a bank holding company of a bank located in South Carolina, the Company also is subject to the South Carolina Banking and Branching Efficiency Act.

 

Permitted Activities. Under the BHCA, a bank holding company is generally permitted to engage in, or acquire direct or indirect control of more than 5% of the voting shares of any company engaged in the following activities:

 

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banking or managing or controlling banks;

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furnishing services to or performing services for our subsidiaries; and

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any activity that the Federal Reserve determines to be so closely related to banking as to be a proper incident to the business of banking.

Activities that the Federal Reserve has found to be so closely related to banking as to be a proper incident to the business of banking include:

 

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factoring accounts receivable;

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making, acquiring, brokering or servicing loans and usual related activities;

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leasing personal or real property;

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operating a non-bank depository institution, such as a savings association;

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trust company functions;

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financial and investment advisory activities;

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conducting discount securities brokerage activities;

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underwriting and dealing in government obligations and money market instruments;

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providing specified management consulting and counseling activities;

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performing selected data processing services and support services;

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acting as agent or broker in selling credit life insurance and other types of insurance in connection with credit transactions; and

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performing selected insurance underwriting activities.

 

As a bank holding company we also can elect to be treated as a “financial holding company,” which would allow us to engage in a broader array of activities. In summary, a financial holding company can engage in activities that are financial in nature or incidental or complimentary to financial activities, including insurance underwriting, sales and brokerage activities, providing financial and investment advisory services, underwriting services and limited merchant banking activities. We have not sought financial holding company status but may elect such status in the future as our business matures. If we were to elect financial holding company status, each insured depository institution we control would have to be well capitalized, well managed, and have at least a satisfactory rating under the Community Reinvestment Act (discussed below).

 

The Federal Reserve has the authority to order a bank holding company or its subsidiaries to terminate any of these activities or to terminate its ownership or control of any subsidiary when it has reasonable cause to believe that the bank holding company’s continued ownership, activity or control constitutes a serious risk to the financial safety, soundness or stability of it or any of its bank subsidiaries.

 

Change in Control. In addition, and subject to certain exceptions, the BHCA and the Change in Bank Control Act, together with regulations promulgated thereunder, require Federal Reserve approval prior to any person or company acquiring “control” of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of a bank holding company. Following the relaxing of these restrictions by the Federal Reserve in September 2008, control will be presumed to exist if a person acquires more than 33% of the total equity of a bank or bank holding company, of which it may own, control or have the power to vote not more than 15% of any class of voting securities.

 

Source of Strength. There are a number of obligations and restrictions imposed by law and regulatory policy on bank holding companies with regard to their depository institution subsidiaries that are designed to minimize potential loss to depositors and to the FDIC insurance funds in the event that the depository institution becomes in danger of defaulting under its obligations to repay deposits. In accordance with Federal Reserve policy, the Company is required to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances in which it might not otherwise do so. Under the Federal Deposit Insurance Corporate Improvement Act of 1991, or FDICIA, to avoid receivership of its insured depository institution subsidiary, a bank holding company is required to guarantee the compliance of any insured depository institution subsidiary that may become “undercapitalized” within the terms of any capital restoration plan filed by such subsidiary with its appropriate federal banking agency up to the lesser of (i) an amount equal to 5% of the institution’s total assets at the time the institution became undercapitalized, or (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with such capital restoration plan.

 

Under the BHCA, the Federal Reserve may require a bank holding company to terminate any activity or relinquish control of a non-bank subsidiary, other than a non-bank subsidiary of a bank, upon the Federal Reserve’s determination that such activity or control constitutes a serious risk to the financial soundness or stability of any depository institution subsidiary of a bank holding company. Further, federal bank regulatory authorities have additional discretion to require a bank holding company to divest itself of any bank or non-bank subsidiaries if the agency determines that divestiture may aid the depository institution’s financial condition.

In addition, the “cross guarantee” provisions of the Federal Deposit Insurance Act, FDIA, require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated by the FDIC as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The FDIC’s claim for damages is superior to claims of stockholders of the insured depository institution or its holding company, but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.

 

The FDIA also provides that amounts received from the liquidation or other resolution of any insured depository institution by any receiver must be distributed (after payment of secured claims) to pay the deposit liabilities of the institution prior to payment of any other general or unsecured senior liability, subordinated liability, general creditor or stockholder. This provision would give depositors a preference over general and subordinated creditors and stockholders in the event a receiver is appointed to distribute the assets of the Bank.

 

Further, any capital loans by a bank holding company to a subsidiary bank are subordinate in right of payment to deposits and certain other indebtedness of the subsidiary bank. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank at a certain level would be assumed by the bankruptcy trustee and entitled to priority payment.

 

Capital Requirements. The Federal Reserve imposes certain capital requirements on the bank holding company under the BHCA, including a minimum leverage ratio and a minimum ratio of “qualifying” capital to risk-weighted assets. These requirements are essentially the same as those that apply to the Bank and are described below under “CresCom Bank.” Subject to our capital requirements and certain other restrictions, we are able to borrow money to make a capital contribution to the Bank, and these loans may be repaid from dividends paid from the Bank to the Company. We are also able to raise capital for contribution to the Bank by issuing securities without having to receive regulatory approval, subject to compliance with federal and state securities laws.

 

Dividends. Since the Company is a bank holding company, its ability to declare and pay dividends is dependent on certain federal and state regulatory considerations, including the guidelines of the Federal Reserve. The Federal Reserve has issued a policy statement regarding the payment of dividends by bank holding companies. In general, the Federal Reserve’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality, and overall financial condition. The Federal Reserve’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds to those banks during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary. Further, under the prompt corrective action regulations, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions.

 

In addition, since the Company is a legal entity separate and distinct from the Bank and does not conduct stand-alone operations, its ability to pay dividends depends on the ability of the Bank to pay dividends to it, which is also subject to regulatory restrictions as described below in “CresCom Bank – Dividends.”

 

South Carolina State Regulation. As a South Carolina bank holding company under the South Carolina Banking and Branching Efficiency Act, we are subject to limitations on sale or merger and to regulation by the South Carolina Board of Financial Institutions (the “SCBFI”). We are not required to obtain the approval of the SCBFI prior to acquiring the capital stock of a national bank, but we must notify them at least 15 days prior to doing so. We must obtain approval from the SCBFI prior to engaging in the acquisition of branches, a South Carolina state chartered bank, or another South Carolina bank holding company.

CresCom Bank

 

The Bank’s primary federal regulator is the FDIC. In addition, the Bank is regulated and examined by the SCBFI. Deposits in the Bank are insured by the FDIC up to a maximum amount of $250,000 per depositor, per ownership category, pursuant to the provisions of the Dodd-Frank Act.

 

The SCBFI and the FDIC regulate or monitor virtually all areas of the Bank’s operations, including:

 

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security devices and procedures;

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adequacy of capitalization and loss reserves;

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loans;

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investments;

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borrowings;

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deposits;

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mergers;

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issuances of securities;

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payment of dividends;

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interest rates payable on deposits;

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interest rates or fees chargeable on loans;

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establishment of branches;

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corporate reorganizations;

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maintenance of books and records; and

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adequacy of staff training to carry on safe lending and deposit gathering practices.

 

These agencies, and the federal and state laws applicable to the Bank’s operations, extensively regulate various aspects of our banking business, including among other things, permissible types and amounts of loans, investments, and other activities capital adequacy, branching, interest rates on loans and deposits, maintenance of reserves and the safety and soundness of our banking practices. See additional discussion related to Basel III above.

 

All insured institutions must undergo regular on-site examinations by their appropriate banking agency. The cost of examinations of insured depository institutions and any affiliates may be assessed by the appropriate federal banking agency against each institution or affiliate as it deems necessary or appropriate. Insured institutions are required to submit annual reports to the FDIC, their federal regulatory agency, and state supervisor when applicable. The FDIC has developed a method for insured depository institutions to provide supplemental disclosure of the estimated fair market value of assets and liabilities, to the extent feasible and practicable, in any balance sheet, financial statement, report of condition or any other report of any insured depository institution. The federal banking regulatory agencies to prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating, among other things, to the following:

 

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internal controls;

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information systems and audit systems;

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loan documentation;

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credit underwriting;

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interest rate risk exposure; and

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asset quality.

 

Prompt Corrective Action. As an insured depository institution, the Bank is required to comply with the capital requirements promulgated under the Federal Deposit Insurance Act and the prompt corrective action regulations thereunder, which set forth five capital categories, each with specific regulatory consequences. Under these regulations, the categories are:

As an insured depository institution, the Bank is required to comply with the capital requirements promulgated under the FDIA and the prompt corrective action regulations thereunder, which set forth five capital categories, each with specific regulatory consequences.  Under these regulations, the categories are:

 

	●		Well Capitalized — The institution exceeds the required minimum level for each relevant capital measure.  A well capitalized institution (i) has total risk-based capital ratio of 10% or greater, (ii) has a Tier 1 risk-based capital ratio of 8% or greater, (iii) has a Common Equity Tier 1 risk-based capital ratio of 6.5% or greater, (iv) has a leverage capital ratio of 5% or greater, and (v) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure.
	●		Adequately Capitalized — The institution meets the required minimum level for each relevant capital measure.  No capital distribution may be made that would result in the institution becoming undercapitalized.  An adequately capitalized institution (i) has a total risk-based capital ratio of 8% or greater, (ii) has a Tier 1 risk-based capital ratio of 6% or greater, (iii) has a Common Equity Tier 1 risk-based capital ratio of 4.5% or greater, and (iv) has a leverage capital ratio of 4% or greater.

	●		Undercapitalized — The institution fails to meet the required minimum level for any relevant capital measure.  An undercapitalized institution (i) has a total risk-based capital ratio of less than 8%, (ii) has a Tier 1 risk-based capital ratio of less than 6%, (iii) has a Common Equity Tier 1 risk-based capital ratio of less than 4.5%, or (iv) has a leverage capital ratio of less than 4%.
	●		Significantly Undercapitalized — The institution is significantly below the required minimum level for any relevant capital measure.  A significantly undercapitalized institution (i) has a total risk-based capital ratio of less than 6%, (ii) has a Tier 1 risk-based capital ratio of less than 4%, (iii) has a Common Equity Tier 1 risk-based capital ratio of less than 3%, or (iv) has a leverage capital ratio of less than 3%.

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Critically Undercapitalized — The institution fails to meet a critical capital level set by the appropriate federal banking agency.  A critically undercapitalized institution has a ratio of tangible equity to total assets that is equal to or less than 2%.

 

If the applicable federal regulator determines, after notice and an opportunity for hearing, that the institution is in an unsafe or unsound condition, the regulator is authorized to reclassify the institution to the next lower capital

 

If the FDIC determines, after notice and an opportunity for hearing, that the bank is in an unsafe or unsound condition, the regulator is authorized to reclassify the bank to the next lower capital category (other than critically undercapitalized) and require the submission of a plan to correct the unsafe or unsound condition.

 

If a bank is not well capitalized, it cannot accept brokered deposits without prior regulatory approval. In addition, a bank that is not well capitalized cannot offer an effective yield in excess of 75 basis points over interest paid on deposits of comparable size and maturity in such institution’s normal market area for deposits accepted from within its normal market area, or national rate paid on deposits of comparable size and maturity for deposits accepted outside the bank’s normal market area. Moreover, the FDIC generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be categorized as undercapitalized. Undercapitalized institutions are subject to growth limitations (an undercapitalized institution may not acquire another institution, establish additional branch offices or engage in any new line of business unless determined by the appropriate federal banking agency to be consistent with an accepted capital restoration plan, or unless the FDIC determines that the proposed action will further the purpose of prompt corrective action) and are required to submit a capital restoration plan. The agencies may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with the capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of an amount equal to 5.0% of the depository institution’s total assets at the time it became categorized as undercapitalized or the amount that is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is categorized as significantly undercapitalized.

Significantly undercapitalized categorized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become categorized as adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. The appropriate federal banking agency may take any action authorized for a significantly undercapitalized institution if an undercapitalized institution fails to submit an acceptable capital restoration plan or fails in any material respect to implement a plan accepted by the agency. A critically undercapitalized institution is subject to having a receiver or conservator appointed to manage its affairs and for loss of its charter to conduct banking activities.

 

An insured depository institution may not pay a management fee to a bank holding company controlling that institution or any other person having control of the institution if, after making the payment, the institution would be undercapitalized. In addition, an institution cannot make a capital distribution, such as a dividend or other distribution that is in substance a distribution of capital to the owners of the institution if following such a distribution the institution would be undercapitalized. Thus, if payment of such a management fee or the making of such would cause a bank to become undercapitalized, it could not pay a management fee or dividend to the bank holding company.

 

As of December 31, 2015, the Bank was deemed to be “well capitalized.”

 

Standards for Safety and Soundness. The Federal Deposit Insurance Act also requires the federal banking regulatory agencies to prescribe, by regulation or guideline, operational and managerial standards for all insured depository institutions relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; and (v) asset growth. The agencies also must prescribe standards for asset quality, earnings, and stock valuation, as well as standards for compensation, fees and benefits. The federal banking agencies have adopted regulations and Interagency Guidelines Prescribing Standards for Safety and Soundness to implement these required standards. These guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. Under the regulations, if the FDIC determines that the Bank fails to meet any standards prescribed by the guidelines, the agency may require the Bank to submit to the agency an acceptable plan to achieve compliance with the standard, as required by the FDIC. The final regulations establish deadlines for the submission and review of such safety and soundness compliance plans.

 

Regulatory Examination. The FDIC also requires the Bank to prepare annual reports on the Bank’s financial condition and to conduct an annual audit of its financial affairs in compliance with its minimum standards and procedures.

 

All insured institutions must undergo regular on-site examinations by their appropriate banking agency. The cost of examinations of insured depository institutions and any affiliates may be assessed by the appropriate federal banking agency against each institution or affiliate as it deems necessary or appropriate. Insured institutions are required to submit annual reports to the FDIC, their federal regulatory agency, and state supervisor when applicable. The FDIC has developed a method for insured depository institutions to provide supplemental disclosure of the estimated fair market value of assets and liabilities, to the extent feasible and practicable, in any balance sheet, financial statement, report of condition or any other report of any insured depository institution. The federal banking regulatory agencies prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating, among other things, to the following:

 

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internal controls;

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information systems and audit systems;

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loan documentation;

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credit underwriting;

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interest rate risk exposure; and

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asset quality.

 

Transactions with Affiliates and Insiders. The Company is a legal entity separate and distinct from the Bank and its other subsidiaries. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company or its non-bank subsidiaries. The Company and the Bank are subject to Sections 23A and 23B of the Federal Reserve Act and Federal Reserve Regulation W.

Section 23A of the Federal Reserve Act places limits on the amount of loans or extensions of credit to, or investments in, or certain other transactions with, affiliates and on the amount of advances to third parties collateralized by the securities or obligations of affiliates. Section 23A also applies to derivative transactions, repurchase agreements and securities lending and borrowing transactions that cause a bank to have credit exposure to an affiliate. The aggregate of all covered transactions is limited in amount, as to any one affiliate, to 10% of the Bank’s capital and surplus and, as to all affiliates combined, to 20% of the Bank’s capital and surplus. Furthermore, within the foregoing limitations as to amount, each covered transaction must meet specified collateral requirements. The Bank is forbidden to purchase low quality assets from an affiliate.

 

Section 23B of the Federal Reserve Act, among other things, prohibits an institution from engaging in certain transactions with certain affiliates unless the transactions are on terms substantially the same, or at least as favorable to such institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

 

Regulation W generally excludes all non-bank and non-savings association subsidiaries of banks from treatment as affiliates, except to the extent that the Federal Reserve decides to treat these subsidiaries as affiliates.

 

The Bank is also subject to certain restrictions on extensions of credit to executive officers, directors, certain principal stockholders, and their related interests. Such extensions of credit (i) must be made on substantially the same terms, including interest rates and collateral requirements, as those prevailing at the time for comparable transactions with unrelated third parties and (ii) must not involve more than the normal risk of repayment or present other unfavorable features.

 

Dividends. The Company’s principal source of cash flow, including cash flow to pay dividends to its stockholders, is dividends it receives from the Bank. Statutory and regulatory limitations apply to the Bank’s payment of dividends to the Company. As a South Carolina chartered bank, the Bank is subject to limitations on the amount of dividends that it is permitted to pay. Unless otherwise instructed by the SCBFI, the Bank is generally permitted under South Carolina state banking regulations to pay cash dividends of up to 100% of net income in any calendar year without obtaining the prior approval of the SCBFI. The FDIC also has the authority under federal law to enjoin a bank from engaging in what in its opinion constitutes an unsafe or unsound practice in conducting its business, including the payment of a dividend under certain circumstances.

 

Branching. Federal legislation permits out-of-state acquisitions by bank holding companies, interstate branching by banks, and interstate merging by banks. The Dodd-Frank Act removed previous state law restrictions on de novo interstate branching in states such as South Carolina. This change effectively permits out-of-state banks to open de novo branches in states where the laws of such state where would permit a bank chartered by that state to open a de novo branch.

 

Anti-Tying Restrictions. Under amendments to the BHCA and Federal Reserve regulations, a bank is prohibited from engaging in certain tying or reciprocity arrangements with its customers. In general, a bank may not extend credit, lease, sell property, or furnish any services or fix or vary the consideration for these on the condition that (i) the customer obtain or provide some additional credit, property, or services from or to the bank, the bank holding company or subsidiaries thereof or (ii) the customer may not obtain some other credit, property, or services from a competitor, except to the extent reasonable conditions are imposed to assure the soundness of the credit extended. Certain arrangements are permissible: a bank may offer combined-balance products and may otherwise offer more favorable terms if a customer obtains two or more traditional bank products; and certain foreign transactions are exempt from the general rule. A bank holding company or any bank affiliate also is subject to anti-tying requirements in connection with electronic benefit transfer services.

 

Community Reinvestment Act. The Community Reinvestment Act, or CRA, requires that the FDIC evaluate the record of the Bank in meeting the credit needs of its local community, including low and moderate income neighborhoods. These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. Failure to adequately meet these criteria could impose additional requirements and limitations on our Bank.

 

The Gramm-Leach-Bliley Act, or GLBA, made various changes to the CRA. Among other changes, CRA agreements with private parties must be disclosed and annual CRA reports must be made available to a bank’s primary federal regulator. A bank holding company will not be permitted to become a financial holding company and no new activities authorized under the GLBA may be commenced by a holding company or by a bank financial subsidiary if any of its bank subsidiaries received less than a satisfactory CRA rating in its latest CRA examination.

On May 15, 2015, the as of date of the most recent examination, the Bank received a “satisfactory” CRA rating.

 

Financial Subsidiaries. Under the GLBA, subject to certain conditions imposed by their respective banking regulators, national and state-chartered banks are permitted to form “financial subsidiaries” that may conduct financial or incidental activities, thereby permitting bank subsidiaries to engage in certain activities that previously were impermissible. The GLBA imposes several safeguards and restrictions on financial subsidiaries, including that the parent bank’s equity investment in the financial subsidiary be deducted from the bank’s assets and tangible equity for purposes of calculating the bank’s capital adequacy. In addition, the GLBA imposes new restrictions on transactions between a bank and its financial subsidiaries similar to restrictions applicable to transactions between banks and non-bank affiliates.

 

Consumer Protection Regulations. Activities of the Bank are subject to a variety of statutes and regulations designed to protect consumers. Interest and other charges collected or contracted for by the Bank are subject to state usury laws and federal laws concerning interest rates. The Bank’s loan operations are also subject to federal laws applicable to credit transactions, such as:

 

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the federal Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;

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the Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;

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the Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;

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the Fair Credit Reporting Act of 1978, governing the use and provision of information to credit reporting agencies;

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the Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies; and

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the rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws.

 

The deposit operations of the Bank also are subject to:

 

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the Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records; and

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the Electronic Funds Transfer Act and Regulation E, which governs automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services.

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the Truth in Savings Act and Regulation DD, which requires depositary institutions to provide certain consumer disclosures.

 

Anti-Money Laundering. Financial institutions must maintain anti-money laundering programs that include established internal policies, procedures, and controls; a designated compliance officer; an ongoing employee training program; and testing of the program by an independent audit function. The Company and the Bank are also prohibited from entering into specified financial transactions and account relationships and must meet enhanced standards for due diligence and “knowing your customer” in their dealings with foreign financial institutions and foreign customers. Financial institutions must take reasonable steps to conduct enhanced scrutiny of account relationships to guard against money laundering and to report any suspicious transactions, and recent laws provide law enforcement authorities with increased access to financial information maintained by banks. Anti-money laundering obligations have been substantially strengthened as a result of the USA Patriot Act, enacted in 2001 and renewed in 2006. Bank regulators routinely examine institutions for compliance with these obligations and are required to consider compliance in connection with the regulatory review of applications. The regulatory authorities have been active in imposing cease and desist orders and money penalty sanctions against institutions found to be violating these obligations.

USA PATRIOT Act/Bank Secrecy Act. Financial institutions must maintain anti-money laundering programs that include established internal policies, procedures, and controls; a designated compliance officer; an ongoing employee training program; and testing of the program by an independent audit function. The USA PATRIOT Act, amended, in part, the Bank Secrecy Act and provides for the facilitation of information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering by enhancing anti-money laundering and financial transparency laws, as well as enhanced information collection tools and enforcement mechanics for the U.S. government, including: (i) requiring standards for verifying customer identification at account opening; (ii) rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering; (iii) reports by nonfinancial trades and businesses filed with the U.S. Treasury Department’s Financial Crimes Enforcement Network for transactions exceeding $10,000; and (iv) filing suspicious activities reports if a bank believes a customer may be violating U.S. laws and regulations and requires enhanced due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non-U.S. persons. Bank regulators routinely examine institutions for compliance with these obligations and are required to consider compliance in connection with the regulatory review of applications.

 

Under the USA PATRIOT Act, the Federal Bureau of Investigation can send to the banking regulatory agencies lists of the names of persons suspected of involvement in terrorist activities. The Bank can be requested to search its records for any relationships or transactions with persons on those lists. If the Bank finds any relationships or transactions, it must file a suspicious activity report and contact the FBI.

 

The Office of Foreign Assets Control, or OFAC, which is a division of the Treasury, is responsible for helping to ensure that United States entities do not engage in transactions with “enemies” of the United States, as defined by various Executive Orders and Acts of Congress. OFAC has sent, and will send, our banking regulatory agencies lists of names of persons and organizations suspected of aiding, harboring or engaging in terrorist acts. If the Bank finds a name on any transaction, account or wire transfer that is on an OFAC list, it must freeze such account, file a suspicious activity report and notify the FBI. The Bank has appointed an OFAC compliance officer to oversee the inspection of its accounts and the filing of any notifications. The Bank actively checks high-risk OFAC areas such as new accounts, wire transfers and customer files. The Bank performs these checks utilizing software, which is updated each time a modification is made to the lists provided by OFAC and other agencies of Specially Designated Nationals and Blocked Persons.

 

Privacy, Data Security and Credit Reporting. Financial institutions are required to disclose their policies for collecting and protecting confidential information. Customers generally may prevent financial institutions from sharing nonpublic personal financial information with nonaffiliated third parties except under narrow circumstances, such as the processing of transactions requested by the consumer. Additionally, financial institutions generally may not disclose consumer account numbers to any nonaffiliated third party for use in telemarketing, direct mail marketing or other marketing to consumers. It is the Bank’s policy not to disclose any personal information unless required by law.

 

Recent cyber attacks against banks and other institutions that resulted in unauthorized access to confidential customer information have prompted the Federal banking agencies to issue several warnings and extensive guidance on cyber security. The agencies are likely to devote more resources to this part of their safety and soundness examination than they have in the past.

 

In addition, pursuant to the Fair and Accurate Credit Transactions Act of 2003 (the “FACT Act”) and the implementing regulations of the federal banking agencies and Federal Trade Commission, the Bank is required to have in place an “identity theft red flags” program to detect, prevent and mitigate identity theft. The Bank has implemented an identity theft red flags program designed to meet the requirements of the FACT Act and the joint final rules. Additionally, the FACT Act amends the Fair Credit Reporting Act to generally prohibit a person from using information received from an affiliate to make a solicitation for marketing purposes to a consumer, unless the consumer is given notice and a reasonable opportunity and a reasonable and simple method to opt out of the making of such solicitations.

Check 21. The Check Clearing for the 21st Century Act gives “substitute checks,” such as a digital image of a check and copies made from that image, the same legal standing as the original paper check. Some of the major provisions include:

 

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allowing check truncation without making it mandatory;

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demanding that every financial institution communicate to accountholders in writing a description of its substitute check processing program and their rights under the law;

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legalizing substitutions for and replacements of paper checks without agreement from consumers;

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retaining in place the previously mandated electronic collection and return of checks between financial institutions only when individual agreements are in place;

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requiring that when accountholders request verification, financial institutions produce the original check (or a copy that accurately represents the original) and demonstrate that the account debit was accurate and valid; and

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requiring the re-crediting of funds to an individual’s account on the next business day after a consumer proves that the financial institution has erred.

 

Effect of Governmental Monetary Policies. Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve have major effects upon the levels of bank loans, investments and deposits through its open market operations in United States government securities and through its regulation of the discount rate on borrowings of member banks and the reserve requirements against member bank deposits. It is not possible to predict the nature or impact of future changes in monetary and fiscal policies. On December 16, 2015, the federal open market committee raised the federal funds target rate by 25 basis point, which was the first increase in several years. Further increases may occur in 2016, but there is no announced timetable.

 

Insurance of Accounts and Regulation by the FDIC. The Bank’s deposits are insured up to applicable limits by the Deposit Insurance Fund of the FDIC. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC insured institutions. It also may prohibit any FDIC insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the insurance fund. The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the bank’s regulatory authority an opportunity to take such action, and may terminate the deposit insurance if it determines that the institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition.

 

FDIC insured institutions are required to pay a Financing Corporation assessment to fund the interest on bonds issued to resolve thrift failures in the 1980s. The Financing Corporation quarterly assessment for the fourth quarter of 2013 equaled 1.085 basis points for each $100 of average consolidated total assets minus average tangible equity. These assessments, which may be revised based upon the level of deposits, will continue until the bonds mature in the years 2017 through 2019.

 

The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is not aware of any practice, condition or violation that might lead to termination of the Bank’s deposit insurance.

Incentive Compensation. In June 2010, the Federal Reserve, the FDIC and the OCC issued a comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

 

The Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

 

The Dodd-Frank Act required the federal banking agencies, the SEC, and certain other federal agencies to jointly issue a regulation on incentive compensation. The agencies proposed such a rule in 2011, which reflects the 2010 guidance, but the agencies have not finalized the rule as of December 31, 2015.

Item 1A.  Risk Factors

 

Our business is subject to certain risks, including those described below.  If any of the events described in the following risk factors actually occurs then our business, results of operations and financial condition could be materially adversely affected.  More detailed information concerning these risks is contained in other sections of this report, including “Part I, Item 1: Business” and “Part II, Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Risks Related to Our Business

 

Negative developments in the financial industry, the domestic and international credit markets, and the economy in general pose significant challenges for our industry and us and could adversely affect our business, financial condition and results of operations.

 

Negative developments that began in the latter half of 2007 and that have continued since then in the global credit and securitization markets have resulted in unprecedented volatility and disruption in the financial markets and a general economic downturn, both nationally and in our markets. The economy’s recovery from these negative developments has been slow and inconsistent in many markets, including some in the Carolinas. As a result of this “credit crunch,” commercial as well as consumer loan portfolio performances deteriorated at many institutions, and the competition for deposits and quality loans has increased significantly. In addition, the values of real estate collateral supporting many commercial loans and home mortgages have declined and may continue to decline. As a result, we may face the following risks:

 

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economic conditions that negatively affect housing prices and the job market may cause the credit quality of our loan portfolios to deteriorate;

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market developments that affect consumer confidence may cause adverse changes in payment patterns by our customers, causing increases in delinquencies and default rates on loans and other credit facilities;

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the processes that we use to estimate our allowance for loan and lease losses and reserves may no longer be reliable because they rely on judgments, such as forecasts of economic conditions, that may no longer be capable of accurate estimation;

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the value of our securities portfolio may decline; and

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we face increased regulation of our industry, and the costs of compliance with such regulation may continue to increase.

 

These conditions or similar ones may continue to persist or worsen, causing us to experience continuing or increased adverse effects on our business, financial condition, results of operations and the price of our common stock.

 

Our mortgage banking profitability could be significantly reduced if we are not able to originate and resell a high volume of mortgage loans.

 

Mortgage production, especially refinancing activity, typically declines in a rising interest rate environment. During 2009-2015, there was a period of historically low interest rates; however, the low interest rate environment likely will not continue indefinitely. Because we sell a substantial portion of the mortgage loans we originate, the profitability of our mortgage banking business depends in large part upon our ability to aggregate a high volume of loans and sell them in the secondary market at a gain. Thus, in addition to our dependence on the interest rate environment, we are dependent upon (i) the existence of an active secondary market and (ii) our ability to profitably sell loans or securities into that market. As our level of mortgage production declines, the profitability from our mortgage operations will depend upon our ability to reduce our costs commensurate with the reduction of revenue from our mortgage operations.

 

Our ability to originate and sell mortgage loans readily is dependent upon the availability of an active secondary market for single-family mortgage loans, which in turn depends in part upon the continuation of programs currently offered by the government sponsored entities, or GSEs, and other institutional and non-institutional investors. These entities account for a substantial portion of the secondary market in residential mortgage loans. Because the largest participants in the secondary market are government-sponsored enterprises whose activities are governed by federal law, any future changes in laws that significantly affect the activity of the GSEs could, in turn, adversely affect our operations. In September 2008, the GSEs were placed into conservatorship by the U.S. government. Although to date the conservatorship has not had a significant or adverse effect on our operations, it remains unclear whether these events or further changes would significantly and adversely affect our operations. The government and others have provided options to reform the GSEs, but the results of any such reform, and their impact on us, are difficult to predict. To date, no reform proposal has been enacted. In addition, our ability to sell mortgage loans readily is dependent upon our ability to remain eligible for the programs offered by the GSEs and other institutional and non-institutional investors. Our ability to remain eligible to originate and securitize government insured loans may also depend on having an acceptable peer-relative delinquency ratio for FHA loans and maintaining a delinquency rate with respect to Ginnie Mae pools that are below Ginnie Mae guidelines.

Any significant impairment of our eligibility with any of the GSEs would materially adversely affect our operations. Further, the criteria for loans to be accepted under such programs may be changed from time-to-time by the sponsoring entity which could result in a lower volume of corresponding loan originations. The profitability of participating in specific programs may vary depending on a number of factors, including our administrative costs of originating and purchasing qualifying loans and our costs of meeting such criteria.

 

An increase in our nonperforming assets would adversely impact our earnings.

 

Our nonperforming assets may increase in future periods. Nonperforming assets adversely affect our net income in various ways. We do not record interest income on non-accrual loans or investments or on real estate owned. We must establish an allowance for loan losses that reserves for losses inherent in the loan portfolio that are both probable and reasonably estimable through current period provisions for loan losses, which are recorded as a charge to income. From time to time, we also write down the other real estate owned portfolio to reflect changing market values. Additionally, there are legal fees associated with the resolution of problem assets as well as carrying costs such as taxes, insurance and maintenance related to the other real estate owned. Further, the resolution of nonperforming assets requires the active involvement of management, which can distract them from our overall supervision of operations and other income-producing activities.

 

We could record other-than-temporary impairment on our securities portfolio. In addition, we may not receive full future interest payments on these securities.

 

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

 

At December 31, 2015, the Company had 45 individual securities available-for-sale in an unrealized loss position. The Company believes, based on industry analyst reports and third-party OTTI evaluations, that the deterioration in the value of these securities is attributable to a combination of the lack of liquidity in these securities, credit ratings and credit quality concerns. There are three additional trust preferred securities classified as available-for-sale securities that had OTTI expense recorded in prior years, but did not incur OTTI expense during fiscal 2015 or 2014. Management believes that there are no other securities other-than-temporarily impaired at December 31, 2015. The Company does not intend to sell these securities, and it is more likely than not that the Company will not be required to sell these securities before recovery of their amortized cost. Management continues to monitor these securities with a high degree of scrutiny. There can be no assurance that the Company will not conclude in future periods that conditions existing at that time indicate some or all of the securities may be sold or are other-than-temporarily impaired, which would require a charge to earnings in such periods.

 

A number of factors or combinations of factors could require us to conclude in one or more future reporting periods that an unrealized loss that exists with respect to our securities portfolio constitutes additional impairment that is other than temporary, which could result in material losses to us. These factors include, but are not limited to, a continued failure by an issuer to make scheduled interest payments, an increase in the severity of the unrealized loss on a particular security, an increase in the continuous duration of the unrealized loss without an improvement in value or changes in market conditions and/or industry or issuer specific factors that would render us unable to forecast a full recovery in value. In addition, the fair values of securities could decline if the overall economy and the financial condition of some of the issuers continue to deteriorate and there remains limited liquidity for these securities.

We may not be able to continue to support the realization of our deferred tax asset.

 

We calculate income taxes in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 740, Income Taxes, which requires the use of the asset and liability method. In accordance with this, we regularly assess available positive and negative evidence to determine whether it is more likely than not that our deferred tax asset balances will be recovered from reversals of deferred tax liabilities, potential utilization of net operating loss carrybacks, tax planning strategies and future taxable income. At December 31, 2015, our net deferred tax asset was $5.3 million. We recognized the deferred tax asset because management believes, based on earnings and detailed financial projections, that it is more likely than not that we will have sufficient future earnings to utilize this asset to offset future income tax liabilities. Realization of a deferred tax asset requires us to apply significant judgment and is inherently speculative because it requires the future occurrence of circumstances that cannot be predicted with certainty. There can be no assurance that we will achieve sufficient future taxable income as the basis for the ultimate realization of our deferred tax asset and therefore we may have to establish a full or partial valuation allowance at some point in the future. If we determine that a valuation allowance is necessary, this would require us to incur a charge to operations that would adversely affect our capital position.

 

At December 31, 2015, we had $5.3 million of allowable net deferred tax assets for regulatory capital purposes, which is the amount that is expected to be recovered based on a two-year net operating loss carryback and the next four quarters calculation. There is no assurance that we will be able to continue to recognize any, or all, of the deferred tax asset for regulatory capital purposes.

 

We may be terminated as a servicer of mortgage loans, be required to repurchase a mortgage loan or reimburse investors for credit losses on a mortgage loan, or incur costs, liabilities, fines and other sanctions if we fail to satisfy our servicing obligations, including our obligations with respect to mortgage loan foreclosure actions.

 

We act as servicer for approximately $2.0 billion of mortgage loans owned by third parties as of December 31, 2015. As a servicer for those loans we have certain contractual obligations, including foreclosing on defaulted mortgage loans or, to the extent applicable, considering alternatives to foreclosure such as loan modifications or short sales. If we commit a material breach of our obligations as servicer, we may be subject to termination as servicer if the breach is not cured within a specified period of time following notice, causing us to lose servicing income.

 

In some cases, we may be contractually obligated to repurchase a mortgage loan or reimburse the investor for credit losses incurred on the loan as a remedy for servicing errors with respect to the loan. If we have increased repurchase obligations because of claims that we did not satisfy our obligations as a servicer, or increased loss severity on such repurchases, we may have a significant reduction to net servicing income within our mortgage banking noninterest income. We may incur costs if we are required to, or if we elect to, re-execute or re-file documents or take other action in our capacity as a servicer in connection with pending or completed foreclosures. We may incur litigation costs if the validity of a foreclosure action is challenged by a borrower. If a court were to overturn a foreclosure because of errors or deficiencies in the foreclosure process, we may have liability to the borrower and/or to any title insurer of the property sold in foreclosure if the required process was not followed. These costs and liabilities may not be legally or otherwise reimbursable to us. In addition, if certain documents required for a foreclosure action are missing or defective, we could be obligated to cure the defect or repurchase the loan. We may incur liability to securitization investors relating to delays or deficiencies in our processing of mortgage assignments or other documents necessary to comply with state law governing foreclosures. The fair value of our mortgage servicing rights may be negatively affected to the extent our servicing costs increase because of higher foreclosure costs. We may be subject to fines and other sanctions imposed by federal or state regulators as a result of actual or perceived deficiencies in our foreclosure practices or in the foreclosure practices of other mortgage loan servicers. Any of these actions may harm our reputation or negatively affect our home lending or servicing business.

We may be required to repurchase mortgage loans or indemnify buyers against losses in some circumstances, which could harm liquidity, results of operations and financial condition.

 

When mortgage loans are sold, whether as whole loans or pursuant to a securitization, we are required to make customary representations and warranties to purchasers, guarantors and insurers, including the government sponsored enterprises, about the mortgage loans and the manner in which they were originated. Whole loan sale agreements require repurchase or substitute mortgage loans, or indemnification of buyers against losses, in the event we breach these representations or warranties. In addition, we may be required to repurchase mortgage loans as a result of early payment default of the borrower on a mortgage loan. With respect to loans that are originated through our broker or correspondent channels, the remedies available against the originating broker or correspondent, if any, may not be as broad as the remedies available to purchasers, guarantors and insurers of mortgage loans against us. We face further risk that the originating broker or correspondent, if any, may not have financial capacity to perform remedies that otherwise may be available. Therefore, if a purchaser, guarantor or insurer enforces its remedies against us, we may not be able to recover losses from the originating broker or correspondent. If repurchase and indemnity demands increase and such demands are valid claims and are in excess of our provision for potential losses, our liquidity, results of operations and financial condition may be adversely affected.

 

Our decisions regarding credit risk and reserves for loan losses may materially and adversely affect our business.

 

Making loans and other extensions of credit is an essential element of our business. Although we seek to mitigate risks inherent in lending by adhering to specific underwriting practices, our loans and other extensions of credit may not be repaid. The risk of nonpayment is affected by a number of factors, including:

 

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the duration of the credit;

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credit risks of a particular customer;

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changes in economic and industry conditions; and

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in the case of a collateralized loan, risks resulting from uncertainties about the future value of the collateral.

 

We attempt to maintain an appropriate allowance for loan losses to provide for potential losses in our loan portfolio. We periodically determine the amount of the allowance based on consideration of several factors, including:

 

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an ongoing review of the quality, mix, and size of our overall loan portfolio;

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our historical loan loss experience;

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evaluation of economic conditions;

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regular reviews of loan delinquencies and loan portfolio quality; and

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the amount and quality of collateral, including guarantees, securing the loans.

 

There is no precise method of predicting credit losses; therefore, we face the risk that charge-offs in future periods will exceed our allowance for loan losses and that additional increases in the allowance for loan losses will be required. Additions to the allowance for loan losses would result in a decrease of our net income, and possibly our capital.

 

Federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in the amount of our provision or loans charged-off as required by these regulatory agencies could have a negative effect on our operating results.

 

We may have higher loan losses than we have allowed for in our allowance for loan losses.

 

Like all financial institutions, we maintain an allowance for loan losses to provide for probable losses caused by customer loan defaults. The allowance for loan losses may not be adequate to cover actual loan losses, and in this case additional and larger provisions for loan losses would be required to replenish the allowance. Provisions for loan losses are a direct charge against income.

 

We establish the amount of the allowance for loan losses based on historical loss rates, as well as estimates and assumptions about future events. Because of the extensive use of estimates and assumptions, our actual loan losses could differ, possibly significantly, from our estimate. We believe that our allowance for loan losses is adequate to provide for probable losses, but it is possible that the allowance for loan losses will need to be increased for credit reasons or that regulators will require us to increase this allowance. Either of these occurrences could materially and adversely affect our earnings and profitability.

A significant portion of our loan portfolio is secured by real estate, and events that negatively impact the real estate market could hurt our business.

 

A significant portion of our loan portfolio is secured by real estate. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. A weakening of the real estate market in our primary market areas could result in an increase in the number of borrowers who default on their loans and a reduction in the value of the collateral securing their loans, which in turn could have an adverse effect on our profitability and asset quality. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected. Acts of nature, including hurricanes, tornados, earthquakes, fires and floods, which could be exacerbated by potential climate change and may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact our financial condition.

 

We have a concentration of credit exposure in commercial real estate and challenges faced by the commercial real estate market could adversely affect our business, financial condition, and results of operations.

 

As of December 31, 2015, we had approximately $342.4 million in loans outstanding to borrowers whereby the collateral securing the loan was commercial real estate, representing approximately 37.1% of our total loans outstanding as of that date. Approximately 36.9%, or $126.5 million, of this real estate are owner-occupied properties. Commercial real estate loans are generally viewed as having more risk of default than residential real estate loans. They are also typically larger than residential real estate loans and consumer loans and depend on cash flows from the owner’s business or the property to service the debt. Cash flows may be affected significantly by general economic conditions, and a downturn in the local economy or in occupancy rates in the local economy where the property is located could increase the likelihood of default. Because our loan portfolio contains a number of commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in our level of nonperforming loans. An increase in nonperforming loans could result in a loss of earnings from these loans, an increase in the related provision for loan losses and an increase in charge-offs, all of which could have a material adverse effect on our financial condition and results of operations.

 

The banking regulators are giving commercial real estate lending greater scrutiny, and may require banks with higher levels of commercial real estate loans to implement more stringent underwriting, internal controls, risk management policies and portfolio stress testing, as well as possibly higher levels of allowances for losses and capital levels as a result of commercial real estate lending growth and exposures.

 

Repayment of our commercial business loans is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.

 

At December 31, 2015, commercial business loans comprised 12.7% of our total loan portfolio. Our commercial business loans are originated primarily based on the identified cash flow and general liquidity of the borrower and secondarily on the underlying collateral provided by the borrower and/or repayment capacity of any guarantor. The borrower’s cash flow may be unpredictable, and collateral securing these loans may fluctuate in value. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories may be obsolete or of limited use. In addition, business assets may depreciate over time, may be difficult to appraise, and may fluctuate in value based on the success of the business. Accordingly, the repayment of commercial business loans depends primarily on the cash flow and credit worthiness of the borrower and secondarily on the underlying collateral value provided by the borrower and liquidity of the guarantor.

Further downturns or a slower recovery in the real estate markets in our primary market areas could significantly adversely impact our business.

 

Our business activities and credit exposure are primarily concentrated in Charleston, Dorchester, and Horry counties in South Carolina. The Company’s primary markets in Charleston and Dorchester counties are heavily influenced by the Port of Charleston, the military, the medical industry and national and international industries. The Company’s primary market areas in Horry County and adjacent counties in North Carolina are heavily influenced by tourism, retirement living, and retail. The real estate markets have experienced a significant decline in these markets in recent years and, if these economic drivers experience further downturns or recover more slowly than expected, real estate in the Company’s markets may experience further declines. If real estate values in our markets decline, the collateral for these loans will provide less security. As a result, the borrower’s ability to pay, or the Company’s ability to recover on defaulted loans by selling the underlying collateral, would be diminished.

 

Our focus on lending to small to mid-sized community-based businesses may increase our credit risk.

 

Most of our commercial business and commercial real estate loans are made to small business or middle market customers. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities and have a heightened vulnerability to economic conditions. If general economic conditions in the markets in which we operate negatively impact this important customer sector, our results of operations and financial condition and the value of our common stock may be adversely affected. Moreover, a portion of these loans have been made by us in recent years and the borrowers may not have experienced a complete business or economic cycle. Furthermore, the deterioration of our borrowers’ businesses may hinder their ability to repay their loans with us, which could have a material adverse effect on our financial condition and results of operations.

 

We face strong competition for customers, which could prevent us from obtaining customers and may cause us to pay higher interest rates to attract customers.

 

The banking business is highly competitive, and we experience competition in our markets from many other financial institutions. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other super-regional, national, and international financial institutions that operate offices in our primary market areas and elsewhere. We compete with these institutions both in attracting deposits and in making loans. In addition, we have to attract our customer base from other existing financial institutions and from new residents. Many of our competitors are well-established, larger financial institutions. These institutions offer some services, such as extensive and established branch networks, that we do not provide. There is a risk that we will not be able to compete successfully with other financial institutions in our markets, and that we may have to pay higher interest rates to attract deposits, resulting in reduced profitability. In addition, competitors that are not depository institutions are generally not subject to the extensive regulations that apply to us.

 

Our deposit insurance premiums could be substantially higher in the future, which could have a material adverse effect on our future earnings.

 

The FDIC insures deposits at FDIC-insured depository institutions, such as the Bank, up to applicable limits. The amount of a particular institution’s deposit insurance assessment is based on that institution’s risk classification under an FDIC risk-based assessment system. An institution’s risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to its regulators. Recent market developments and bank failures significantly depleted the FDIC’s Deposit Insurance Fund and reduced the ratio of reserves to insured deposits. As a result of recent economic conditions and the enactment of the Dodd-Frank Act, banks are now assessed deposit insurance premiums based on the bank’s average consolidated total assets, and the FDIC has modified certain risk-based adjustments, which increase or decrease a bank’s overall assessment rate. This has resulted in increases to the deposit insurance assessment rates and thus raised deposit premiums for many insured depository institutions. If these increases are insufficient for the Deposit Insurance Fund to meet its funding requirements, further special assessments or increases in deposit insurance premiums may be required. We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures, we may be required to pay even higher FDIC premiums than the recently increased levels. Any future additional assessments, increases or required prepayments in FDIC insurance premiums could reduce our profitability, may limit our ability to pursue certain business opportunities or otherwise negatively impact our operations.

The accuracy of our financial statements and related disclosures could be affected if the judgments, assumptions or estimates used in our critical accounting policies are inaccurate.

 

The preparation of financial statements and related disclosure in conformity with accounting principles generally accepted in the United States requires us to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are included in the section captioned “Management’s Discussion and Analysis of Results of Operations and Financial Condition”, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that we consider “critical” because they require judgments, assumptions and estimates that materially affect our consolidated financial statements and related disclosures. As a result, if future events differ significantly from the judgments, assumptions and estimates in our critical accounting policies, those events or assumptions could have a material impact on our consolidated financial statements and related disclosures.

 

Our funding sources may prove insufficient to replace deposits and support future growth.

 

We rely on customer deposits, including brokered deposits, advances from the Federal Home Loan Bank of Atlanta (the “FHLB”) and the Federal Reserve, and other borrowings to fund operations. Although the Company has historically been able to replace maturing deposits and advances, if desired, no assurance can be given that we would be able to replace such funds in the future if the financial condition of the FHLB or programs sponsored by the Federal Reserve, regulatory restrictions on brokered deposits or regulatory restrictions on the pricing of local deposits or other market conditions were to change. In addition, certain borrowing sources are on a secured basis. The FHLB has become more restrictive on the types of collateral it will accept and the amount of borrowings allowed on acceptable collateral. Due to changes applied by rating agencies on bonds, changes in collateral requirements or deteriorating loan quality, outstanding borrowings could be required to be repaid, incurring prepayment penalties. Our financial flexibility will be severely constrained if we are unable to maintain access to funding at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future operations, our revenues may not increase proportionally to cover these costs. In addition, Crescent Mortgage Company funds mortgage loans held for sale through a purchase and sale agreement with the Bank. A decline in economic conditions could affect Crescent Mortgage Company’s ability to fund loans held for sale.

 

Our operating results may fluctuate based upon the results of our mortgage subsidiary, Crescent Mortgage Company.

 

There are a number of items that could adversely affect the volumes and margin of the Company’s mortgage banking operations. These include, but are not limited to, the Federal Reserve’s monetary policy including its quantitative easing program, aggressively low rates, reduction in prices paid by the mortgage banking aggregators, aggressive competition, the housing market recovery, the status and financial condition of Fannie Mae and Freddie Mac, potential changes in Fannie Mae and Freddie Mac lending guidelines and programs, proposed changes in the FHA lending requirements, extensive regulatory changes and liquidity. Should these factors significantly impact production of mortgages, it is likely that the Company’s earnings would be adversely affected.

 

Our mortgage subsidiary’s operations are exposed to significant repurchase risk.

 

Crescent Mortgage Company is exposed to significant repurchase risk on mortgage loan production related to potential reimbursements for loans sold to third parties for borrower fraud, underwriting and documentation issues, early defaults and prepayments of sold loans. If the Company experiences significant losses related to repurchase risk, it is possible that the reserve established for such exposure is not adequate. The Company continues to receive repurchase requests. The Company evaluates each request and provides estimated reserves as necessary. We believe that the reserve related to repurchase risk is adequate to absorb probable losses; however, we cannot predict these losses or whether our reserve will be adequate. Any of these occurrences could materially and adversely affect our business, financial condition and profitability.

The value of our loan servicing portfolio may become impaired in the future.

 

As of December 31, 2015, Crescent Mortgage Company serviced approximately $2.0 billion of loans. At that date, our mortgage loan servicing rights were recorded as an asset with a carrying value of approximately $11.4 million. We expect that our loan servicing portfolio will increase in the future. If interest rates decline and the actual and expected mortgage loan prepayment rates increase or other factors that cause a reduction of the valuation of our mortgage servicing asset, the Company could incur an impairment of its mortgage loan servicing asset.

 

Hurricanes and other natural disasters may adversely affect loan portfolios and operations and increase the cost of doing business.

 

The Company operates in markets that are susceptible to hurricanes and other natural disasters. Large-scale natural disasters may significantly affect loan portfolios by damaging properties pledged as collateral, affecting the economies our borrowers live in, and by impairing the ability of the borrower to repay their loans.

 

Changes in prevailing interest rates may reduce our profitability.

 

Our results of operations depend in large part upon the level of our net interest income, which is the difference between interest income from interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings. Depending on the terms and maturities of our assets and liabilities, we believe it is more likely than not a significant change in interest rates could have a material adverse effect on our profitability. Many factors cause changes in interest rates, including governmental monetary policies and domestic and international economic and political conditions. While we intend to manage the effects of changes in interest rates by adjusting the terms, maturities, and pricing of our assets and liabilities, our efforts may not be effective and our financial condition and results of operations could suffer.

 

We are dependent on key individuals, and the loss of one or more of these key individuals could curtail our growth and adversely affect our prospects.

 

Jerold L. Rexroad, the Company’s President and Chief Executive Officer, has extensive and long-standing ties within our primary markets. Mr. Rexroad has substantial experience in banking operations, wholesale mortgage operations, investment securities, and mergers and acquisitions. If we lose the services of Mr. Rexroad he would be difficult to replace and our business and development could be materially and adversely affected.

 

David L. Morrow, the Bank’s President and Chief Executive Officer, also has extensive and long-standing ties within our primary markets and substantial commercial lending experience within our Charleston and Myrtle Beach markets. If we lose the services of Mr. Morrow, he would be difficult to replace and our business and development could be materially and adversely affected.

 

Fowler C. Williams, Crescent Mortgage Company’s President and Chief Executive Officer, has extensive knowledge and long-standing ties with the mortgage Industry. If we lose the services of Mr. Williams, he would be difficult to replace and our wholesale mortgage company results could be materially and adversely affected.

 

Our success also depends, in part, on our continued ability to attract and retain experienced loan originators, as well as other management personnel. Competition for personnel is intense, and we may not be successful in attracting or retaining qualified personnel. Our failure to compete for these personnel, or the loss of the services of several of such key personnel, could adversely affect our business strategy and seriously harm our business, results of operations, and financial condition.

The Dodd-Frank Act may have a material adverse effect on our operations.

 

The Dodd-Frank Act imposes significant regulatory and compliance changes on banks and bank holding companies. The key effects of the Dodd-Frank Act on our business are:

 

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changes to regulatory capital requirements;

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exclusion of hybrid securities, including trust preferred securities, issued on or after May 19, 2010 from Tier 1 capital;

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creation of new government regulatory agencies (such as the Financial Stability Oversight Council, which oversees systemic risk, and the Consumer Financial Protection Bureau, which develops and enforces rules for bank and non-bank providers of consumer financial products);

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potential limitations on federal preemption;

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changes to deposit insurance assessments;

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regulation of debit interchange fees we earn;

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changes in retail banking regulations, including potential limitations on certain fees we may charge; and

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changes in regulation of consumer mortgage loan origination and risk retention.

 

In addition, the Dodd-Frank Act restricts the ability of banks to engage in certain proprietary trading or to sponsor or invest in private equity or hedge funds. The Dodd-Frank Act also contains provisions designed to limit the ability of insured depository institutions, their holding companies and their affiliates to conduct certain swaps and derivatives activities and to take certain principal positions in financial instruments.

 

Some provisions of the Dodd-Frank Act became effective immediately upon its enactment. Many provisions, however, will require regulations to be promulgated by various federal agencies in order to be implemented, some but not all of which have been proposed or finalized by the applicable federal agencies. The provisions of the Dodd-Frank Act may have unintended effects, which will not be clear until after implementation. Certain changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements. Failure to comply with the new requirements may negatively impact our results of operations and financial condition. While we cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, these changes could be materially adverse to investors in our common stock.

 

New capital rules that were recently issued generally require insured depository institutions and their holding companies to hold more capital.  The impact of the new rules on our financial condition and operations is uncertain but could be materially adverse.

 

On July 2, 2013, the Federal Reserve adopted a final rule for the Basel III capital framework and, on July 9, 2013, the OCC also adopted a final rule and the FDIC adopted the same provisions in the form of an “interim final.”  The requirements in the rule began to phase in on January 1, 2014 for advanced approaches banking organizations, and on January 1, 2015 for other covered banking organizations, including the Company and the Bank. The requirements in the rule will be fully phased in by January 1, 2019. These rules substantially amend the regulatory risk-based capital rules applicable to us.  

 

The final rules increase capital requirements and generally include two new capital measurements that will affect us, a risk-based Common Equity Tier 1 ratio and a capital conservation buffer. Common Equity Tier 1 (CET1) capital is a subset of Tier 1 capital and is limited to common equity (plus related surplus), retained earnings, accumulated other comprehensive income and certain other items. Other instruments that have historically qualified for Tier 1 treatment, including non-cumulative perpetual preferred stock, are consigned to a category known as additional Tier 1 capital and must be phased out over a period of nine years beginning in 2015. The rules permit bank holding companies with less than $15 billion in assets (such as us) to continue to include trust preferred securities and non-cumulative perpetual preferred stock issued before May 19, 2010 in Tier 1 capital, but not CET1. Tier 2 capital consists of instruments that have historically been placed in Tier 2, as well as cumulative perpetual preferred stock.

 

The final rules adjust all three categories of capital by requiring new deductions from and adjustments to capital that will result in more stringent capital requirements and may require changes in the ways we do business. Among other things, the current rule on the deduction of mortgage servicing assets from Tier 1 capital has been revised in ways that are likely to require a greater deduction than we currently make and that will require the deduction to be made from CET1.  This deduction phases in over a three-year period from 2015 through 2017.  We closely monitor our mortgage servicing assets, and we expect to maintain our mortgage servicing asset at levels close to the deduction thresholds by a combination of sales of portions of these assets from time to time either on a flowing basis as we originate mortgages or through bulk sale transactions. Additionally, any gains on sales from mortgage loans sold into securitizations must be deducted in full from CET1.  This requirement phases in over three years from 2015 through 2017.  Under the earlier rule and through 2014, no deduction was required.

Beginning in 2015, our minimum capital requirements were increased to (i) a CET1 ratio of 4.5%, (ii) a Tier 1 capital (CET1 plus Additional Tier 1 capital) of 6% (up from 4%) and (iii) a total capital ratio of 8% (the current requirement). Our leverage ratio requirement will remain at the 4% level now required. Beginning in 2016, a capital conservation buffer will phase in over three years, ultimately resulting in a requirement of 2.5% on top of the CET1, Tier 1 and total capital requirements, resulting in a require CET1 ratio of 7%, a Tier 1 ratio of 8.5%, and a total capital ratio of 10.5%. Failure to satisfy any of these three capital requirements will result in limits on paying dividends, engaging in share repurchases and paying discretionary bonuses. These limitations will establish a maximum percentage of eligible retained income that could be utilized for such actions. While the final rules will result in higher regulatory capital standards, it is difficult at this time to predict when or how any new standards will ultimately be applied to us.

 

In addition to the higher required capital ratios and the new deductions and adjustments, the final rules increased the risk weights for certain assets, meaning that we will have to hold more capital against these assets. For example, commercial real estate loans that do not meet certain new underwriting requirements must be risk-weighted at 150%, rather than the previous requirement of 100%. There are also new risk weights for unsettled transactions and derivatives. We also are required to hold capital against short-term commitments that are not unconditionally cancelable; currently, there are no capital requirements currently for these off-balance sheet assets.

 

In addition, in the current economic and regulatory environment, bank regulators may impose capital requirements that are more stringent than those required by applicable existing regulations. The application of more stringent capital requirements for us could, among other things, result in lower returns on equity, require the raising of additional capital, and result in regulatory actions if we were to be unable to comply with such requirements. Implementation of changes to asset risk weightings for risk-based capital calculations, items included or deducted in calculating regulatory capital or additional capital conservation buffers, could result in management modifying our business strategy and could limit our ability to make distributions, including paying dividends or buying back our shares.

 

We face a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statutes and regulations.

 

The federal Bank Secrecy Act, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”), and other laws and regulations require financial institutions, among other duties, to institute and maintain effective anti-money laundering programs and file suspicious activity and currency transaction reports as appropriate. The federal Financial Crimes Enforcement Network, established by the Treasury to administer the Bank Secrecy Act, is authorized to impose significant civil money penalties for violations of those requirements and has recently engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the Department of Justice, Drug Enforcement Administration and Internal Revenue Service. There is also increased scrutiny of compliance with the rules enforced by OFAC. Federal and state bank regulators also have begun to focus on compliance with Bank Secrecy Act and anti-money laundering regulations. If our policies, procedures and systems are deemed deficient we would be subject to liability, including fines and regulatory actions, such as restrictions on our ability to pay dividends, which would negatively impact our business, financial condition and results of operations. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us.

Federal, state and local consumer lending laws may restrict our ability to originate certain mortgage loans or increase our risk of liability with respect to such loans and could increase our cost of doing business.

 

Federal, state and local laws have been adopted that are intended to eliminate certain lending practices considered “predatory.” These laws prohibit practices such as steering borrowers away from more affordable products, selling unnecessary insurance to borrowers, repeatedly refinancing loans and making loans without a reasonable expectation that the borrowers will be able to repay the loans irrespective of the value of the underlying property. Since 2013, the CFPB has issued several rules on mortgage lending, notably a rule requiring all home mortgage lenders to determine a borrower’s ability to repay the loan.  Loans with certain terms and conditions and that otherwise meet the definition of a “qualified mortgage” may be protected from liability to a borrower for failing to make the necessary determinations.  In either case, we may find it necessary to tighten our mortgage loan underwriting standards in response to the CFPB rules, which may constrain our ability to make loans consistent with our business strategies. It is our policy not to make predatory loans and to determine borrowers’ ability to repay, but the law and related rules create the potential for increased liability with respect to our lending and loan investment activities. They increase our cost of doing business and, ultimately, may prevent us from making certain loans and cause us to reduce the average percentage rate or the points and fees on loans that we do make.

 

The requirements of being a public company may strain our resources, divert management’s attention and affect our ability to attract and retain executive management and qualified board members.

 

Our common stock was registered under the Exchange Act in 2014, thereby subjecting the Company to the reporting requirements of the Exchange Act, the Sarbanes-Oxley Act, the Dodd-Frank Act, and other applicable securities rules and regulations. Compliance with these rules and regulations have and will continue to increase our legal and financial compliance costs, make some activities more difficult, time-consuming or costly and increase demand on our systems and resources. The Exchange Act requires, among other things, that we file annual, quarterly and current reports with respect to our business and operating results. The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and internal control over financial reporting. In order to maintain and, if required, improve our disclosure controls and procedures and internal control over financial reporting to meet this standard, significant resources and management oversight may be required. As a result, management’s attention may be diverted from other business concerns, which could adversely affect our business and operating results. Although we have hired additional employees to comply with these requirements, we may need to hire more employees in the future or engage outside consultants, which will increase our costs and expenses.

 

In addition, changing laws, regulations and standards relating to corporate governance and public disclosure are creating uncertainty for public companies, increasing legal and financial compliance costs and making some activities more time consuming. These laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We intend to invest resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management’s time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to their application and practice, regulatory authorities may initiate legal proceedings against us and our business may be adversely affected.

 

We also expect that being a public reporting company, our higher market capitalization, and these new rules and regulations will increase the costs of our director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These factors could also make it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee and compensation committee, and qualified executive officers.

 

As a result of disclosure of information in this report and in filings required of a public company, our business and financial condition will become more visible, which may result in threatened or actual litigation, including by competitors and other third parties. If such claims are successful, our business and operating results could be adversely affected, and even if the claims do not result in litigation or are resolved in our favor, these claims, and the time and resources necessary to resolve them, could divert the resources of our management and adversely affect our business and operating results.

We may be adversely affected by the soundness of other financial institutions.

 

Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by the bank cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to the bank. Any such losses could have a material adverse affect on our financial condition and results of operations.

 

We may face risks if we seek to expand through acquisitions or mergers.

 

From time to time, we may seek to acquire other financial institutions or parts of those institutions. We may also expand into new markets or lines of business or offer new products or services. These activities would involve a number of risks, including:

 

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the potential inaccuracy of the estimates and judgments used to evaluate credit, operations, management, and market risks with respect to a target institution;

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the time and costs of evaluating new markets, hiring or retaining experienced local management, and opening new offices and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;

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the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse effects on our results of operations; and

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the risk of loss of key employees and customers.

 

We depend on the accuracy and completeness of information about clients and counterparties and our financial condition could be adversely affected if we rely on misleading information.

 

In deciding whether to extend credit or to enter into other transactions with clients and counterparties, we may rely on information furnished to us by or on behalf of clients and counterparties, including financial statements and other financial information, which we do not independently verify. We also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. For example, in deciding whether to extend credit to clients, we may assume that a customer’s audited financial statements conform with GAAP and present fairly, in all material respects, the financial condition, results of operations and cash flows of the customer. Our financial condition and results of operations could be negatively impacted to the extent we rely on financial statements that do not comply with GAAP or are materially misleading.

 

Our ability to pay cash dividends is limited, and we may be unable to pay future dividends even if we desire to do so.

 

The Federal Reserve has issued a policy statement regarding the payment of dividends by bank holding companies. In general, the Federal Reserve’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality and overall financial condition. The Federal Reserve’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds to those banks during periods of financial stress or adversity and by maintaining the financial flexibility and capital raising capacity to obtain additional resources for assisting its subsidiary banks where necessary. In addition, under the prompt corrective action regulations, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions.

 

Our ability to pay cash dividends may be limited by regulatory restrictions, by our Bank’s ability to pay cash dividends to the Company and by our need to maintain sufficient capital to support our operations. As a South Carolina chartered bank, the Bank is subject to limitations on the amount of dividends that it is permitted to pay. Unless otherwise instructed by the SCBFI, the Bank is generally permitted under South Carolina state banking regulations to pay cash dividends of up to 100% of net income in any calendar year without obtaining the prior approval of the SCBFI. If our Bank is not permitted to pay cash dividends to the Company, it is unlikely that we would be able to pay cash dividends on our common stock. Moreover, holders of our common stock are entitled to receive dividends only when, and if declared by our board of directors. Although we have historically paid cash dividends on our common stock, we are not required to do so and our board of directors could reduce or eliminate our common stock dividend in the future.

A failure in or breach of our operational or security systems or infrastructure, or those of our third party vendors and other service providers or other third parties, including as a result of cyber attacks, could disrupt our businesses, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs, and cause losses.

 

We rely heavily on communications and information systems to conduct our business. Information security risks for financial institutions such as ours have generally increased in recent years in part because of the proliferation of new technologies, the use of the internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, and terrorists, activists, and other external parties. As customer, public, and regulatory expectations regarding operational and information security have increased, our operating systems and infrastructure must continue to be safeguarded and monitored for potential failures, disruptions, and breakdowns. Our business, financial, accounting, and data processing systems, or other operating systems and facilities may stop operating properly or become disabled or damaged as a result of a number of factors, including events that are wholly or partially beyond our control. For example, there could be electrical or telecommunication outages; natural disasters such as earthquakes, tornadoes, and hurricanes; disease pandemics; events arising from local or larger scale political or social matters, including terrorist acts; and as described below, cyber attacks.

 

As noted above, our business relies on our digital technologies, computer and email systems, software and networks to conduct its operations. Although we have information security procedures and controls in place, our technologies, systems, networks, and our customers’ devices may become the target of cyber attacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss, or destruction of our or our customers’ or other third parties’ confidential information. Third parties with whom we do business or that facilitate our business activities, including financial intermediaries, or vendors that provide service or security solutions for our operations, and other unaffiliated third parties could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints.

 

While we have disaster recovery and other policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. Our risk and exposure to these matters remains heightened because of the evolving nature of these threats. As a result, cyber security and the continued development and enhancement of our controls, processes, and practices designed to protect our systems, computers, software, data, and networks from attack, damage or unauthorized access remain a focus for us. As threats continue to evolve, we may be required to expend additional resources to continue to modify or enhance our protective measures or to investigate and remediate information security vulnerabilities. Disruptions or failures in the physical infrastructure or operating systems that support our businesses and clients, or cyber attacks or security breaches of the networks, systems or devices that our clients use to access our products and services could result in client attrition, regulatory fines, penalties or intervention, reputation damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could have a material effect on our results of operations or financial condition.

 

Negative public opinion surrounding our Company and the financial institutions industry generally could damage our reputation and adversely impact our earnings and our ability to make loans or to acquire deposits.

 

Reputation risk, or the risk to our business, earnings and capital from negative public opinion surrounding our company and the financial institutions industry generally, is inherent in our business. Negative public opinion can result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions, and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect our ability to keep and attract clients and employees and can expose us to litigation and regulatory action. Although we take steps to minimize reputation risk in dealing with our clients and communities, this risk will always be present given the nature of our business.

We are an emerging growth company and we cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make our common stock less attractive to investors.

 

We are an emerging growth company. Under the JOBS Act, emerging growth companies can take advantage of certain exemptions from various reporting requirements that are applicable to other public companies including, without limitation, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, exemptions from the requirements of holding a nonbinding advisory stockholder vote on executive compensation and any golden parachute payments not previously approved, exemption from the requirement of auditor attestation in the assessment of our internal control over financial reporting and exemption from any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about our audit and the financial statements (auditor discussion and analysis). As a result of the foregoing, the information that we provide stockholders may be different than what is available with respect to other public companies. We cannot predict if investors will find our common stock less attractive because we will rely on these exemptions. If investors find our common stock less attractive as a result of our status as an emerging growth company, there may be less liquidity for our common stock and our stock price may be more volatile.

 

We will remain an emerging growth company until the earliest of (i) the end of the fiscal year in which the market value of our common stock that is held by non-affiliates exceeds $700 million as of the end of the second fiscal quarter, (ii) the end of the fiscal year in which we have total annual gross revenues of $1 billion or more during such fiscal year, (iii) the date on which we issue more than $1 billion in non-convertible debt in a three-year period or (iv) the end of the fiscal year following the fifth anniversary of the date of the first sale of our common stock pursuant to an effective registration statement filed under the Securities Act, which will be in December of 2019.

 

Risks Related to Our Common Stock

 

Our stock price may be volatile, which could result in losses to our investors and litigation against us.

 

Several factors could cause our stock price to fluctuate substantially in the future. These factors include but are not limited to: actual or anticipated variations in earnings, changes in analysts’ recommendations or projections, our announcement of developments related to our businesses, operations and stock performance of other companies deemed to be peers, new technology used or services offered by traditional and non-traditional competitors, news reports of trends, irrational exuberance on the part of investors, new federal banking regulations, and other issues related to the financial services industry. Our stock price may fluctuate significantly in the future, and these fluctuations may be unrelated to our performance. General market declines or market volatility in the future, especially in the financial institutions sector, could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices. Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. Moreover, in the past, securities class action lawsuits have been instituted against some companies following periods of volatility in the market price of its securities. We could in the future be the target of similar litigation. Securities litigation could result in substantial costs and divert management’s attention and resources from our normal business.

 

Future sales of our stock by our stockholders or the perception that those sales could occur may cause our stock price to decline.

 

Although our common stock is listed on the Nasdaq Global Market under the symbol “CARO,” the trading volume in our common stock is lower than that of other larger financial services companies . A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the relatively low trading volume of our common stock, significant sales of our common stock in the public market, or the perception that those sales may occur, could cause the trading price of our common stock to decline or to be lower than it otherwise might be in the absence of those sales or perceptions.

Economic and other circumstances may require us to raise capital at times or in amounts that are unfavorable to us. If we have to issue shares of common stock, they will dilute the percentage ownership interest of existing stockholders and may dilute the book value per share of our common stock and adversely affect the terms on which we may obtain additional capital.

 

We may need to incur additional debt or equity financing in the future to make strategic acquisitions or investments or to strengthen our capital position. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of our control and our financial performance. We cannot provide assurance that such financing will be available to us on acceptable terms or at all, or if we do raise additional capital that it will not be dilutive to existing stockholders.

 

If we determine, for any reason, that we need to raise capital, our board generally has the authority, without action by or vote of the stockholders, to issue all or part of any authorized but unissued shares of stock for any corporate purpose, including issuance of equity-based incentives under or outside of our equity compensation plans. Additionally, we are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market price of our common stock could decline as a result of sales by us of a large number of shares of common stock or preferred stock or similar securities in the market or from the perception that such sales could occur. Any issuance of additional shares of stock will dilute the percentage ownership interest of our stockholders and may dilute the book value per share of our common stock. Shares we issue in connection with any such offering will increase the total number of shares and may dilute the economic and voting ownership interest of our existing stockholders.

 

Our board of directors may issue shares of preferred stock that would adversely affect the rights of our common stockholders.

 

Our authorized capital stock includes 1,000,000 shares of preferred stock of which no preferred shares are issued and outstanding. Our board of directors, in its sole discretion, may designate and issue one or more series of preferred stock from the authorized and unissued shares of preferred stock. Subject to limitations imposed by law or our certificate of incorporation, our board of directors is empowered to determine:

 

●

the designation of, and the number of, shares constituting each series of preferred stock;

●

the dividend rate for each series;

●

the terms and conditions of any voting, conversion and exchange rights for each series;

●

the amounts payable on each series on redemption or our liquidation, dissolution or winding-up;

●

the provisions of any sinking fund for the redemption or purchase of shares of any series; and

●

the preferences and the relative rights among the series of preferred stock.

 

We could issue preferred stock with voting and conversion rights that could adversely affect the voting power of the shares of our common stock and with preferences over the common stock with respect to dividends and in liquidation.

 

Our securities are not FDIC insured.

 

Our securities, including our common stock, are not savings or deposit accounts or other obligations of the Bank, are not insured by the Deposit Insurance Fund, the FDIC or any other governmental agency and are subject to investment risk, including the possible loss of principal.

Item 1B. Unresolved Staff Comments.

 

None.

 

Item 2. Properties.

 

Our main office is located at 288 Meeting Street, Charleston, South Carolina 29401-1575.  In addition, the Bank operates 26 additional branches located primarily along the South Carolina coast and southeastern coastal region of North Carolina.  The addresses of these offices are provided below. In August 2015, we opened a branch in Greenville, South Carolina. We also operate loan production offices in Greenville, South Carolina and Wilmington, North Carolina. In addition to our main office and branches, we also operate Crescent Mortgage Company, which is headquartered in Atlanta, Georgia, and Carolina Services Corporation of Charleston, with Carolina Services Corporation’s operations conducted from our West Ashley location. We believe these premises will be adequate for present and anticipated needs and that we have adequate insurance to cover our owned and leased premises. For each property that we lease, we believe that upon expiration of the lease we will be able to extend the lease on satisfactory terms or relocate to another acceptable location.

 

	Office		Address		City, State, Zip		Lease/Own
1	Myrtle Beach Office		991 38th Avenue N.		Myrtle Beach, South Carolina 29577		Own
2	North Myrtle Beach Office		700 Main Street		North Myrtle Beach, South Carolina 29582		Land Lease
3	Conway Office		2069 Highway 501 East		Conway, South Carolina 29526		Land Lease
4	Garden City Office		2636 South Highway 17 Business		Garden City, South Carolina 29576		Own
5	Socastee Office		4506 Highway 707		Myrtle Beach, South Carolina 29588		Own
6	Meeting Street Office		288 Meeting Street		Charleston, South Carolina 29401-1575		Lease
7	West Ashley Office		884 Orleans Road		Charleston, South Carolina 29407-4937		Own
8	James Island Office		430 Folly Road		Charleston, South Carolina 29412-2641		Own
9	Summerville Office		200 North Cedar Street		Summerville, South Carolina 29483-6404		Own
10	Mount Pleasant Office		1492 Stuart Engals Blvd		Mt. Pleasant, South Carolina 29464		Own
11	North Charleston Office		8485 Dorchester Road		N. Charleston, South Carolina 29420-7307		Own
12	Litchfield/Pawleys Island Office		13021 Ocean Highway		Pawleys Island, South Carolina 29585		Own
13	St. George Office		5561 Memorial Boulevard		St. George, South Carolina 29477		Own
14	Cane Bay Office		1274 State Road, Suite 4C		Summerville, South Carolina 29483		Lease
15	Conway 16th Ave Office		1230 16th Avenue		Conway, South Carolina 29526		Lease
16	Little River Office		1180 Highway 17		Little River, South Carolina 29566		Own
17	Heath Springs Office		202 N. Main Steet		Heath Springs, South Carolina 29058		Own
18	Greenville Office		3695 E. North Street		Greenville, South Carolina 29615		Own
19	Whiteville Office		110 N J K Powell Blvd		Whiteville, North Carolina 28472		Own
20	Chadbourn Office		111 Strawberry Blvd		Chadbourn, North Carolina 28431		Own
21	Tabor City Office		105 Hickman Rd		Tabor City, North Carolina 28463		Lease
22	Elizabethtown Office		306 S. Poplar Street		Elizabethtown, North Carolina 28337		Land Lease
23	Shallotte Office		200 Smith Avenue		Shallotte, North Carolina 28459		Own
24	Sunset Beach Office		7290-17 Beach Drive SW		Ocean Isle Beach, North Carolina 28469		Lease
25	Holden Beach Office		3178 Holden Beach Road SW		Supply, North Carolina 28462		Lease
26	Southport Howe St Office		115 North Howe Street		Southport, North Carolina 48461		Lease
27	Southport Supply Rd Office		4945 Southport-Supply Road		Southport, North Carolina 48461		Land Lease
28	Crescent Mortgage Company		5901 Peachtree Dunwoody Road NE		Atlanta, Georgia 30328		Lease

 

Item 3. Legal Proceedings.

 

In the ordinary course of operations, we may be a party to various legal proceedings from time to time. We do not believe that there is any pending or threatened proceeding against us, which, if determined adversely, would have a material effect on our business, results of operations, or financial condition.

 

Item 4. Mine Safety Disclosures.

 

None.

PART II

 

Item 5. Market for Common Equity and Related Shareholder Matters.

 

As of March 14, 2016, there were approximately 258 stockholders of record of our common stock. Our common stock is listed on the NASDAQ Capital Market on July 1, 2014. From October 9, 2013 to June 30, 2014, our common stock was quoted on the OTCQB marketplace (the “OTCQB”) and a sponsoring broker-dealer matched buy and sell orders for our common stock. Although our common stock was quoted on the OTCQB during this period, the trading markets on the OTCQB lacked the depth, liquidity, and orderliness necessary to maintain a liquid market. The OTCQB prices are quotations, which reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not represent actual transactions. The following table sets forth the high and low sales price information as reported by NASDAQ or OTCQB quotations, as applicable, for each quarter of 2014 and 2015, and the dividends per share declared on our common stock in each quarter of 2014 and 2015. All information has been adjusted for any stock splits and stock dividends effected during the periods presented.

 

		High				Low				Dividends
2015
Quarter Ended December 31, 2015		$	18.20				14.50			$	0.03
Quarter Ended September 30, 2015			17.00				13.13				0.03
Quarter Ended June 30, 2015			14.78				10.85				0.03
Quarter Ended March 31, 2015			11.87				10.83				0.03
2014
Quarter Ended December 31, 2014		$	12.51				10.56			$	0.03
Quarter Ended September 30, 2014			12.08				8.27				0.03
Quarter Ended June 30, 2014			8.96				8.08				0.03
Quarter Ended March 31, 2014			9.79				6.41				0.03

 

We are authorized to pay dividends as declared by our board of directors, provided that no such distribution results in our insolvency on a going concern or balance sheet basis. Future dividends will be subject to board approval. As we are a legal entity separate and distinct from the Bank, our principal source of funds with which we can pay dividends to our shareholders is dividends we receive from the Bank. For that reason, our ability to pay dividends is subject to the limitations that apply to the Bank. For more information on restrictions on payments of dividends, see Note 20 “Capital Requirements and Other Restrictions” included in Part II, Item 8 – Financial Statements and Supplementary Data.

Equity Compensation Plan Information

 

The following table provides information as of December 31, 2015, with respect to shares of our common stock that may be issued under existing equity compensation plans.

Plan Category		Number of securities to be issued upon exercise of outstanding options, warrants and rights				Weighted-average exercise price of outstanding options, warrants and rights				Number of securities remaining available for future issuance under equity compensation plans
Equity compensation plans approved by security holders			191,570			$	6.61				453,022
Equity compensation plans not approved by security holders			—				—				—
Total			191,570			$	6.61				453,022

 

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

 

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

 

On June 22, 2015, the Board of Directors of the Company declared a six-for-five stock split representing a 20% stock dividend to stockholders of record as of July 15, 2015, payable on July 31, 2015.

 

All share, earnings per share, and per share data have been retroactively adjusted to reflect these stock splits for all periods presented in accordance with generally accepted accounting principles.

Item 6. Selected Financial Data

 

		For The Years Ended December 31,
		2015				2014				2013				2012				2011
		(In thousands)
Operating Data:
Interest income		$	49,604				37,656				32,948				35,356				38,441
Interest expense			6,604				5,602				5,718				7,513				11,113
Net interest income			43,000				32,054				27,230				27,843				27,328
Provision for loan losses			—				—				(860	)			2,707				10,735
Net interest income after provision for loan losses			43,000				32,054				28,090				25,136				16,593
Noninterest income			27,679				21,148				44,086				53,524				19,721
Noninterest expense			49,199				41,443				45,972				51,387				37,413
Income (loss) before income taxes			21,480				11,759				26,204				27,273				(1,099	)
Income tax expense (benefit)			7,060				3,448				9,386				10,395				(128	)
Net income (loss)		$	14,420				8,311				16,818				16,878				(971	)

 

		At December 31,
		2015				2014				2013				2012				2011
		(In thousands)
Balance Sheet Data:
Total assets		$	1,409,669				1,199,017				881,584				888,724				826,218
Interest-bearing cash			16,421				10,694				34,176				11,340				16,679
Securities available for sale			306,474				251,717				167,535				148,407				136,944
Securities held to maturity			17,053				25,544				24,554				9,166				9,401
Federal Home Loan Bank stock			9,919				5,405				4,103				6,413				7,185
Loans held for sale			41,774				40,912				36,897				144,849				80,007
Loans receivable, net			912,582				768,122				535,221				501,691				513,335
Allowance for loan losses			10,141				9,035				8,091				9,520				12,039
Deposits			1,031,528				964,190				697,581				653,247				621,803
Short-term borrowed funds			120,000				57,800				10,300				82,482				63,484
Long-term debt			103,465				61,740				74,540				64,840				80,390
Stockholders’ equity			139,859				93,700				82,227				67,514				45,655

		For The Years Ended December 31,
		2015				2014				2013				2012				2011
		(Dollars in thousands)
Selected Average Balances:
Total assets		$	1,303,402				990,773				889,851				837,066				858,432
Loans receivable			827,787				613,144				509,455				495,889				545,556
Deposits			1,012,659				777,622				696,784				641,085				649,002
Stockholders’ equity			101,896				88,474				76,322				54,002				47,003
Performance Ratios:
Return on average equity			14.15	%			9.39	%			22.04	%			31.25	%			(2.07	)%
Return on average assets			1.11	%			0.84	%			1.89	%			2.02	%			(0.11	)%
Average earning assets to average total assets			91.92	%			91.43	%			91.38	%			92.29	%			92.24	%
Average loans receivable to average deposits			81.74	%			78.85	%			73.12	%			77.35	%			84.06	%
Average equity to average assets			7.82	%			8.93	%			8.58	%			6.45	%			5.48	%
Net interest margin			3.59	%			3.54	%			3.35	%			3.60	%			3.45	%
Net interest margin - tax equivalent (1)			3.68	%			3.62	%			3.41	%			3.61	%			3.45	%
Net (recovery) charge-offs to average loans receivable			(0.13	)%			(0.15	)%			0.11	%			1.05	%			2.38	%
Non-performing assets to total loans receivable			0.72	%			0.73	%			3.24	%			4.29	%			7.84	%
Non-performing assets to total assets			0.47	%			0.47	%			1.97	%			2.42	%			4.87	%
Non-performing loans to total loans receivable			0.47	%			0.31	%			2.04	%			2.98	%			6.50	%
Allowance for loan losses as a percentage of loans receivable (end of period) (2)			1.10	%			1.16	%			1.49	%			1.86	%			2.29	%
Allowance for loan losses as a percentage of nonperforming loans			235.73	%			371.20	%			73.03	%			62.43	%			35.24	%

 

		At or For The Years Ended December 31,
		2015				2014				2013				2012				2011
Per Share Data:
Book value (end of period)		$	11.92				10.02				8.91				7.33				4.96
Basic earnings (loss)			1.51				0.89				1.83				1.83				(0.11	)
Diluted earnings (loss)			1.48				0.87				1.77				1.83				(0.11	)
Average common shares - basic			9,537,358				9,314,048				9,218,952				9,211,162				9,211,162
Average common shares - diluted			9,718,356				9,507,425				9,500,987				9,211,162				9,211,162

 

Note: Book value is calculated using common shares less unvested restricted shares.

(1)

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

(2)

Included in loans receivable are approximately $64.1 million and $80.3 million in acquired loans at December 31, 2015 and 2014.

 

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

 

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

 

On June 22, 2015, the Board of Directors of the Company declared a six-for-five stock split representing a 20% stock dividend to stockholders of record as of July 15, 2015, payable on July 31, 2015.

 

All share, earnings per share, and per share data have been retroactively adjusted to reflect these stock splits for all periods presented in accordance with generally accepted accounting principles.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis of our consolidated financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report.  Historical results of operations and the percentage relationships among any amounts included, and any trends that may appear, may not indicate trends in operations or results of operations for any future periods.

 

We have made, and will continue to make, various forward-looking statements with respect to financial and business matters.  Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties.  Actual results may differ materially from those contained in these forward-looking statements.  For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” at the beginning of this report.

 

Company Overview

 

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

 

During 2014, we registered our common stock with the Securities and Exchange Commission (the “SEC”) and became a public reporting company and listed our common stock on the NASDAQ Capital Market under the ticker symbol “CARO”. We experienced strong organic loan and deposit growth and completed two branch acquisitions in contiguous markets that have more than doubled our branch network. In addition, the Company added a branch in the Charleston market and a branch in the Myrtle Beach market along with two loan production offices, one each in Greenville, South Carolina and Wilmington, North Carolina.

 

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

 

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

 

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

 

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

Executive Summary of Operating Results

 

At December 31, 2015, our total assets were $1.4 billion, an increase of $210.7 million, from total assets of $1.2 billion at December 31, 2014. The largest components of our total assets are loans receivable, net and securities which were $912.6 million and $323.5 million, respectively at December 31, 2015. Comparatively, our loans receivable and securities totaled $768.1 million and $277.2 million, respectively, at December 31, 2014. At December 31, 2015 loans held for sale were $41.8 million compared to $40.9 million as of December 31, 2014. Our liabilities and stockholders’ equity at December 31, 2015 totaled $1.3 billion and $139.9 million, respectively, compared to liabilities of $1.1 billion and stockholders’ equity of $93.7 million at December 31, 2014. The principal components of our liabilities are deposits which were $1.0 billion and $964.2 million at December 31, 2015 and 2014, respectively. The increase in total assets and deposits during 2015 primarily related strong organic growth during the current year.

 

The Company reported net income available to common stockholders of approximately $14.4 million, or $1.48 per diluted share, for the year ended December 31, 2015, compared to $8.3 million, or $0.87 per diluted share for the year ended December 31, 2014. Our 2014 results include pretax acquisition related expenses associated with branch acquisitions of $1.4 million. The increase in net income from period to period is attributable to the significant growth in loans and securities, increased checking fees, and improved results from the Company’s retail mortgage team and Crescent Mortgage Company.

 

Asset quality remained steady, with nonperforming assets to total assets of 0.47% as of December 31, 2015 and 2014. Nonperforming loans were $4.3 million as of December 31, 2015 as compared to $2.4 million at December 31, 2014.

 

The allowance for loan losses was $10.1 million, or 1.10% of total loans (1.18% of total non-acquired loans), at December 31, 2015, compared to $9.0 million, or 1.16% of total loans (1.28% of total non-acquired loans) at December 31, 2014. The Company experienced net recoveries of $1.1 million during 2015 compared to net recoveries of $944,000 during 2014. No provision expense was recorded during 2015 or 2014 due to the sustained low level of NPAs as well as the net recoveries experienced.

 

At December 31, 2015, the Company’s capital ratios exceeded “well capitalized” levels under applicable law. Stockholders’ equity totaled $139.9 million as of December 31, 2015, compared to $93.7 million at December 31, 2014. On December 14, 2015, the Company closed a public offering of 2,262,296 shares of its common stock with net proceeds of approximately $32.1 million after deducting underwriting discounts, commissions and offering expenses incurred by the Company.

 

Critical Accounting Policies

 

We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in the notes to our consolidated financial statements within Item 8 “Financial Statements and Supplementary Data” elsewhere in this report.

 

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

 

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

Other-Than Temporary Impairment. The evaluation and recognition of other-than-temporary impairment, or OTTI, on certain investments including our private label mortgage-backed securities and trust preferred securities requires significant judgment and estimates. Some of the more critical judgments supporting the evaluation of OTTI include projected cash flows including prepayment assumptions, default rates and severities of losses on the underlying collateral within the security. Under different conditions or utilizing different assumptions, the actual OTTI realized by us may be different from the actual amounts recognized in our consolidated financial statements. See Note 4 to the consolidated financial statements to within Item 8 “Financial Statements and Supplementary Data” for the disclosure of certain assumptions used in the financial statements during the years ended December 31, 2015 and 2014.

 

Derivatives. The determination of fair value related to derivatives of the Company requires significant judgment and estimates. The primary uses of derivative instruments are related to the mortgage banking activities of the Company. As such, the Company holds derivative instruments, which consist of rate lock agreements related to expected funding of fixed-rate mortgage loans to customers (“interest rate lock commitments”) and forward commitments to sell mortgage-backed securities and individual fixed-rate mortgage loans (“forward commitments”). The Company’s objective in obtaining the forward commitments is to mitigate the interest rate risk associated with the interest rate lock commitments and the mortgage loans that are held for sale. Derivatives related to these commitments are recorded as either a derivative asset or a derivative liability in the balance sheet and are measured at fair value. Both the interest rate lock commitments and the forward commitments are reported at fair value, with adjustments recorded in current period earnings in mortgage banking within noninterest income section of the consolidated statements of operations. Derivative instruments not related to mortgage banking activities primarily relate to interest rate swap agreements.

 

For additional discussion related to the determination of fair value related to derivative instruments, see Note 5 to the consolidated financial statements within Item 8 “Financial Statements and Supplementary Data.”

 

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

 

Income Taxes. Income taxes are provided for the tax effects of the transactions reported in our consolidated financial statements and consist of taxes currently due plus deferred taxes related to differences between the tax basis and accounting basis of certain assets and liabilities, including available for sale securities, allowance for credit losses, writedowns of real estate acquired in settlement of loans, accumulated depreciation, net operating loss carry forwards, mortgage servicing rights and other intangible assets. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. Deferred tax assets and liabilities are reflected at income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. A valuation allowance is recorded in situations where it is “more likely than not” that a deferred tax asset is not realizable. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. We file a consolidated federal income tax return for the Company and the Bank. In addition, we evaluate the need for income tax reserves related to uncertain income tax positions but had no such reserves at December 31, 2015 or 2014.

 

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

Recent Accounting Standards and Pronouncements

 

For information relating to recent accounting standards and pronouncements, see Note 1 to the audited consolidated financial statements within Item 8 “Financial Statements and Supplementary Data.”

 

Results of Operations

 

Summary

 

The Company reported net income available to common stockholders of approximately $14.4 million, or $1.48 per diluted share, for the year ended December 31, 2015, compared to $8.3 million, or $0.87 per diluted share for the year ended December 31, 2014. Our 2014 results include pretax acquisition related expenses associated with branch acquisitions of $1.4 million. The increase in net income from period to period is attributable to the significant growth in loans and securities, increased checking fees, and improved results from the Company’s retail mortgage team and Crescent Mortgage Company.

 

Details of the changes in the various components of net income are further discussed below.

 

Net Interest Income and Margin

 

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

 

For the years ended December 31, 2015 and 2014, our net interest income was $43.0 million and $32.1 million, respectively. The $10.9 million, or 34.1%, increase in net interest income during 2015 was related to several factors including an increase in average earnings assets balances as well as a decrease in rates paid on interest-bearing liabilities and a shift to lower cost of funding. Included in interest income for loans for the years ended December 31, 2014 was $793,000 of nonaccrual interest recognized related to the resolution of nonperforming loan that paid off during the fourth quarter.

 

The Company is focused on continuing to improve the utilization of its capital. To accomplish this, the Bank has incorporated various strategies to increase the loan and securities portfolio. Accordingly, the increase in average earnings assets for the year ended December 31, 2015, is primarily the result of increased balances of loans receivable and securities.

 

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

 

●

Residential mortgage – In addition to selling a portion of its production, the Company has retained a portion of the mortgage production. Due to the emphasis to grow the residential mortgage portfolio, gross loans receivable within the one-to-four family portfolio have increased $90.9 million since December 31, 2014. This growth includes the purchase of a non-conforming residential loan pool during the fourth quarter of 2015 with a balance of $36.6 million as of December 31, 2015.

 

●

Commercial lending – during 2014 and 2015, the Company expanded its commercial lending team by hiring additional loan officers in its Charleston and Myrtle Beach markets of South Carolina. The Company also has opened its first branch in the upstate of South Carolina, and a loan production office in Wilmington, North Carolina. As a result, gross loans receivable within commercial real estate increased $24.5 million since December 31, 2014.

 

●

Syndicated loans – The Charleston and Myrtle Beach markets of South Carolina have provided limited opportunities for the Bank to develop a Commercial and Industrial (“C&I”) loan portfolio. The Company’s primary markets are generally concentrated in real estate lending. However, in order to diversify our lending portfolio, the Company began a syndicated loan program in 2014 to purchase C&I loans to retain in the loan portfolio. These loans typically have terms of seven years and are tied to a floating rate index such as LIBOR or prime. To effectively manage this new line of lending, the Company hired an experienced senior lending executive in 2014 with relevant experience to lead and manage this area of the loan portfolio and retained a consulting firm that specializes in syndicated loans. Syndicated loans have grown $32.9 million since December 31, 2014. As of December 31, 2015, the syndicated loan portfolio outstanding was $83.1 million and is grouped within commercial business loans. The Company’s policy currently limits the syndicated loan portfolio not to exceed 75% of the Bank’s Tier 1 regulatory capital. As of December 31, 2015, the Moody’s weighted average credit facility rating of the syndicated loan portfolio was Ba2, with no credit rated less than B2.

The growth in securities is a result of the Company’s continued effort to deploy capital into earning assets as we grow the balance sheet.

 

The decrease in rates paid on interest-bearing liabilities is based on the continued historically low interest rates that have positively impacted our ability to reduce funding cost and an increase in average balances of checking, savings and money markets, which typically yield less than other forms of interest-bearing accounts. The increase in the average balance of deposits is primarily due to the deposits acquired in a branch acquisition completed in December of 2014 where the Company assumed approximately $152.8 million of checking, savings, and money markets.

 

Short term borrowings increased period over period as a result of the rise in mortgage production as well as the growth in loans and securities during 2015. Syndicated loans as well as collateralized loan obligations securities, which are typically tied to floating rate indexes, have grown $32.9 million and $12.9 million, respectively, since December 31, 2014.

The following table sets forth information related to our average balance sheet, average yields on assets, and average costs of liabilities for the years ended December 31, 2015, 2014 and 2013. We derived these yields or costs by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. During the same periods, we had no securities purchased with agreements to resell. All investments were owned at an original maturity of over one year. Nonaccrual loans are included in earning assets in the following tables. Loan yields have been reduced to reflect the negative impact on our earnings of loans on nonaccrual status. The net capitalized loan costs and fees, which are considered immaterial, are amortized into interest income on loans.

 

		For The Years Ended December 31,
		2015												2014												2013
						Interest				Average								Interest				Average								Interest				Average
		Average				Paid/				Yield/				Average				Paid/				Yield/				Average				Paid/				Yield/
		Balance				Earned				Rate				Balance				Earned				Rate				Balance				Earned				Rate
														(Dollars in thousands)
Interest-earning assets:
Loans held for sale		$	38,536				1,472				3.82	%			31,563				1,253				3.92	%			72,975				2,696				3.69	%
Loans receivable (1)			827,787				39,548				4.78	%			613,144				30,064				4.90	%			509,455				25,035				4.91	%
Interest-bearing cash			14,362				36				0.25	%			22,988				55				0.24	%			43,151				107				0.25	%
Securities available for sale			286,812				7,621				2.62	%			206,977				5,199				2.51	%			170,061				4,662				2.74	%
Securities held to maturity			19,513				555				2.84	%			24,314				884				3.64	%			11,428				292				2.56	%
Federal Home Loan Bank stock			7,684				328				4.27	%			4,939				158				3.20	%			4,221				111				2.63	%
Other investments			3,448				44				1.28	%			1,938				43				2.22	%			1,872				45				2.40	%
Total interest-earning assets			1,198,142				49,604				4.14	%			905,863				37,656				4.16	%			813,163				32,948				4.05	%
Non-earning assets			105,260												84,910												76,688
Total assets		$	1,303,402												990,773												889,851
Interest-bearing liabilities:
Demand accounts			163,982				199				0.12	%			114,867				179				0.16	%			56,405				115				0.20	%
Money market accounts			235,283				457				0.19	%			213,149				473				0.22	%			213,924				857				0.40	%
Savings accounts			38,303				50				0.13	%			24,617				38				0.15	%			14,387				46				0.32	%
Certificates of deposit			395,131				3,661				0.93	%			311,246				2,793				0.90	%			302,999				2,321				0.77	%
Short-term borrowed funds			113,968				331				0.29	%			41,324				106				0.26	%			22,335				239				1.07	%
Long-term debt			57,380				1,906				3.32	%			68,620				2,013				2.93	%			75,595				2,140				2.83	%
Total interest-bearing liabilities			1,004,047				6,604				0.66	%			773,823				5,602				0.72	%			685,645				5,718				0.83	%
Noninterest-bearing deposits			179,960												113,743												109,069
Other liabilities			17,499												14,733												18,815
Stockholders’ equity			101,896												88,474												76,322
Total liabilities and
Stockholders’ equity		$	1,303,402												990,773												889,851
Net interest spread											3.48	%											3.44	%											3.22	%
Net interest margin			3.59	%											3.54	%											3.35	%
Net interest margin (tax equivalent) (2)			3.68	%											3.62	%											3.41	%
Net interest income							43,000												32,054												27,230

 

(1)

Average balances of loans include nonaccrual loans.

(2)

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

 

Our net interest margin was 3.59%, and 3.68% on a tax equivalent basis, for the twelve months ended December 31, 2015 compared to 3.54%, and 3.62% on a tax equivalent basis, for 2014. The 5 basis point increase in net interest margin during 2014 as compared to the prior year was driven primarily by the 6 basis point decrease in the contract rate paid on in interest bearing liabilities.

Our average interest-earning assets increased by $292.3 million during 2015 and our interest income increased $11.9 million. As previously stated, the increase in interest income is primarily related to the increase in loans receivable and securities during 2015.

 

Our interest expense increased $1.0 million during 2015 as compared to the year ended 2014 while our average interest-bearing liabilities increased $230.2 million. The increase in interest expense is primarily related to the growth in average balance of deposits from the branch acquisition completed in the fourth quarter of 2014 and being outstanding for all of 2015.

 

Our net interest spread was 3.48% for the year ended December 31, 2015 as compared to 3.44% for the same period in 2014. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The 6 basis point reduction in rate on our interest-bearing liabilities offset by the 2 basis point decline on yield of interest-earning assets, resulted in a 4 basis point increase in our net interest spread for the 2014 period.

 

Rate/Volume Analysis

 

Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume. The following tables set forth the effect which the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented.

 

		For The Years Ended December 31,
		2015 vs. 2014																2014 vs. 2013
		Increase (decrease)												Net				Increase (decrease)												Net
		due to								Rate/				Dollar				due to								Rate/				Dollar
		Volume				Rate				Volume				Change				Volume				Rate				Volume				Change
		(In thousands)
Loans held for sale		$	266				(58	)			11				219				(1,644	)			87				114				(1,443	)
Loans receivable, net			10,255				(1,040	)			269				9,484				5,084				(66	)			11				5,029
Interest-bearing cash			(22	)			2				1				(19	)			(48	)			(2	)			(2	)			(52	)
Securities available for sale			2,121				417				(116	)			2,422				927				(475	)			85				537
Securities held to maturity			(137	)			(154	)			(38	)			(329	)			469				263				(139	)			593
FHLB stock			117				82				(29	)			170				23				28				(4	)			47
Other investments			19				(33	)			15				1				1				(4	)			—				(3	)
Interest income			12,619				(784	)			113				11,948				4,812				(169	)			65				4,708
Demand accounts			60				(57	)			17				20				91				(55	)			28				64
Money market accounts			43				(65	)			6				(16	)			(2	)			(381	)			(1	)			(384	)
Savings accounts			18				(9	)			3				12				16				(41	)			17				(8	)
Certificates of deposit			777				115				(24	)			868				74				409				(11	)			472
Short-term borrowed funds			211				39				(25	)			225				49				(336	)			154				(133	)
Long-term debt			(373	)			223				43				(107	)			(205	)			70				8				(127	)
Interest expense		$	736				246				20				1,002				23				(334	)			195				(116	)
Net interest income															10,946																4,824

Provision for Loan Loss

 

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

 

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

 

		For the Years
		Ended December 31,
		2015				2014
		(Dollars in thousands)
Balance, beginning of period		$	9,035				8,091
Provision for loan losses			—				—
Loan charge-offs			(1,230	)			(363	)
Loan recoveries			2,336				1,307
Balance, end of period		$	10,141				9,035

 

For the year ended December 31, 2015 and 2014, there was no provision for loan loss recorded primarily due to the net recoveries experienced. The Company experienced net recoveries of $1.1 million during 2015 compared to net recoveries of $944,000 during 2014. The allowance for loan losses was $10.1 million, or 1.10% of total loans (1.18% of total non-acquired loans), at December 31, 2015, compared to $9.0 million, or 1.16% of total loans (1.28% of total non-acquired loans) at December 31, 2014.

 

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

Noninterest Income and Expense

 

Noninterest income provides us with additional revenues that are significant sources of income. In 2015 and 2014, noninterest income comprised 35.8% and 36.0%, respectively, of total interest and noninterest income. The major components of noninterest income for the Company are listed below:

 

		For the Years
		Ended December 31,
		2015				2014
		(In thousands)
Noninterest income:
Mortgage banking income		$	17,417				11,908
Deposit service charges			3,496				2,065
Net loss on extinguishment of debt			(1,251	)			(58	)
Net gain on sale of securities			1,493				1,084
Fair value adjustments on interest rate swaps			(1,111	)			(1,170	)
Net gain on sale of servicing assets			—				775
Net increase in cash value life insurance			726				731
Mortgage loan servicing income			5,313				5,077
Other			1,596				736
Total noninterest income		$	27,679				21,148

 

Noninterest income increased $6.5 million to $ 27.7 million for the year ended December 31, 2015 compared to $21.1 million for the year ended December 31, 2014. The increase in noninterest income primarily relates to the increase in mortgage banking income from our retail mortgage team as well as our wholesale mortgage banking subsidiary and an increase in deposit service charges during the period.

 

The increase in mortgage banking income is attributable to an increase in originations as well as overall margin expansion experienced during 2015. The following table provides a break out of mortgage banking income from our retail mortgage team “Community banking” and Crescent Mortgage Company “Wholesale mortgage banking”. Mortgage banking income consists primarily of gain on sale of loans and related fees as well as fair value changes in derivatives related to the mortgage company.

 

		For the Year Ended December, 31
		Loan Originations								Mortgage Banking Income								Margin
		2015				2014				2015				2014				2015				2014
Additional segment information:
Community banking		$	73,591				33,654				1,656			$	761				2.25	%			2.26	%
Wholesale mortgage banking			986,650				948,550				15,761				11,147				1.60	%			1.18	%
Total mortgage banking income		$	1,060,241				982,204				17,417			$	11,908				1.64	%			1.21	%

 

Originations for 2015 were comprised of approximately 65% in purchase transactions and 35% in refinance transactions. This compares to 70% originations from purchase transactions and 30% from refinance transactions for 2014.

Deposit service charge income increased $1.4 million to $3.5 million for the year ended December 31, 2015 from $2.1 million for the year ended December 31, 2014. The increase in deposit service charge income is a result of the increase in deposits assumed as part of the two branch acquisitions completed during 2014 as well as the Company’s sustained efforts to grow checking accounts. The number of checking accounts, excluding acquired accounts, have grown 11.1% since December 31, 2014.

 

For the year ended December 31, 2015, the Company incurred a $1.3 million loss on extinguishment of debt as a result of the prepayment of a Federal Home Loan Bank borrowing. This compares to a loss on extinguishment of debt of $58,000 for the year ended December 31, 2014.

 

Partially offsetting the overall increase in noninterest income for the year ended December 31, 2015 was a decrease in the net gain on sale of servicing assets. During the first quarter of 2014, the Company sold $147.7 million in unpaid principal balance of mortgage servicing rights for a net gain of $775,000. There were no servicing rights sold during 2015.

 

During the year ended December 31, 2015, the Company recognized net gains on sale of available-for-sale securities of $1.5 million compared to gains on sale of securities during year ended December 31, 2014 of $1.1 million.

 

The fair value adjustment on interest rate swaps reduced noninterest income by $1.1 million for the year ended December 31, 2015 compared to a reduction of non-interest income of $1.2 million for the year ended December 31, 2014. The change in fair value adjustment on interest rate swaps relates to the change in interest rates from period to period. The Company uses standalone interest rate swaps to more closely match the interest rate characteristics of assets and liabilities and to mitigate the risks arising from timing mismatches between assets and liabilities including duration mismatches.

 

Other noninterest income increased $860,000 to $1.6 million for the year ended December 31, 2015 compared to $736,000 for the year ended December 31, 2014. The increase in other non-interest income is primarily related to in an increase in debit card and ATM surcharge income.

 

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

 

		For the Years
		Ended December 31,
		2015				2014
		(In thousands)
Noninterest expense:
Salaries and employee benefits		$	28,629				23,308
Occupancy and equipment			7,228				4,858
Marketing and public relations			1,434				1,251
FDIC insurance			698				581
Recovery of mortgage loan repurchase losses			(1,000	)			(750	)
Legal expense			407				438
Other real estate expense, net			138				638
Mortgage subservicing expense			1,634				1,392
Amortization of mortgage servicing rights			1,986				1,795
Other			8,045				7,932
Total noninterest expense		$	49,199				41,443

 

Noninterest expense represents the largest expense category for the Company. Noninterest expense increased $7.8 million to $49.2 million for the year ended December 31, 2015 compared to $41.4 million for the year ended December 31, 2014. The increase in noninterest expense for 2015 compared to the prior periods is primarily a result of the increase in salaries and employee benefits paid as well as the increase in expenses related to occupancy and equipment.

Included in non-interest expense for the period ended December 31, 2014 was approximately $1.4 million in acquisition related expenses of which $880,000 was included in Other, $90,000 was included Marketing and Public Relations, $242,000 was included in Occupancy and Equipment and $149,000 was included in Salaries and Employee Benefits.

 

Salaries and employee benefits increased $5.3 million to $28.6 million for the year ended December 31, 2015 compared to $23.3 million for the year ended December 31, 2014. Occupancy and equipment increased $2.4 million to $7.2 million for the year ended December 31, 2015 compared to $4.9 million for the year ended December 31, 2014.

 

The increase in salaries and employee benefits as well as occupancy and equipment from year to year are primarily a result of the personnel and occupancy costs associated with the acquisition of branches completed during the fourth quarter of 2014. The company added approximately 72 employees and 13 branches during 2014 as a result of this acquisitions. The expense associated with the acquisition of branches were reflective all of 2015. In addition, the Company opened three branches and two loan production offices during 2014 and a full service branch in the upstate of South Carolina during 2015.

 

Offsetting the increase in noninterest expense was a decline in expenses associated with other real estate as well as a negative provision for mortgage loan repurchase losses. Other real estate expenses, net declined as a result of the reduction in other real estate balances and write-downs in 2015 compared to 2014. Other real estate balances were $2.4 million and $3.2 million as of December 31, 2015 and 2014, respectively. The Company was not required to write down other real estate owned during 2015 compared to write downs of $526,000 during 2014. The negative provision for mortgage loan repurchase losses is the result of continued low repurchase request as well as a change a change in the regulatory framework concerning repurchase requests. For further discussion regarding the provision for mortgage loan repurchase losses, see the “Reserve For Mortgage Repurchase Losses” discussion below.

 

The increase in other noninterest expense primarily relates to general costs associated with the branches acquired during 2014 as well as the amortization of the core deposit intangible which was reflective for all of 2015.

 

Income Tax Expense

 

Our effective tax rate increased to 32.9% for the year ended December 31, 2015 compared to 29.3% for the year ended December 31, 2014. The lower effective tax rate in 2014 is primarily attributable to higher proportion of tax-exempt municipal securities, bank-owned life insurance, and certain tax credits recognized during the year ended 2014 compared to the year ended 2015.

Balance Sheet Review

 

Investment Securities

 

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

 

At December 31, 2015, the $323.5 million in our investment securities portfolio, excluding FHLB stock and other investments, represented approximately 23.0% of our assets. Our available-for-sale investment portfolio included US agency securities, municipal securities, mortgage-backed securities (agency and non-agency), collateralized loan obligations and trust preferred securities with a fair value of $306.5 million and an amortized cost of $306.0 million for an unrealized gain of $502,000. Our held-to-maturity portfolio included municipal securities with a fair value of $18.0 million and a cost of $17.1 million for an unrealized gain of $912,000.

 

For additional information regarding the trust preferred securities see Note 4 “Securities” within Item 8. “Financial Statements and Supplementary Data.”

 

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

 

During 2015, the Company transferred trust preferred securities totaling $11.4 million to available-for-sale from held-to-maturity as a result of the implementation of the regulatory changes in risk weightings and capital deductions dictated by Basel III. The transfer was in accordance with ASC 320-10-25-6; therefore, management has determined the transfer out of held-to-maturity is consistent with the original designation and does not taint the remaining portfolio.

The amortized costs and the fair value of our investments are as follows:

 

		At December 31,
		2015								2014								2013
		Amortized				Fair				Amortized				Fair				Amortized				Fair
		Cost				Value				Cost				Value				Cost				Value
										(In thousands)
Securities available-for-sale:
Municipal securities		$	60,603				62,475				43,119				44,717				39,790				38,499
US government agencies			7,015				7,096				4,770				4,748				5,199				5,175
Collateralized loan obligations			38,957				38,758				25,883				25,872				—				—
Mortgage-backed securities:
Agency			112,608				113,855				122,727				125,542				68,813				69,929
Non-agency			75,415				75,536				49,936				50,838				53,195				53,932
Total mortgage-backed securities			188,023				189,391				172,663				176,380				122,008				123,861
Trust preferred securities			11,374				8,754				—				—
Total securities available-for-sale		$	305,972				306,474				246,435				251,717				166,997				167,535
Securities held-to-maturity:
Municipal securities		$	17,053				17,965				16,787				17,652				15,488				15,177
Trust preferred securities			—				—				8,757				9,733				9,066				8,370
Total securities held-to- maturity		$	17,053				17,965				25,544				27,385				24,554				23,547

 

The Company uses prices from third party pricing services and, to a lesser extent, indicative (nonbinding) quotes from third party brokers, to estimate the fair value of our investment securities. While we obtain fair value information from multiple sources, we generally obtain one price / quote for each individual security. For securities priced by third party pricing services, we determine the most appropriate and relevant pricing service for each security class and have that vendor provide the price for each security in the class. We record the value provided by the third party pricing service / broker in our Consolidated Financial Statements, subject to our internal price verification procedures, which include periodic comparisons to other brokers and Bloomberg pricing screens.

Contractual maturities and yields on our investments are shown in the following table. Municipal yields were not tax effected in the table below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities available-for-sale are presented at fair value and held-to-maturity securities are presented at amortized cost.

 

		At December 31, 2015
		Less than 12 Months								One to Five Years								Five to Ten Years								Over Ten Years								Total
		Amount				Yield				Amount				Yield				Amount				Yield				Amount				Yield				Amount				Yield
		(Dollars in thousands)
Securities available-for-sale:
Municipal securities		$	—				—				—				—				9,420				2.31	%			53,055				3.06	%			62,475				2.95	%
US government agencies			—				—				—				—				7,096				2.74	%			—				—				7,096				2.74	%
Collateralized loan obligations			—				—				—				—				13,153				2.08	%			25,605				2.24	%			38,758				2.18	%
Mortgage-backed securities:
Agency			—				—				—				—				1,067				3.08	%			112,788				2.49	%			113,855				2.50	%
Non-agency			—				—				269				3.76	%			—				—				75,267				3.50	%			75,536				3.50	%
Total mortgage-backed securities			—				—				269				3.76	%			1,067				3.08	%			188,055				2.90	%			189,391				2.90	%
Trust preferred securities			—				—				—				—				—				—				8,754				2.49	%			8,754				2.49	%
Total securities available-for-sale		$	—				—				269				3.76	%			30,736				2.34	%			275,469				2.84	%			306,474				2.79	%
Securities held-to-maturity:
Municipal securities		$	—				—				430				2.14	%			4,397				1.86	%			12,226				3.51	%			17,053				3.05	%
Total securities held-to- maturity		$	—				—				430				2.14	%			4,397				1.86	%			12,226				3.51	%			17,053				3.05	%

 

For disclosures related to the Company’s evaluation of securities for OTTI, see Note 4 “Securities” within Item 8. “Financial Statements and Supplementary Data.”

 

Non-marketable investments are comprised of the following and are recorded at cost which approximates fair value since no readily available market exists for these securities.

 

		At December 31,
		2015				2014
		(In thousands)
Community Reinvestment Act fund		$	1,295				1,277
SBIC Investments			1,513				567
Investment in Statutory Business Trusts			465				465
Total other investments			3,273				2,309
Federal Home Loan Bank stock			9,919				5,405
Non-marketable investments		$	13,192				7,714

Loans by Type

 

Since loans typically provide higher interest yields than other types of interest-earning assets, a substantial percentage of our earning assets are invested in our loan portfolio. Before allowance for loan losses, loans outstanding at December 31, 2015 and 2014 were $922.7 million and $777.2 million, respectively.

 

Our loan portfolio consists primarily of loans secured by real estate mortgages. As of December 31, 2015, our loan portfolio included $801.1 million, or 86.8%, of total loans secured by real estate. As of December 31, 2014, our loan portfolio included $690.3 million, or 88.7%, of total loans secured by real estate. Most of our real estate loans are secured by residential or commercial property. We obtain a security interest in real estate, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans to coincide with the appropriate regulatory guidelines. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral and business types. The Bank’s primary markets are generally concentrated in real estate lending. In order to diversify our lending portfolio, the Bank began a syndicated loan program during 2014. Syndicated loan balances were $83.1 and $50.2 million as of December 31, 2015 and 2014, respectively, and are grouped within commercial business loans in the table below

 

As shown in the table below, loans excluding the allowance for loan losses, increased $145.6 million to $922.7 million at December 31, 2015 from $777.2 million at December 31, 2014. The increase in loans receivable primarily relates to the Bank’s focus on growing residential mortgage, commercial lending, and syndicated loans. See additional discussion regarding the increase in loans during 2014 in “Results of Operations – Net Interest Income and Margin”.

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

 

		At December 31,
		2015								2014								2013
						% of Total								% of Total								% of Total
		Amount				Loans				Amount				Loans				Amount				Loans
										(Dollars in thousands)
Loans secured by real estate:
One-to-four family		$	343,686				37.23	%			252,819				32.48	%			183,736				33.81	%
Home equity			23,303				2.52	%			27,547				3.54	%			23,342				4.30	%
Commercial real estate			342,395				37.10	%			317,912				40.85	%			247,867				45.61	%
Construction and development			91,713				9.94	%			92,008				11.82	%			60,104				11.06	%
Consumer loans			5,181				0.56	%			5,675				0.73	%			2,815				0.52	%
Commercial business loans			116,737				12.65	%			82,305				10.58	%			25,546				4.70	%
Total gross loans receivable			923,015				100.00	%			778,266				100.00	%			543,410				100.00	%
Less:
Allowance for loan losses			10,141								9,035								8,091
Deferred fees, net			292								1,109								98
Total loans receivable, net		$	912,582								768,122								535,221

 

		At December 31,
		2012								2011
						% of Total				% of Total
		Amount				Loans				Amount				Loans
						(Dollars in thousands)
Loans secured by real estate:
One-to-four family		$	146,329				28.62	%			124,595				23.71	%
Home equity			30,710				6.01	%			34,113				6.49	%
Commercial real estate			236,230				46.20	%			245,949				46.81	%
Construction and development			63,475				12.42	%			74,593				14.20	%
Consumer loans			3,501				0.68	%			4,845				0.92	%
Commercial business loans			31,029				6.07	%			41,347				7.87	%
Total gross loans receivable			511,274				100.00	%			525,442				100.00	%
Less:
Allowance for loan losses			9,520								12,039
Deferred fees, net			63								68
Total loans receivable, net		$	501,691								513,335

 

Maturities and Sensitivity of Loans to Changes in Interest Rates

 

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

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

 

		At December 31, 2015
						After one
		One Year				but within				After five
		or Less				five years				years				Total
						(In thousands)
Loans secured by real estate:
One-to-four family		$	9,387				45,788				288,511				343,686
Home equity			4,156				6,744				12,403				23,303
Commercial real estate			31,513				249,177				61,705				342,395
Construction and development			17,620				56,189				17,904				91,713
Consumer loans			1,140				3,265				776				5,181
Commercial business loans			11,967				39,494				65,276				116,737
Total gross loans receivable			75,783				400,657				446,575				923,015
Less:
Deferred fees, net			40				1,048				(796	)			292
Total loans receivable		$	75,743				399,609				447,371				922,723
Loans maturing - after one year:
Variable rate loans														$	347,741
Fixed rate loans															499,239
														$	846,980

 

Nonperforming and Problem Assets

 

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

 

Troubled Debt Restructurings (“TDRs”)

 

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

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

 

		At December 31,
		2015				2014				2013				2012				2011
		(In thousands)
Loans receivable:
Nonaccrual loans-renegotiated loans		$	59				58				7,641				10,733				18,704
Nonaccrual loans-other			4,243				2,376				3,438				4,515				11,227
Accruing loans 90 days or more delinquent			—				—				—				—				4,231
Real estate acquired through foreclosure, net			2,374				3,239				6,273				6,284				6,097
Total Non-Performing Assets		$	6,676				5,673				17,352				21,532				40,259
Problem Assets not included in Non-Performing Assets- Accruing renegotiated loans outstanding		$	13,212				14,251				16,367				17,195				23,421

 

At December 31, 2015, nonperforming assets were $6.7 million, or 0.47% of total assets, and nonperforming loans were $4.3 million, or 0.47 % of gross loans. Comparatively, at December 31, 2014, nonperforming assets were $5.7 million, or 0.47% of total assets, and nonperforming loans were $2.4 million, or 0.31% of gross loans. Nonaccrual loans increased slightly to $4.3 million at December 31, 2015 from $2.4 million at December 31, 2014 while real estate acquired through foreclosure decreased slightly to $2.4 million at December 31, 2015 from $3.2 million at December 31, 2014.

 

Potential problem loans, which are not included in nonperforming loans, amounted to approximately $13.2 million, or 1.43% of total gross loans at December 31, 2015, compared to $14.3 million, or 1.83% of gross loans at December 31, 2014. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms.

 

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

 

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

Allowance for Loan Losses

 

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

 

The general component covers nonimpaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by major loan category and is based on the actual loss history trends for the previous 20 quarters. The actual loss experience is supplemented with internal and external qualitative factors as considered necessary at each period and given the facts at the time. These qualitative factors adjust the 20 quarter historical loss rate to recognize the most recent loss results and changes in the economic conditions to ensure the estimated losses in the portfolio are recognized in the period incurred and that the allowance at each balance sheet date is adequate and appropriate in accordance with GAAP. Qualitative factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries for the most recent twelve quarters; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations.

 

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

 

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

 

The allowance for loan losses was $10.1 million, or 1.10% of total loans (1.18% of total non-acquired loans), at December 31, 2015, compared to $9.0 million, or 1.16% of total loans (1.28% of total non-acquired loans) at December 31, 2014. Loans remaining in the portfolio from branch acquisitions were $64.1 and $80.2 million at December 31, 2015 and 2014, respectively. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk.

 

The Company experienced net recoveries of $1.1 million and $944,000 for the year ended December 31, 2015 and 2014. Asset quality has remained relatively consistent with nonperforming assets to total assets of 0.47% as of December 31, 2015 and 2014. No provision expense was recorded during 2015 or 2014 primarily due to the net recoveries experienced. See Note 6 to the Consolidated Financial Statements for more information on our allowance for loan losses.

The following table summarizes the activity related to our allowance for loan losses for the five years ended December 31, 2015.

 

		For the Years Ended December 31,
		2015				2014				2013				2012				2011
		(Dollars in thousands)
Balance, beginning of period		$	9,035				8,091				9,520				12,039				14,263
Provision for loan losses			—				—				(860	)			2,707				10,735
Loan charge-offs:
Loans secured by real estate:
One-to-four family			(1,050	)			(80	)			(168	)			(2,680	)			(3,837	)
Home equity			—				—				(28	)			(319	)			(211	)
Commercial real estate			—				(28	)			(269	)			(1,432	)			(3,548	)
Construction and development			(90	)			(172	)			(765	)			(1,506	)			(6,043	)
Consumer loans			(20	)			(24	)			(35	)			(84	)			(221	)
Commercial business loans			(70	)			(59	)			(410	)			(1,169	)			(929	)
Total loan charge-offs			(1,230	)			(363	)			(1,675	)			(7,190	)			(14,789	)
Loan recoveries:
Loans secured by real estate:
One-to-four family			576				158				438				375				764
Home equity			150				—				1				—				—
Commercial real estate			350				100				126				231				182
Construction and development			479				457				110				740				203
Consumer loans			38				71				53				172				41
Commercial business loans			743				521				378				446				640
Total loan recoveries			2,336				1,307				1,106				1,964				1,830
Net loan recoveries (charge-offs)			1,106				944				(569	)			(5,226	)			(12,959	)
Balance, end of period		$	10,141				9,035				8,091				9,520				12,039
Allowance for loan losses as a percentage of loans receivable (end of period)			1.10	%			1.16	%			1.49	%			1.86	%			2.29	%
Net (recoveries) charge-offs to average loans receivable			(0.13	)%			(0.15	)%			0.11	%			1.05	%			2.38	%

The following table summarizes an allocation of the allowance for loan losses and the related percentage of loans outstanding in each category for the five years ended December 31, 2015.

 

		At December 31,
		2015								2014								2013								2012								2011
		Amount				%				Amount				%				Amount				%				Amount				%				Amount				%
		(Dollars in thousands)
Loans receivable:
One-to-four family		$	2,903				37.23	%			2,888				32.48	%			2,472				33.81	%			3,193				28.62	%			3,978				23.71	%
Home equity			151				2.52	%			221				3.54	%			231				4.30	%			276				6.01	%			550				6.49	%
Commercial real estate			3,402				37.10	%			3,283				40.85	%			2,855				45.61	%			3,315				46.20	%			3,283				46.81	%
Construction and development			1,138				9.94	%			1,069				11.82	%			1,418				11.06	%			1,792				12.42	%			2,695				14.20	%
Consumer loans			27				0.56	%			30				0.73	%			42				0.52	%			82				0.68	%			210				0.92	%
Commercial business loans			2,100				12.65	%			1,430				10.58	%			339				4.70	%			862				6.07	%			1,323				7.87	%
Unallocated			420				—				114				—				734				—				—				—				—				—
Total		$	10,141				100.00	%			9,035				100.00	%			8,091				100.00	%			9,520				100.00	%			12,039				100.00	%

 

Mortgage Operations

 

Mortgage Activities and Servicing

 

Our mortgage banking operations are conducted through our wholesale mortgage subsidiary, Crescent Mortgage Company. Mortgage activities involve the purchase of mortgage loans and table funded originations for the purpose of generating gains on sales of loans and fee income on the origination of loans. While the Company originates residential one-to-four family loans that are held in its loan portfolio, the majority of new loans are generally sold pursuant to secondary market guidelines through our wholesale mortgage origination subsidiary, Crescent Mortgage Company. Generally, residential mortgage loans are sold and, depending on the pricing in the marketplace, servicing rights are either sold or retained. The level of loan sale activity and its contribution to the Company’s profitability depends on maintaining a sufficient volume of loan originations. Changes in the level of interest rates and the local economy affect the volume of loans originated by the Company and the amount of loan sales and loan fees earned. Discussion related to the impact and changes within the mortgage operations are provided in “Results of Operations” above. Additional segment information is provided in Note 21 “Supplemental Segment Information” to the consolidated financial statements included under Item 8.

 

Loan Servicing

 

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

 

At December 31, 2015, the Company was servicing $2.0 billion of loans for others, a slight increase from $1.9 billion at December 31, 2014.

We recognize the rights to service mortgage loans for others as an asset. We initially record the MSR at fair value and subsequently account for the asset at lower of cost or market using the amortization method. Servicing assets are amortized in proportion to, and over the period of, the estimated net servicing income and are carried at amortized cost. A valuation is performed by an independent third party on a quarterly basis to assess the servicing assets for impairment based on the fair value at each reporting date. The fair value of servicing assets is determined by calculating the present value of the estimated net future cash flows consistent with contractually specified servicing fees. This valuation is performed on a disaggregated basis, based on loan type and year of production. Generally, loan servicing becomes more valuable when interest rates rise (as prepayments typically decrease) and less valuable when interest rates decline (as prepayments typically increase). As discussed in detail in notes to the consolidated financial statements, we use an appropriate weighted average constant prepayment rate, discount rate, and other defined assumptions to model the respective cash flows and determine the fair value of the servicing asset at each reporting date. See Note 7 to the consolidated financial statements for further detail regarding the assumptions used in determining the economic estimated fair value of the mortgage servicing rights retained.

 

In aggregate, the net servicing asset had a balance of $11.4 million and $10.2 million at December 31, 2015 and 2014, respectively. The economic estimated fair value of the mortgage servicing rights was $17.6 million and $15.7 million at December 31, 2015 and 2014, respectively.

 

Below is a roll-forward of activity in the balance of the servicing assets for the years ended December 31, 2015 and 2014 respectively:

 

		December 31,
		2015				2014
		(In thousands)
MSR beginning balance		$	10,181				10,908
Amount capitalized			3,238				1,868
Amount sold			—				(800	)
Amount amortized			(1,986	)			(1,795	)
MSR ending balance		$	11,433				10,181

 

Losses on Mortgage Loans Previously Sold

 

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

The following table demonstrates the activity for the mortgage repurchase reserve for the years ended December 31, 2015 and 2014:

 

		December 31,
		2015				2014
		(In thousands)
Beginning Balance		$	4,999				6,109
Losses paid			(165	)			(389	)
Recoveries			42				29
Provision for mortgage repurchase losses			(1,000	)			(750	)
Ending balance		$	3,876				4,999

 

For the years ended December 31, 2015 and 2014, the Company recorded a negative provision for mortgage repurchase losses of $1.0 million and $750,000, respectively. The decline in the provision for mortgage loan repurchase losses is related to several factors. The Company sells mortgage loans to various third parties, including government-sponsored entities (“GSEs”), under contractual provisions that include various representations and warranties as previously stated. The Company establishes the reserve for mortgage loan repurchase losses based on a combination of factors, including estimated levels of defects on internal quality assurance, default expectations, historical investor repurchase demand and appeals success rates, reimbursement by correspondent and other third party originators, and projected loss severity. Prior to 2012, there was no expiration date related to representations and warranties as long as the loan sold to the investor was outstanding. As a result, the Company received loan repurchase requests years after the loan was originated and sold to various third parties. In the latter part of 2012, the regulatory framework for certain GSEs changed where, under certain circumstances, the loan repurchase risk was limited for production beginning in January 2013. In addition, in May 2014, additional regulatory changes further limited loan repurchase risk. In addition, net losses paid have continued to decline from period to period.

 

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

 

Deposits and Other Interest-Bearing Liabilities

 

We provide a range of deposit services, including noninterest-bearing demand accounts, interest-bearing demand and savings accounts, money market accounts and time deposits. These accounts generally pay interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. Deposits continue to be our primary funding source. At December 31, 2015 deposits totaled $1.0 billion, an increase of $67.3 million from deposits of $964.2 million at December 31, 2014.

 

The Company established a deposit relationship with its mortgage subservicing provider whereby the subservicer deposited impound funds. As of December 31, 2015 and 2014, impound funds were $22.8 million and $26.1 million at December 31, 2015 and 2014, respectively. These funds are included in interest-bearing demand accounts within deposits.

 

Our retail deposits represented $882.9 million, or 85.6% of total deposits at December 31, 2015, while our out-of-market, or brokered deposits and institutional certificate of deposits, represented $148.6 million, or 14.4% of our total deposits. At December 31, 2014, retail deposits represented $842.1 million, or 87.3% of total deposits at December 31, 2015, while our out-of-market, or brokered deposits and institutional certificate of deposits, represented $122.1 million, or 12.7% of our total deposits.

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

 

		For the Years Ended December 31,
		2015								2014								2013
						Average								Average								Average
		Average				Yield/				Average				Yield/				Average				Yield/
		Balance				Rate				Balance				Rate				Balance				Rate
		(Dollars in thousands)
Interest-bearing demand accounts		$	163,982				0.12	%			114,867				0.16	%			56,405				0.20	%
Money market accounts			235,283				0.19	%			213,149				0.22	%			213,924				0.40	%
Savings accounts			38,303				0.13	%			24,617				0.15	%			14,387				0.32	%
Certificates of deposit less than $100,000			236,461				0.89	%			211,128				0.91	%			210,029				0.79	%
Certificates of deposit of $100,000 or more			158,670				0.98	%			100,118				0.87	%			92,970				0.71	%
Total interest-bearing average deposits			832,699				0.52	%			663,879				0.52	%			587,715				0.57	%
Noninterest-bearing deposits			179,960								113,743								109,069
Total average deposits		$	1,012,659								777,622								696,784

 

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

 

		At December 31,
		2015				2014
		(In thousands)
Three months or less		$	33,787				24,245
Over three through six months			31,895				17,032
Over six through twelve months			37,609				18,655
Over twelve months			88,028				72,367
Total certificates of deposits		$	191,319				132,299

Borrowings and Other Interest-Bearing Liabilities

 

The following table outlines our various sources of borrowed funds during the years ended December 31, 2015, 2014, and 2013, and the amounts outstanding at the end of each period, the maximum amount for each component during the periods, the average amounts for each period, and the average interest rate that we paid for each borrowing source. The maximum month-end balance represents the high indebtedness for each component of borrowed funds at any time during each of the periods shown.

 

										Maximum
						Period				Month				Average for the
		Ending				End				End				Period
At or for the year ended December 31, 2015		Balance				Rate				Balance				Balance				Rate
		(Dollars in thousands)
Short-term borrowed funds
Short-term FHLB advances			120,000				0.28%-0.64	%			147,500				113,840				0.29	%
Subordinated debenture, due 2016			—				—				300				125				2.71	%
Other short-term borrowings			—				—				—				3				0.73	%
Long-term borrowed funds
Long-term FHLB advances, due 2017 through 2021			88,000				0.35%-4.00	%			88,000				41,276				3.26	%
Subordinated debentures, due 2017 through 2020			—				—				1,275				639				2.54	%
Subordinated debentures issued to Carolina Financial Capital Trust I, due 2032			5,155				3.75	%			5,155				5,155				3.75	%
Subordinated debentures issued to Carolina Financial Capital Trust II, due 2034			10,310				3.38	%			10,310				10,310				3.38	%

 

 

										Maximum
						Period				Month				Average for the
		Ending				End				End				Period
At or for the year ended December 31, 2014		Balance				Rate				Balance				Balance				Rate
		(Dollars in thousands)
Short-term borrowed funds
Short-term FHLB advances			57,500				0.19%-0.56	%			110,500				40,886				0.24	%
Subordinated debenture, due 2015			300				2.68	%			300				300				2.02	%
Other short-term borrowings			—				—				10,000				137				0.75	%
Long-term borrowed funds
Long-term FHLB advances, due 2015 through 2021			45,000				1.20%-4.00	%			57,500				51,694				2.83	%
Subordinated debentures, due 2016 through 2020			1,275				2.68	%			1,575				1,461				2.87	%
Subordinated debentures issued to Carolina Financial Capital Trust I, due 2032			5,155				3.75	%			5,155				5,155				3.75	%
Subordinated debentures issued to Carolina Financial Capital Trust II, due 2034			10,310				3.28	%			10,310				10,310				3.33	%

										Maximum
						Period				Month				Average for the
		Ending				End				End				Period
At or for the year ended December 31, 2013		Balance				Rate				Balance				Balance				Rate
		(Dollars in thousands)
Short-term borrowed funds
Unsecured line of credit		$	—				—				2,700				1,987				5.00	%
Short-term FHLB advances			10,000				0.36	%			73,000				18,428				0.27	%
Mortgage loan warehouse line of credit			—				—				3,748				1,620				5.20	%
Subordinated debenture, due 2020			300				2.70	%			300				300				2.73	%
Long-term borrowed funds
Long-term FHLB advances, due 2014 through 2021			57,500				0.42% - 4.00	%			57,500				50,726				2.67	%
Subordinated debentures, due 2016 through 2020			1,575				2.70	%			11,875				9,404				1.99	%
Subordinated debentures issued to Carolina Financial Capital Trust I, due 2032			5,155				3.75	%			5,155				5,155				3.75	%
Subordinated debentures issued to Carolina Financial Capital Trust II, due 2034			10,310				3.29	%			10,310				10,310				3.57	%

 

Liquidity

 

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

 

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

 

Lines of credit with the FHLB are based upon FHLB-approved percentages of Bank assets, but must be supported by appropriate collateral to be available. The Company has pledged first lien residential mortgage, second lien residential mortgage, residential home equity line of credit, commercial mortgage and multifamily mortgage portfolios under blanket lien agreements resulting in approximately $273.6 million of collateral for these advances. In addition, at December 31, 2015, the Company has pledged securities with a fair value of $76.4 million for these advances. At December 31, 2015 the Company had FHLB advances of $208 million outstanding with excess collateral pledged to the FHLB during those periods that would support additional borrowings of approximately $77.4 million.

 

Lines of credit with the Federal Reserve Bank (“FRB”) are based on collateral pledged. The Company has pledged approximately $168.5 million of certain non-mortgage commercial, acquisition and development, and lot loan portfolios under blanket lien agreements to the FRB. At December 31, 2015 the Company had lines available with the FRB for $84.3 million. At December 31, 2015 the Company had no FRB advances outstanding. 

Capital Resources

 

The Company and the Bank are subject to various federal and state regulatory requirements, including regulatory capital requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions that if undertaken could have a direct material effect on the Company’s and the Bank’s financial statements.

 

In 2013, federal bank regulatory agencies issued a final rule that revises their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with agreements that were reached by the Basel Committee on Banking Supervision (“Basel III”) and certain provisions of the Dodd-Frank Act.

 

The rule imposes higher risk-based capital and leverage requirements than those in place at the time the rule was issued. Specifically, the rule imposes the following minimum capital requirements:

 

●

A new Common Equity Tier 1 risk-based capital ratio of 4.5%

●

A Tier 1 risk-based capital ratio of 6% (increased from the previous 4% requirement),

●

A total risk-based capital ratio of 8% (unchanged from previous requirement),

●

A leverage ratio of 4% and

●

A new supplementary leverage ratio of 3% applicable to advanced approaches banking organizations resulting in a leverage ratio requirement of 7% for such institutions

 

The rule also includes changes in what constitutes regulatory capital, some of which are subject to a transition period. These changes include the phasing-out of certain instruments as qualifying capital. In addition, Tier 2 capital is no longer limited to the amount of Tier 1 capital included in total capital. Mortgage servicing rights, certain deferred tax assets and investments in unconsolidated subsidiaries over designated percentages of common stock are required to be deducted from capital, subject to a transition period. Finally, Common Equity Tier 1 capital includes accumulated other comprehensive income (which includes all unrealized gains and losses on available for sale debt and equity securities), subject to a transition period and a one-time opt-out election. The Bank elected to opt-out of this provision. As such, accumulated comprehensive income is not included in the Bank’s Tier 1 capital.

 

The rule also includes changes in the risk-weights of assets to better reflect credit risk and other risk exposures. These include a 150% risk weight (up from 100%) for certain high volatility commercial real estate acquisition, development and construction loans and non-residential mortgage loans that are 90 days past due or otherwise on nonaccrual status, a 20% (up from 0%) credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable, a 250% risk weight (up from 100%) for mortgage servicing rights and deferred tax assets that are not deducted from capital and increased risk-weights (from 0% to up to 600%) for equity exposures.

 

Finally, the rule limits capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of 2.5% of Common Equity Tier 1 capital to risk-weighted assets in addition to the amount necessary to meet its minimum risk-based capital requirements.

 

The final rule became effective on January 1, 2015, and the requirements in the rule will be fully phased-in by January 1, 2019. While the ultimate impact of the fully phased-in capital standards on the Company and the Bank is being reviewed, we currently do not believe Basel III will have a material impact once fully implemented.

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

 

																		To Be Well
										Minimum Required								Capitalized Under
										For Capital								Prompt Corrective
		Actual								Adequacy Purposes								Action Regulations
		Amount				Ratio				Amount				Ratio				Amount				Ratio
		(Dollars in thousands)
December 31, 2015
Carolina Financial Corporation
CET1 capital (to risk weighted assets)		$	138,213				13.97	%			44,527				4.50	%			N/A				N/A
Tier 1 capital (to risk weighted assets)			153,213				15.48	%			59,370				6.00	%			N/A				N/A
Total capital (to risk weighted assets)			163,353				16.51	%			79,160				8.00	%			N/A				N/A
Tier 1 capital (to total average assets)			153,213				11.23	%			54,557				4.00	%			N/A				N/A
CresCom Bank
CET1 capital (to risk weighted assets)			139,025				14.08	%			44,442				4.50	%			64,194				6.50	%
Tier 1 capital (to risk weighted assets)			139,025				14.08	%			59,256				6.00	%			79,008				8.00	%
Total capital (to risk weighted assets)			149,165				15.10	%			79,008				8.00	%			98,760				10.00	%
Tier 1 capital (to total average assets)			139,025				10.21	%			54,466				4.00	%			68,082				5.00	%
December 31, 2014
Carolina Financial Corporation
Tier 1 capital (to risk weighted assets)		$	104,613				12.03	%			34,787				4.00	%			N/A				N/A
Total risk based capital (to risk weighted assets)			114,323				13.15	%			69,574				8.00	%			N/A				N/A
Tier 1 capital (to total average assets)			104,613				9.49	%			44,079				4.00	%			N/A				N/A
CresCom Bank
Tier 1 capital (to risk weighted assets)			103,319				11.90	%			34,716				4.00	%			52,074				6.00	%
Total risk based capital (to risk weighted assets)			113,029				13.02	%			69,433				8.00	%			86,791				10.00	%
Tier 1 capital (to total average assets)			103,319				9.40	%			43,985				4.00	%			54,981				5.00	%

 

The following table shows the return on average assets (net income divided by average total assets), return on average equity (net income divided by average equity), and equity to assets ratio (average equity divided by average total assets) for the three years ended December 31, 2015, 2014, and 2013.

 

		For the Years Ended December 31,
		2015				2014				2013
Return on average assets			1.11	%			0.84	%			1.89	%
Return on average equity			14.15	%			9.39	%			22.04	%
Average equity to average assets ratio			7.82	%			8.93	%			8.58	%

The following table provides the amount of dividends and payout ratios (dividends declared divided by net income) for the years ended December 31, 2015, 2014, and 2013.

 

		For the Years Ended December 31,
		2015				2014				2013
Shareholder dividends declared		$	1,142,000			$	855,000			$	401,000
Dividend payout ratios			7.92	%			10.29	%			2.38	%

 

We retain earnings to have capital sufficient to grow our loan and investment portfolios and to support certain acquisitions or other business expansion opportunities as they arise. The dividend payout ratio is calculated by dividing dividends paid during the year by net income for the year.

 

Off Balance Sheet Arrangements

 

Through the operations of our Bank, we have made contractual commitments to extend credit in the ordinary course of our business activities. These commitments are legally binding agreements to lend money to our customers at predetermined interest rates for a specified period of time. We evaluate each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, commercial and residential real estate. We manage the credit risk on these commitments by subjecting them to normal underwriting and risk management processes.

 

At December 31, 2015, we had issued commitments to extend credit of approximately $70.4 million through various types of lending arrangements. There were 22 standby letters of credit included in the commitments for $1.4 million. Fixed rate commitments were $12.6 million and variable rate commitments were $59.2 million.

 

Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. A significant portion of the unfunded commitments relate to consumer equity lines of credit and commercial lines of credit. Based on historical experience, we anticipate that a portion of these lines of credit will not be funded.

 

Except as disclosed in this report, we are not involved in off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements or transactions that could result in liquidity needs or other commitments that significantly impact earnings.

  

Market Risk Management and Interest Rate Risk

 

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

 

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

As of December 31, 2015, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward movements in interest rates of 100, 200, and 300 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates. Downward movements do not appear to be applicable due to the low interest rate environment experienced during 2014 and 2015. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the Consolidated Financial Statements. Therefore, management’s assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. In addition, this analysis does not consider any strategic changes to our balance sheet which management may consider as a result of changes in market conditions.

 

Interest Rate Scenario				Annualized Hypothertical Percentage
Change		Prime Rate		Change in Net Interest Income
0.00%		3.50%		0.00%
1.00%		4.50%		-1.10%
2.00%		5.50%		-1.80%
3.00%		6.50%		-2.90%

 

The primary uses of derivative instruments are related to the mortgage banking activities of the Company. As such, the Company holds derivative instruments, which consist of rate lock agreements related to expected funding of fixed-rate mortgage loans to customers (interest rate lock commitments) and forward commitments to sell mortgage-backed securities and individual fixed-rate mortgage loans. The Company’s objective in obtaining the forward commitments is to mitigate the interest rate risk associated with the interest rate lock commitments and the mortgage loans that are held for sale. Derivatives related to these commitments are recorded as either a derivative asset or a derivative liability in the balance sheet and are measured at fair value. Both the interest rate lock commitments and the forward commitments are reported at fair value, with adjustments recorded in current period earnings in mortgage banking income within the noninterest income of the consolidated statements of operations. Derivative instruments not related to mortgage banking activities primarily relate to interest rate swap agreements.

 

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

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

 

		At December 31,
		2015								2014
		Fair				Notional				Fair				Notional
		Value				Value				Value				Value
						(In thousands)
Derivative assets:
Cash flow hedges:
Interest rate swaps		$	180				30,000				—				—
Non-hedging derivatives:
Mortgage loan interest rate lock commitments			1,246				143,318				1,122				106,440
Mortgage loan forward sales commitments			340				31,513				567				27,292
Mortgage-backed securities forward sales commitments			179				105,014				—				—
Total derivative assets		$	1,945				309,845				1,689				133,732
Derivative liabilities:
Non-hedging derivatives:
Interest rate swaps		$	306				10,000				530				20,000
Mortgage-backed securities forward sales commitments			—				—				506				93,000
Total derivative liabilities		$	306				10,000				1,036				113,000

 

The Company has entered into forward starting interest rate swaps to reduce the exposure to variability in interest-related cash outflows attributable to changes in forecasted LIBOR based FHLB borrowings. These derivative instruments are designated as cash flow hedges. The hedged item is the LIBOR portion of the series of future short-term fixed rate borrowings over the term of the interest rate swap. Accordingly, changes to the amount of interest payment cash flows for the hedged transactions attributable to a change in credit risk are excluded from our assessment of hedge effectiveness. The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. The Company has not recorded any hedge ineffectiveness since inception.

 

As of December 31, 2015, the Company had two outstanding interest rate derivatives with a notional value of $30.0 million that were designated as cash flow hedges of interest rate risk with a weighted average remaining term of 9.84 years.

 

In the event that the forecasted transaction was no longer be probable, the Company would recognize a gain of $180,000 directly into earnings, the current fair value, as of December 31, 2015.

Contractual Obligations

 

The following table presents payment schedules for certain of our contractual obligations as of December 31, 2015. Operating lease obligations of $3.8 million pertain to banking facilities and equipment. Certain lease agreements include payment of property taxes and insurance and contain various renewal options. Additional information regarding leases is contained in Note 14 of the audited consolidated financial statements.

 

						Less than				1 to 3				3 to 5				More than
		Total				1 Year				Years				Years				5 Years
		(Dollars in thousands)
Advances from FHLB		$	208,000				120,000				68,000				20,000				—
Interest rate swap - cash flow hedge derivative			30,000				—				—				—				30,000
Interest rate swap - non-hedging derivative			10,000				—				—				—				10,000
Subordinated debentures issued to Carolina Financial Capital Trust I, due 2032			5,155				—				—				—				5,155
Subordinated debentures issued to Carolina Financial Capital Trust II, due 2034			10,310				—				—				—				10,310
Operating lease obligations			3,809				1,013				1,701				1,026				69

 

Accounting, Reporting, and Regulatory Matters

 

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

 

Effect of Inflation and Changing Prices

 

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

 

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

 

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

 

See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Market Risk and Interest Rate Sensitivity and – Liquidity and Capital Resources.

Item 8. Financial Statements and Supplementary Data

 

 

 

 

 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders

Carolina Financial Corporation

Charleston, South Carolina

 

We have audited the accompanying consolidated balance sheets of Carolina Financial Corporation and subsidiaries as of December 31, 2015 and 2014, and the related consolidated statements of operations, comprehensive income, stockholders’ equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting under Public Company Accounting Oversight Board (PCAOB) standards. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting under PCAOB standards. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Carolina Financial Corporation and subsidiaries as of December 31, 2015 and 2014, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

 

 

Greenville, South Carolina

March 14, 2016

 

CAROLINA FINANCIAL CORPORATION CONSOLIDATED

BALANCE SHEETS

 

		At December 31,
		2015				2014
		(In thousands)
ASSETS
Cash and due from banks		$	10,206				10,453
Interest-bearing cash			16,421				10,694
Cash and cash equivalents			26,627				21,147
Securities available-for-sale (cost of $305,972 at December 31, 2015 and $246,435 at December 31, 2014)			306,474				251,717
Securities held-to-maturity (fair value of $17,965 at December 31, 2015 and $27,385 at December 31, 2014)			17,053				25,544
Federal Home Loan Bank stock, at cost			9,919				5,405
Other investments			3,273				2,309
Derivative assets			1,945				1,689
Loans held for sale			41,774				40,912
Loans receivable, net of allowance for loan losses of $10,141 at December 31, 2015 and $9,035 at December 31, 2014			912,582				768,122
Premises and equipment, net			32,562				31,075
Accrued interest receivable			4,333				3,628
Real estate acquired through foreclosure, net			2,374				3,239
Deferred tax assets, net			5,273				4,715
Mortgage servicing rights			11,433				10,181
Cash value life insurance			28,082				21,532
Core deposit intangible			2,961				3,303
Other assets			3,004				4,499
Total assets		$	1,409,669				1,199,017
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Noninterest-bearing deposits		$	163,054				142,900
Interest-bearing deposits			868,474				821,290
Total deposits			1,031,528				964,190
Short-term borrowed funds			120,000				57,800
Long-term debt			103,465				61,740
Derivative liabilities			306				1,036
Drafts outstanding			2,154				3,320
Advances from borrowers for insurance and taxes			641				613
Accrued interest payable			333				312
Reserve for mortgage repurchase losses			3,876				4,999
Dividends payable to stockholders			361				243
Accrued expenses and other liabilities			7,146				11,064
Total liabilities			1,269,810				1,105,317
Commitments and contingencies
Stockholders’ equity:
Preferred stock, par value $.01; 1,000,000 authorized at December 31, 2015 and December 31, 2014; no shares issued or outstanding			—				—
Common stock, par value $.01; 15,000,000 and 10,000,000 shares authorized at December 31, 2015 and December 31, 2014, respectively; 12,023,557 and 9,717,043 issued and outstanding at December 31, 2015 and December 31, 2014, respectively			120				97
Additional paid-in capital			56,418				23,194
Retained earnings			82,859				69,625
Accumulated other comprehensive income			462				784
Total stockholders’ equity			139,859				93,700
Total liabilities and stockholders’ equity		$	1,409,669				1,199,017

See accompanying notes to consolidated financial statements.

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

 

		For the Years
		Ended December 31,
		2015				2014
		(In thousands, except share data)
Interest income
Loans		$	41,020				31,317
Investment securities			8,176				6,083
Dividends from FHLB			328				158
Other interest income			80				98
Total interest income			49,604				37,656
Interest expense
Deposits			4,367				3,483
Short-term borrowed funds			331				106
Long-term debt			1,906				2,013
Total interest expense			6,604				5,602
Net interest income			43,000				32,054
Provision for loan losses			—				—
Net interest income after provision for loan losses			43,000				32,054
Noninterest income
Mortgage banking income			17,417				11,908
Deposit service charges			3,496				2,065
Net loss on extinguishment of debt			(1,251	)			(58	)
Net gain on sale of securities			1,493				1,084
Fair value adjustments on interest rate swaps			(1,111	)			(1,170	)
Net gain on sale of servicing assets			—				775
Net increase in cash value life insurance			726				731
Mortgage loan servicing income			5,313				5,077
Other			1,596				736
Total noninterest income			27,679				21,148
Noninterest expense
Salaries and employee benefits			28,629				23,308
Occupancy and equipment			7,228				4,858
Marketing and public relations			1,434				1,251
FDIC insurance			698				581
Recovery of mortgage loan repurchase losses			(1,000	)			(750	)
Legal expense			407				438
Other real estate expense, net			138				638
Mortgage subservicing expense			1,634				1,392
Amortization of mortgage servicing rights			1,986				1,795
Other			8,045				7,932
Total noninterest expense			49,199				41,443
Income before income taxes			21,480				11,759
Income tax expense			7,060				3,448
Net income		$	14,420				8,311
Earnings per common share:
Basic		$	1.51				0.89
Diluted		$	1.48				0.87
Average common shares outstanding:
Basic			9,537,358				9,314,048
Diluted			9,718,356				9,507,425

 

See accompanying notes to consolidated financial statements.

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

		For the Years
		Ended December 31,
		2015				2014
		(In thousands)
Net income		$	14,420				8,311
Other comprehensive income (loss), net of tax:
Unrealized (losses) gain on securities			(939	)			5,828
Tax effect			338				(2,101	)
Reclassification adjustment for (gains) included in earnings			(1,493	)			(1,084	)
Tax effect			537				390
Unrealized gains on interest rate swaps designated as cash flow hedges			180				—
Tax effect			(65	)			—
Transfer from held-to-maturity to available for sale securities			1,604				—
Tax effect			(580	)			—
Accretion of unrealized losses on held-to-maturity securities previously recognized in other comprehensive income			151				198
Tax effect			(55	)			(72	)
Other comprehensive (loss) income, net of tax			(322	)			3,159
Comprehensive income		$	14,098				11,470

See accompanying notes to consolidated financial statements.

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

 

																		Accumulated
										Additional								Other
		Common Stock								Paid-in				Retained				Comprehensive
		Shares				Amount				Capital				Earnings				Income (Loss)				Total
		(In thousands, except share data)
Balance, December 31, 2013			9,636,490			$	96				22,337				62,169				(2,375	)			82,227
Stock awards			69,225				1				64				—				—				65
Stock options exercised			11,328				—				50				—				—				50
Excess tax benefit in connection with equity awards			—				—				126				—				—				126
Stock-based compensation expense, net			—				—				617				—				—				617
Net income			—				—				—				8,311				—				8,311
Dividends declared to stockholders			—				—				—				(855	)			—				(855	)
Other comprehensive income, net of tax			—				—				—				—				3,159				3,159
Balance, December 31, 2014			9,717,043				97				23,194				69,625				784				93,700
Issuance of common stock, net of offering expenses			2,262,296				23				32,133				—				—				32,156
Stock awards			37,491				—				—				—				—				—
Vested stock awards surrendered in cashless exercise			(7,289	)			—				(42	)			(44	)			—				(86	)
Stock options exercised			14,016				—				70				—				—				70
Excess tax benefit in connection with equity awards			—				—				189				—				—				189
Stock-based compensation expense, net			—				—				874				—				—				874
Net income			—				—				—				14,420				—				14,420
Dividends declared to stockholders			—				—				—				(1,142	)			—				(1,142	)
Other comprehensive loss, net of tax			—				—				—				—				(322	)			(322	)
Balance, December 31, 2015			12,023,557			$	120				56,418				82,859				462				139,859

See accompanying notes to consolidated financial statements.

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

		For the Years
		Ended December 31,
		2015				2014
		(In thousands)
Cash flows from operating activities:
Net income		$	14,420				8,311
Adjustments to reconcile net income to net cash provided by operating activities:
Deferred tax (benefit) expense			(307	)			888
Amortization of unearned discount/premiums on investments, net			3,416				2,802
Amortization of deferred loan fees			(955	)			(550	)
Amortization of core deposit intangibles			343				47
Gain on sale of available-for-sale securities, net			(1,493	)			(1,084	)
Mortgage banking income			(17,417	)			(11,908	)
Originations of loans held for sale			(1,060,241	)			(982,204	)
Proceeds from sale of loans held for sale			1,076,796				990,097
Loss on extinquishment of debt			1,251				58
Provision for mortgage loan repurchase losses			(1,000	)			(750	)
Mortgage loan losses paid, net of recoveries			(123	)			(360	)
Fair value adjustments on interest rate swaps			1,111				1,170
Stock-based compensation			874				617
Increase in cash surrender value of bank owned life insurance			(726	)			(731	)
Depreciation			1,778				1,229
Loss on disposals of premises and equipment			11				8
Gain on sale of real estate acquired through foreclosure			(10	)			(91	)
Write-down of real estate acquired through foreclosure			—				526
Gain on sale of servicing assets			—				(775	)
Originations of mortgage servicing assets			(3,238	)			(1,868	)
Amortization of mortgage servicing rights			1,986				1,795
(Increase) decrease in:
Accrued interest receivable			(705	)			(668	)
Other assets			109				464
Increase (decrease) in:
Accrued interest payable			21				1
Dividends payable to stockholders			118				243
Accrued expenses and other liabilities			(4,917	)			3,228
Cash flows provided by operating activities			11,102				10,495

 

Continued

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED

 

		For the Years
		Ended December 31,
		2015				2014
		(In thousands)
Cash flows from investing activities:
Activity in available-for-sale securities:
Purchases		$	(207,316	)			(193,577	)
Maturities, payments and calls			52,906				37,782
Proceeds from sales			105,840				74,901
Activity in held-to-maturity securities:
Purchases			(497	)			(1,487	)
Maturities, payments and calls			199				536
Increase in other investments			(973	)			(419	)
Increase in Federal Home Loan Bank stock			(4,514	)			(1,302	)
Increase in loans receivable, net			(144,812	)			(163,846	)
Proceeds from the sale of servicing assets			—				1,575
Purchase of premises and equipment			(3,329	)			(4,017	)
Proceeds from disposals of premises and equipment			34				—
Proceeds from sale of real estate acquired through foreclosure			2,182				4,060
Purchase of bank owned life insurance			(6,025	)			—
Distribution of bank owned life insurance			175				—
Net cash received for acquisitions			—				131,135
Cash flows used in investing activities			(206,130	)			(114,659	)
Cash flows from financing activities:
Net increase in deposit accounts			67,338				51,488
Net increase in Federal Home Loan Bank advances			104,249				34,942
Principal repayment of subordinated debt			(1,575	)			(300	)
Net increase (decrease) in drafts outstanding			(1,166	)			617
Net increase in advances from borrowers for insurance and taxes			28				329
Cash dividends paid on common stock			(781	)			(606	)
Proceeds from issuance of common stock			32,156				—
Net increase in excess tax benefit in connection with equity awards			189				126
Proceeds from exercise of stock options			70				50
Cash flows provided by financing activities			200,508				86,646
Net increase (decrease) in cash and cash equivalents			5,480				(17,518	)
Cash and cash equivalents, beginning of year			21,147				38,665
Cash and cash equivalents, end of year		$	26,627				21,147
Supplemental disclosure
Cash paid for:
Interest on deposits and borrowed funds		$	6,583				5,601
Income taxes paid, net of refunds			7,160				3,553
Noncash investing and financing activities:
Transfer of loans receivable to real estate acquired through foreclosure			1,307				1,461
Transfer of held-to-maturity securities to available-for-sale securities			12,652				—

See accompanying notes to consolidated financial statements.

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Organization

 

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

 

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

 

Management’s Estimates

 

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

 

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

 

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

 

Subsequent Events

 

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

 

On January 5, 2016, Carolina Financial Corporation announced the signing of a definitive agreement pursuant to which Carolina Financial Corporation will acquire Congaree Bancshares, Inc. in a cash and stock transaction with a total current value of approximately $16.3 million including the assumption of approximately $1.6 million in preferred stock. The transaction is anticipated to close at the end of the second quarter of 2016, subject to customary closing conditions.

Cash and Cash Equivalents

 

Cash and cash equivalents consists of cash and due from banks and interest-bearing cash with banks. Substantially all of the interest-bearing cash at December 31, 2015 and 2014 consists of Federal Reserve Bank of Richmond (“FRB”) and Federal Home Loan Bank of Atlanta (“FHLB”) overnight deposits. Cash and cash equivalents have maturities of three months or less. Accordingly, the carrying amount of such instruments is considered a reasonable estimate of fair value. The Bank is required to maintain average balances on hand or with the FRB. At December 31, 2014 these reserve balances amounted to $12.1 million. There were no reserve requirements at December 31, 2015.

 

Securities

 

Investment securities are classified into three categories: (a) Held-to-Maturity – debt securities that the Company has positive intent and ability to hold to maturity, which are reported at amortized cost; (b) Trading – debt and equity securities that are bought and held principally for the purpose of selling them in the near term, which are reported at fair value, with unrealized gains and losses included in earnings; and (c) Available-for-Sale – debt and equity securities that may be sold under certain conditions, which are reported at fair value, with unrealized gains and losses excluded from earnings and reported in accumulated other comprehensive income.

 

The Company determines the category of the investment at the time of purchase. If a security is transferred from available–for-sale to held-to-maturity, the fair value at the time of transfer becomes the held-to-maturity security’s new cost basis. Premiums and discounts on securities are accreted and amortized as an adjustment to interest yield over the estimated life of the security using a method which approximates a level yield. Dividends and interest income are recognized when earned. Unrealized losses on securities, reflecting a decline in value judged by the Company to be other-than-temporary, are charged to income in the consolidated statements of operations.

 

The cost basis of securities sold is determined by specific identification. Purchases and sales of securities are recorded on a trade date basis.

 

Loans Held for Sale

 

The Company’s residential mortgage lending activities for sale in the secondary market are comprised of accepting residential mortgage loan applications, qualifying borrowers to standards established by investors, funding residential mortgage loans and selling mortgage loans to investors under pre-existing commitments. Loans held for sale are recorded at fair value. Origination fees and costs are recognized in earnings at the time of origination for loans held for sale that are recorded at fair value. Fair value is derived from observable current market prices, when available, and includes loan servicing value. When observable market prices are not available, the Company uses judgment and estimates fair value using internal models, in which the Company uses its best estimates of assumptions it believes would be used by market participants in estimating fair value. Adjustments to reflect unrealized gains and losses resulting from changes in fair value and realized gains and losses upon ultimate sale of the loans are classified as noninterest income, mortgage banking income in the consolidated statements of operations.

 

The Company issues rate lock commitments to borrowers on prices quoted by secondary market investors. Derivatives related to these commitments are recorded as either assets or liabilities in the balance sheet and are measured at fair value. Changes in the fair value of the derivatives are reported in current earnings or other comprehensive income depending on the purpose for which the derivative is held and whether the derivative qualifies for hedge accounting.

 

Derivative Financial Instruments

 

Derivatives are recognized as either assets or liabilities and are recorded at fair value on the Company’s Consolidated Balance Sheet. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and resulting designation. The Company’s hedging policies permit the use of various derivative financial instruments to manage interest rate risk or to hedge specified assets and liabilities.

To qualify for hedge accounting, derivatives must be highly effective at reducing the risk associated with the exposure being hedged and must be designated as a hedge at the inception of the derivative contract. If derivative instruments are designated as fair value hedges, and such hedges are highly effective, both the change in the fair value of the hedge and the hedged item are included in current earnings. If derivative instruments are designated as cash flow hedges, fair value adjustments related to the effective portion are recorded in other comprehensive income and are reclassified to earnings when the hedged transaction is reflected in earnings. Ineffective portions of cash flow hedges are reflected in earnings as they occur. Actual cash receipts and/or payments and related accruals on derivatives related to hedges are recorded as adjustments to the interest income or interest expense associated with the hedged item. During the life of the hedge, the Company formally assesses whether derivatives designated as hedging instruments continue to be highly effective in offsetting changes in the fair value or cash flows of hedged items. If it is determined that a hedge has ceased to be highly effective, the Company will discontinue hedge accounting prospectively. At such time, previous adjustments to the carrying value of the hedged item are reversed into current earnings and the derivative instrument is reclassified to a trading position recorded at fair value. For derivatives not designated as hedges, changes in fair value are recognized in earnings, in non-interest income.

 

For additional discussion related to the determination of fair value related to derivative instruments, see Note 5.

 

Loans Receivable, Net

 

Loans that management has the intent and ability to hold for the foreseeable future are reported at their outstanding principal balances net of any unearned income, charge-offs, deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. The net amount of nonrefundable loan origination fees, commitment fees and certain direct costs associated with the lending process are deferred and amortized to interest income over the contractual lives of the loans using methods that approximate a level yield or noninterest income when the loan is sold. Discounts and premiums on purchased loans are amortized to interest income over the estimated life of the loans using methods that approximate a level yield, or noninterest income when the loan is sold. Commercial loans and substantially all installment loans accrue interest on the unpaid balance of the loans.

 

A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or as a practical expedient, at the loan’s observable market price or the fair value of the collateral if the loan is collateral-dependent. When the fair value of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a specific reserve allocation that is a component of the allowance for loan losses. A loan is charged-off against the allowance for loan losses when all meaningful collection efforts have been exhausted and the loan is viewed as uncollectible in the immediate or foreseeable future.

 

Troubled Debt Restructurings (“TDRs”)

 

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

 

Nonperforming Assets

 

Nonperforming assets include loans on which interest is not being accrued, accruing loans that are 90 days or more delinquent and foreclosed property. Foreclosed property consists of real estate and other assets acquired as a result of a borrower’s loan default. Loans are generally placed on nonaccrual status when concern exists that principal or interest is not fully collectible, or when any portion of principal or interest becomes 90 days past due, whichever occurs first. Loans past due 90 days or more may remain on accrual status if management determines that concern over the collectability of principal and interest is not significant. When loans are placed on nonaccrual status, interest receivable is reversed against interest income in the current period. Interest payments received thereafter are applied as a reduction to the remaining principal balance as long as concern exists as to the ultimate collection of the principal. Loans are removed from nonaccrual status when they become current as to both principal and interest and when concern no longer exists as to the collectability of principal or interest.

Assets acquired as a result of foreclosure are initially recorded at fair value less estimated selling costs at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Gains and losses on the sale of assets acquired through foreclosure and related revenue and expenses of these assets are included in noninterest expense in other real estate expenses, net.

 

Allowance for Loan Losses

 

The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.

 

The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. Impaired loans are evaluated for impairment using the discounted cash flow methodology or based on the net realizable value of the underlying collateral. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment.

 

Factors considered by management in determining impaired loans include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

 

If a loan has impairment, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. For collateral-dependent loans, the measurement of impairment was based on the net investment of the loan compared to the fair value of the collateral less estimated selling costs. In most cases, the fair value of the collateral was based on appraised value. When appropriate, the fair value was based on the probable sales price of the collateral when sale of the collateral was imminent or contracted sales price if the collateral is subject to a binding sales contract as of the end of the quarter.

 

The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The Company considers the actual loss history experience over the trailing twenty quarters to determine the historical loss experience used in the general component. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries for the most recent sixteen quarters; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations.

While management uses the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the valuations or, if required by regulators, based upon information available to them at the time of their examinations. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels may vary from previous estimates.

 

Business Combinations and Method of Accounting for Loans Acquired

 

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

 

There are two methods to account for acquired loans as part of a business combination. Acquired loans that contain evidence of credit deterioration on the date of purchase are carried at the net present value of expected future proceeds in accordance with ASC 310-30. All other acquired loans are recorded at their initial fair value, adjusted for subsequent advances, pay downs, amortization or accretion of any premium or discount on purchase, charge-offs and any other adjustment to carrying value in accordance with ASC 310-20.

 

In determining the Day 1 Fair Values of acquired loans without evidence of credit deterioration at the date of acquisition, management includes (i) no carry over of any previously recorded allowance for loan losses and (ii) an adjustment of the unpaid principal balance to reflect an appropriate market rate of interest, given the risk profile and grade assigned to each loan. This adjustment will be accreted into earnings as a yield adjustment, using the effective yield method, over the remaining life of each loan.

 

To the extent that current information indicates it is probable that the Company will collect all amounts according to the contractual terms thereof, such loan is not considered impaired and is not considered in the determination of the required allowance for loan losses. To the extent that current information indicates it is probable that the Company will not be able to collect all amounts according to the contractual terms thereon, such loan is considered impaired and is considered in the determination of the required level of allowance for loan and lease losses.

 

Core Deposit Intangible

 

In connection with business combinations, the Company records core deposit intangibles, representing the value of the acquired core deposit base. Core deposit intangibles are amortized over their estimated useful lives ranging up to 10 years.

 

Mortgage Servicing Rights, Fees and Costs

 

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

 

Mortgage servicing rights are amortized in proportion to, and over the period of, estimated net servicing income. The amortization of the mortgage servicing rights is analyzed periodically and is adjusted to reflect changes in prepayment rates and other estimates.

 

The Company evaluates potential impairment of mortgage servicing rights based on the difference between the carrying amount and current estimated fair value of the servicing rights. In determining impairment, the Company aggregates all servicing rights and stratifies them into tranches based on predominant risk characteristics. If impairment exists, a valuation allowance is established for any excess of amortized cost over the current estimated fair value by a charge to income. If the Company later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as an increase to income.

Service fee income is recorded for fees earned for servicing mortgage loans under servicing agreements with the Federal National Mortgage Association (“FNMA”), the Federal Home Loan Mortgage Corporation (“FHLMC”), Government National Mortgage Association (“GNMA”) and certain private investors. The fees are based on a contractual percentage of the outstanding principal balance of the loans serviced and are recorded as income when received in noninterest income. Amortization of mortgage servicing rights and mortgage servicing costs are charged to expense when incurred.

 

Guarantees

 

Standby letters of credit obligate the Company to meet certain financial obligations of its customers, under the contractual terms of the agreement, if the customers are unable to do so. Payment is only guaranteed under these letters of credit upon the borrower’s failure to perform its obligations to the beneficiary. The Company can seek recovery of the amounts paid from the borrower; however, these standby letters of credit are generally not collateralized. Commitments under standby letters of credit are usually one year or less. At December 31, 2015 and 2014, the Company had recorded no liability for the current carrying amount of the obligation to perform as a guarantor; as such amounts are not considered material. The maximum potential amount of undiscounted future payments related to standby letters of credit at December 31, 2015 was $1.4 million.

 

Premises and Equipment, Net

 

Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the asset’s estimated useful life. Estimated lives range up to forty years for buildings and improvements and up to ten years for furniture, fixtures and equipment. Maintenance and repairs are charged to expense as incurred. Improvements that extend the lives of the respective assets are capitalized. When property or equipment is sold or otherwise disposed of, the cost and related accumulated depreciation are removed from the respective accounts and the resulting gain or loss is reflected in income.

 

Advertising

 

The Company expenses advertising costs as incurred. These expenses are reflected as marketing and public relations in the accompanying consolidated statements of operations.

 

Income Taxes

 

The provision for income taxes is based upon income or loss before taxes for financial statement purposes, adjusted for nontaxable income and nondeductible expenses. Deferred income taxes have been provided when different accounting methods have been used in determining income for income tax purposes and for financial reporting purposes. Deferred tax assets and liabilities are recognized based on future tax consequences attributable to differences arising from the financial statement carrying values of assets and liabilities and their tax bases. In the event of changes in the tax laws, deferred tax assets and liabilities are adjusted in the period of the enactment of those changes, with the cumulative effects included in the current year’s income tax provision.

 

Positions taken by the Company’s tax returns may be subject to challenge by the taxing authorities upon examination. The benefits of uncertain tax positions are initially recognized in the financial statements only when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are both initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with the tax authority, assuming full knowledge of the position and all relevant facts. The Company believes that its income tax filing positions taken or expected to be taken in its tax returns will more likely than not be sustained upon audit by the taxing authorities and does not anticipate any adjustments that will result in a material adverse impact on the Company’s financial condition, results of operations, or cash flow. Therefore, no reserves for uncertain tax positions have been recorded. The Company’s federal income tax returns were examined for the years 2008 through 2010. No changes were proposed.

 

Interest and penalties on income tax uncertainties are classified within income tax expense in the statement of operations. There were no significant interest and penalties paid on income tax uncertainties during 2015 or 2014.

 

It is management’s belief that the realization of the remaining net deferred tax assets is more likely than not. Accordingly, no additional reserve was considered necessary. See Note 13 for additional information.

Drafts Outstanding

 

The Company invests excess funds on deposit at other banks (including amounts on deposit for payment of outstanding disbursement checks) on a daily basis in an overnight interest-bearing account. Accordingly, outstanding checks are reported as a liability.

 

Reserve for Mortgage Loan Repurchase Losses

 

The Company sells mortgage loans to various third parties, including government-sponsored entities, under contractual provisions that include various representations and warranties that typically cover ownership of the loan, compliance with loan criteria set forth in the applicable agreement, validity of the lien securing the loan, absence of delinquent taxes or liens against the property securing the loan, and similar matters. The Company may be required to repurchase the mortgage loans with identified defects, indemnify the investor or insurer, or reimburse the investor for credit loss incurred on the loan (collectively “repurchase”) in the event of a material breach of such contractual representations or warranties. Risk associated with potential repurchases or other forms of settlement is managed through underwriting and quality assurance practices and by servicing mortgage loans to meet investor and secondary market standards.

 

The Company establishes mortgage repurchase reserves related to various representations and warranties that reflect management’s estimate of losses based on a combination of factors. Such factors incorporate estimated levels of defects on internal quality assurance, default expectations, historical investor repurchase demand and appeals success rates, reimbursement by correspondent and other third party originators, changes in the regulatory repurchase framework and projected loss severity. The Company establishes a reserve at the time loans are sold and quarterly updates the reserve estimate during the estimated loan life.

 

The following table presents activity in the reserve for mortgage loan repurchase losses:

 

		December 31,
		2015				2014
		(In thousands)
Beginning Balance		$	4,999				6,109
Losses paid			(165	)			(389	)
Recoveries			42				29
Provision for mortgage repurchase losses			(1,000	)			(750	)
Ending balance		$	3,876				4,999

 

Transfers of Financial Assets

 

Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

 

Off-Balance-Sheet Financial Instruments

 

In the ordinary course of business, the Company entered into off-balance-sheet financial instruments consisting of commitments to extend credit, commitments under revolving credit agreements, and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded.

Stock Compensation Plans

 

The Company can issue stock options, restricted stock, and restricted stock units under various plans to directors, officers and other key employees. The Company accounts for its stock compensation plans in accordance with ASC Topics 718 and 505. Under those provisions, the Company has adopted a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized on a straight-line basis over the service period, which is usually the vesting period, taking into account retirement eligibility. As a result, compensation expense relating to stock options and restricted stock is reflected in net income as part of “salaries and employee benefits” on the consolidated statements of operations.

 

Earnings Per Common Share

 

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

 

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

 

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

 

On June 22, 2015, the Board of Directors of the Company declared a six-for-five stock split representing a 20% stock dividend to stockholders of record as of July 15, 2015, payable on July 31, 2015.

 

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

 

Reclassification

 

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

 

Recently Issued Accounting Pronouncements

 

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

 

In May 2014 and August 2015, the FASB issued guidance to change the recognition of revenue from contracts with customers. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. The guidance will be effective for the Company for reporting periods beginning after December 15, 2017. The Company will apply the guidance using a modified retrospective approach. The Company does not expect these amendments to have a material effect on its financial statements.

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

 

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

 

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

 

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

 

In August 2015, the FASB issued amendments to the Interest topic of the Accounting Standards Codification to clarify the SEC staff’s position on presenting and measuring debt issuance costs incurred in connection with line-of-credit arrangements. The amendments were effective upon issuance. The amendments did not have a material effect on the financial statements

 

In January 2016, the FASB amended the Financial Instruments topic of the Accounting Standards Codification to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The amendments will be effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company will apply the guidance by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The amendments related to equity securities without readily determinable fair values will be applied prospectively to equity investments that exist as of the date of adoption of the amendments. The Company does not expect these amendments to have a material effect on its financial statements.

 

In February 2016, the FASB issued new guidance to change accounting for leases and that will generally require most leases to be recognized on the balance sheet. The new lease standard only contains targeted changes to accounting by lessors, however, lessees will be required to recognize most leases in their balance sheets as lease liabilities for lease payments and right-of-use assets representing the lessee’s rights to use the underlying assets for the lease terms for lease arrangements longer than 12 months. Under this approach, a lessee will account for most existing capital/finance leases as Type A leases and most existing operating leases as Type B leases. Type A and Type B leases have unique accounting and disclosure requirements. Existing sale-leaseback guidance, including guidance for real estate, will be replaced with a new model applicable to both lessees and lessors. The new guidance will be effective for fiscal years beginning after December 15, 2018. Early adoption is permitted for all companies and organizations. Management is currently analyzing the impact of the adoption of this guidance on the Company’s consolidated financial statements, including assessing changes that might be necessary to information technology systems, processes and internal controls to capture new data and address changes in financial reporting.

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.

 

Risks and Uncertainties

 

In the normal course of its business, the Company encounters two significant types of risks: economic and regulatory. There are three main components of economic risk: interest rate risk, credit risk, and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or re-price at different speeds, or on a different basis, than its interest-earning assets. Credit risk is the risk of default on the loan portfolio or certain securities that results from borrowers’ inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of collateral underlying loans receivable and the valuation of real estate held by the Company. The Company is subject to the regulations of various governmental agencies. These regulations can and do change significantly from period to period. Periodic examinations by the regulatory agencies may subject the Company to further changes with respect to asset valuations, amounts of required loss allowances and operating restrictions from the regulators’ judgments based on information available to them at the time of their examination.

NOTE 2 – BUSINESS COMBINATION

 

On December 12, 2014, CresCom Bank purchased 13 branches from First Community Bank. In accordance with the Purchase and Assumption Agreement, dated as of August 6, 2014, by and between First Community Bank and CresCom Bank (the “P&A Agreement”), CresCom Bank acquired approximately $215.1 million of deposits, approximately $70.9 million of performing loans and the bank facilities and certain other assets of the acquired branches. In consideration of the purchased assets and transferred liabilities, CresCom Bank paid (a) the recorded investment of the loans acquired, (b) the net book value, or approximately $6.6 million, for the bank facilities and certain assets located at the acquired branches, (c) a deposit premium of 3.25% on substantially all of the deposits assumed, which equated to approximately $6.5 million. The acquisition settled by First Community Bank paying cash of $131.1 million to CresCom Bank for the difference between these amounts and the total deposits assumed.

 

The purchase was accounted for under the acquisition method in accordance with ASC 805, “Business Combinations,” and accordingly the assets and liabilities were recorded at their fair values on the date of acquisition. Determining the fair value of assets and liabilities, especially the loan portfolio, is a complicated process involving significant judgment regarding methods and assumptions used to calculate estimated fair values. Fair values are preliminary and subject to refinement for up to one year after the closing date of the acquisition as information relative to closing date fair values become available. We made no adjustments to our Day 1 fair values during 2015.

 

The following table summarizes the estimated fair values of assets acquired and liabilities assumed at the date of acquisition.

 

December 12, 2014		Acquired Book Value				Fair Value Adjustments				Amount Recorded
		(In thousands)				(In thousands)				(In thousands)
Assets
Cash and cash equivalents		$	131,135			$	—			$	131,135
Loans receivable			70,906				(940	) (1)			69,966
Premises and equipment			6,608				4,102	(2)			10,710
Accrued interest receivable			158				—				158
Core deposit intangible			—				3,175	(3)			3,175
Other assets			53				—				53
Total assets acquired		$	208,860			$	6,337			$	215,197
Liabilities
Deposits		$	215,121			$	—			$	215,121
Accrued interest payable			42				—				42
Other liabilities			34				—				34
Total liabilities assumed		$	215,197			$	—			$	215,197

 

Explanation of Fair Value Adjustments

 

(1)

The fair value adjustment on loans relates to the interest rate and credit adjustments applied to the loan portfolio. The interest rate adjustment is calculated by analyzing the gain or loss based on movements in interest rates since origination of loans within the portfolio. The credit adjustment utilizes assumptions regarding the underlying probability of default and loss given default of the loan portfolio by risk characteristics such as risk grade and segment type. The combination of these adjustments will be accreted into earnings as a yield adjustment, using the effective yield method, over the remaining life of each loan. The Company hired an independent consulting firm to assist in the determination of the fair value of the loan portfolio.

 

(2)

The fair value adjustment represents the difference between the fair value of the acquired branches and the book value of the assets acquired. The Company utilized third party appraisals to assist in the determination of the fair value.

 

(3)

The fair value adjustment represents the value of the core deposit base assumed in the acquisition based on a study performed by an independent consulting firm. This amount was recorded by the Company as an identifiable intangible asset and will be amortized as an expense on a straight-line basis over the average life of the core deposit base, which is estimated to be 10 years.

The following table presents loans acquired at the acquisition date summarized by category:

 

		At December 12, 2014
						% of Total
		Amount				Loans
		(Dollars in thousands)
Loans secured by real estate:
One-to-four family		$	20,675				29.55	%
Home equity			3,833				5.48	%
Commercial real estate			18,179				25.98	%
Construction and development			20,926				29.91	%
Consumer loans			3,220				4.60	%
Commercial business loans			3,133				4.48	%
Total loans receivable, at fair value		$	69,966				100.00	%

 

As stated in Note 1 under “Business Combination and Method of Accounting for Loans Acquired”, all identifiable assets acquired, including loans, are recorded at fair value. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk.

 

The following table presents deposits acquired at the acquisition date by type of account:

 

		At December 12, 2014
		(In thousands)
Noninterest-bearing demand accounts		$	43,910
Interest-bearing demand accounts			43,743
Savings accounts			13,715
Money market accounts			51,415
Certificates of deposit:
Less than $100,000			33,394
$100,000 or more			28,944
Total certificates of deposit			62,338
Total deposits		$	215,121

Included in non-interest expense for the period ended December 31, 2014 was approximately $1.4 million in acquisition related expenses of which $880,000 was included in Other, $90,000 was included Marketing and Public Relations, $242,000 was included in Occupancy and Equipment and $149,000 was included in Salaries and Employee Benefits.

 

As the transaction occurred on December 12, 2014, the amount of revenue and earnings included in the consolidated income statement were deemed immaterial. Furthermore, it was concluded that it would be impracticable to provide revenue and earnings of the combined entity as if the acquisition date for the business combination had been as of the beginning of the annual reporting period for several reasons. The branches acquired were only a portion of the seller’s branch network; therefore, historical and pro forma statements of revenue and earnings for the branches acquired would not accurately reflect all of the overhead and other administrative expenses associated with operating them as a stand-alone branch network. Also, the loans acquired only represent a sub-set of the loans as the remaining loans not purchased were still subject to loss-share protection (cannot be sold). Finally, the seller would not be able to provide accurate, historical information regarding the revenue and earnings of the acquired branches to facilitate appropriate presentation. As such, no historical or pro forma financial statements are provided.

On February 21, 2014, the Bank completed the acquisition of one branch in St. George from First Federal of South Carolina in a transaction that had been announced on August 28, 2013. The Bank added approximately $24.5 million in deposits and $11.2 million in loans receivable as a result of this branch acquisition. Business combination accounting resulted in an immaterial effect on the balance sheet and income statement of the Company.

 

There are two methods to account for acquired loans as part of a business combination. Acquired loans that contain evidence of credit deterioration on the date of purchase are carried at the net present value of expected future proceeds in accordance with Financial Accounting Standards Board Accounting Standards Codification (“ASC”) 310-30. All other acquired loans are recorded at their initial fair value, adjusted for subsequent advances, pay downs, amortization or accretion of any premium or discount on purchase, charge-offs and any other adjustment to carrying value in accordance with ASC 310-20. All loans acquired as part of the branch acquisitions were accounted for under ASC 310-20, as the loans acquired did not have signs of deteriorated credit and the Company expects to receive all of the contractually specified principal and interest payments.

 

NOTE 3 - CORE DEPOSIT INTANGIBLES

 

In connection with business combinations, the Company records core deposit intangibles, representing the value of the acquired core deposit base. As of December 31, 2015 and 2014, core deposit intangible was $3.0 million and $3.3 million, respectively. Core deposit intangibles are amortized straight line ranging up to ten years.

 

Amortization expense (in thousands) for core deposit intangible is expected to be as follows.

 

Year 1		$	343
Year 2			343
Year 3			343
Year 4			343
Year 5			343
Thereafter			1,246
Total		$	2,961

 

Amortization expense of $343,000 and $47,000 related to the core deposit intangible was recognized in 2015 and 2014, respectively.

NOTE 4 - SECURITIES

 

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

 

		At December 31,
		2015																2014
						Gross				Gross												Gross				Gross
		Amortized				Unrealized				Unrealized				Fair				Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				Losses				Value				Cost				Gains				Losses				Value
		(In thousands)
Securities available-for-sale:
Municipal securities		$	60,603				1,885				(13	)			62,475				43,119				1,621				(23	)			44,717
US government agencies			7,015				81				—				7,096				4,770				—				(22	)			4,748
Collateralized loan obligations			38,957				8				(207	)			38,758				25,883				11				(22	)			25,872
Mortgage-backed securities:
Agency			112,608				1,370				(123	)			113,855				122,727				2,856				(41	)			125,542
Non-agency			75,415				580				(459	)			75,536				49,936				1,065				(163	)			50,838
Total mortgage-backed securities			188,023				1,950				(582	)			189,391				172,663				3,921				(204	)			176,380
Trust preferred securities			11,374				1,145				(3,765	)			8,754				—				—				—				—
Total		$	305,972				5,069				(4,567	)			306,474				246,435				5,553				(271	)			251,717
Securities held-to-maturity:
Municipal securities		$	17,053				912				—				17,965				16,787				882				(17	)			17,652
Trust preferred securities			—				—				—				—				8,757				3,125				(2,149	)			9,733
Total		$	17,053				912				—				17,965				25,544				4,007				(2,166	)			27,385

As of December 31, 2014, the Company had all trust preferred securities classified as held-to-maturity. As a result of the implementation of the regulatory changes in risk weightings and capital deductions dictated by Basel III, the Company transferred all trust preferred securities to available-for-sale during 2015. The transfer was in accordance with ASC 320-10-25-6; therefore, management has determined the transfer out of held-to-maturity is consistent with the original designation and does not taint the remaining portfolio. The amortized cost of the securities reclassified to available-for-sale from held-to-maturity was $11.4 million. The net unrealized gains recorded in other comprehensive income during 2015 as result of this reclassification were approximately $1.0 million.

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

 

		At December 31, 2014
														Recognized in												Not Recognized
														OCI												in OCI
														Gross Unrealized												Gross Unrealized
		Purchased				Cumula-																												Estimated				Collateral-
		Face				tive				Carrying												Amortized												Fair				ization
		Value				OTTI				Value				Gains				Losses				Cost				Gains				Losses				Value				Percentage
		(In thousands)
Held-to-Maturity:
Trust Preferred Securities
Total A-Class		$	2,381				—				2,381				—				(558	)			1,823				336				(75	)			2,084				17 5% - 3 7 8%
Total B-Class			11,718				(2,635	)			9,083				—				(2,458	)			6,625				1,788				(2,074	)			6,339				9 6% - 111%
Total C-Class			2,727				(1,340	)			1,387				—				(1,078	)			309				1,001				—				1,310				9 2% - 9 2%
		$	16,826				(3,975	)			12,851				—				(4,094	)			8,757				3,125				(2,149	)			9,733

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

 

As of December 31, 2015, $0.8 million of the pooled trust preferred securities were investment grade and $8.0 million were below investment grade. As of December 31, 2014, $0.9 million of the pooled trust preferred securities were investment grade, $1.0 million were split-rated, and the remaining $6.9 million were below investment grade. In terms of risk-based capital calculation, the Company allocates additional risk-based capital to the below investment grade securities.

 

As of December 31, 2015, senior tranches represent $764,000 of the Company’s pooled securities, while mezzanine tranches represented $8.0 million. All of the $8.0 million in mezzanine tranches are still subordinate to senior tranches as the senior notes have not been paid to a zero balance. As of December 31, 2014, senior tranches represent $1.8 million of the Company’s pooled securities, while mezzanine tranches represented $7.0 million. All of the $7.0 million in mezzanine tranches are still subordinate to senior tranches as the senior notes have not been paid to a zero balance.

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

 

		2015
		Amortized				Fair
		Cost				Value
		(In thousands)
Securities available-for-sale:
One to five years		$	264				269
Six to ten years			30,453				30,736
After ten years			275,255				275,469
Total		$	305,972				306,474
Securities held-to-maturity:
One to five years		$	430				441
Six to ten years			4,397				4,482
After ten years			12,226				13,042
Total		$	17,053				17,965

The contractual maturity dates of the securities were used for this table. No estimates were made to anticipate principal repayments.

 

Sales of investment securities available-for-sale for the years ended December 31, 2015 and 2014 are as follows.

 

		For the Years
		Ended December 31,
		2015				2014
		(In thousands)
Proceeds		$	105,840				74,901
Realized gains			1,639				1,251
Realized losses			(146	)			(167	)
Total investment securities gains, net		$	1,493				1,084

At December 31, 2015, the Company has pledged $76.4 million of securities for FHLB advances. See Note 11 – Short-Term Borrowed Funds for further discussion.

 

At December 31, 2015, the Company has pledged $13.4 million of securities to secure public agency funds.

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

 

		At December 31, 2015
		Less than 12 Months												12 Months or Greater												Total
		Amortized				Fair				Unrealized				Amortized				Fair				Unrealized				Amortized				Fair				Unrealized
		Cost				Value				Losses				Cost				Value				Losses				Cost				Value				Losses
		(In thousands)
Available-for-sale:
Municipal securities		$	2,579				2,566				(13	)			—				—				—				2,579				2,566				(13	)
Collateralized loan obligations			24,289				24,130				(159	)			9,706				9,658				(48	)			33,995				33,788				(207	)
Mortgage-backed securities:
Agency			22,528				22,416				(112	)			804				793				(11	)			23,332				23,209				(123	)
Non-agency			27,724				27,432				(292	)			12,242				12,075				(167	)			39,966				39,507				(459	)
Total mortgage-backed securities			50,252				49,848				(404	)			13,046				12,868				(178	)			63,298				62,716				(582	)
Trust preferred securities			—				—				—				8,803				5,038				(3,765	)			8,803				5,038				(3,765	)
Total		$	77,120				76,544				(576	)			31,555				27,564				(3,991	)			108,675				104,108				(4,567	)

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

 

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

 

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

 

At December 31, 2015 and 2014, the Company had 45 and 26, respectively, individual investments available-for-sale that were in an unrealized loss position. The unrealized losses on the Company’s investments in US government-sponsored agencies, municipal securities, mortgage-backed securities (agency and non-agency), and trust preferred securities summarized above were attributable primarily to changes in interest rates. Management has performed various analyses, including cash flows as needed, and determined that no OTTI expense was necessary during 2015 or 2014.

 

The Company had 1 municipal security and 4 trust preferred securities within the held-to-maturity portfolio that were in an unrealized loss position at December 31, 2014. There were no securities held-to-maturity in an unrealized loss position at December 31, 2015.

 

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

 

In 2009, the Company adopted a four year “burst” scenario for its modeled default rates (2010 - 2015) that replicated the default rates for the banking industry from the four peak years of the Savings and Loan crisis, which then reduced to 0.25% annually. The last year of the elevated default rate was 2014. The constant default rate used by the Company is now 0.25% annually. All issuers that were currently in deferral were presumed to be in default. Additionally, all defaults are assumed to have a 15% recovery after two years and 1% of the pool is presumed to prepay annually. If this analysis results in a present value of expected cash flows that is less than the book value of a security (that is, a credit loss exists), an OTTI is considered to have occurred. If there is no credit loss, any impairment is considered temporary. The cash flow analysis we performed used discount rates equal to the credit spread at the time of purchase for each security and then added the current 3-month LIBOR forward interest rate curve.

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

 

The following table presents detail of non-marketable investments at December 31, 2015 and 2014.

 

		At December 31,
		2015				2014
		(In thousands)
Community Reinvestment Act fund		$	1,295				1,277
SBIC Investments			1,513				567
Investment in Statutory Business Trusts			465				465
Total other investments			3,273				2,309
Federal Home Loan Bank stock			9,919				5,405
Non-marketable investments		$	13,192				7,714

 

The Company, as a member of the FHLB, is required to own capital stock in the FHLB based generally upon a membership-based requirement and an activity-based requirement. FHLB capital stock is pledged to secure FHLB advances. No secondary market exists for this stock, and it has no quoted market price. However, redemption through the FHLB of this stock has historically been at par value.

 

For additional information regarding the investments in statutory business trust, see Note 12-Long Term Debt.

NOTE 5 – DERIVATIVES

 

In the ordinary course of business, the Company enters into various types of derivative transactions. The Company’s primary uses of derivative instruments are related to the mortgage banking activities. As such, the Company holds derivative instruments, which consist of rate lock agreements related to expected funding of fixed-rate mortgage loans to customers (interest rate lock commitments) and forward commitments to sell mortgage-backed securities and individual fixed-rate mortgage loans. The Company’s objective in obtaining the forward commitments is to mitigate the interest rate risk associated with the interest rate lock commitments and the mortgage loans that are held for sale. Derivative instruments not related to mortgage banking activities primarily relate to interest rate swap agreements.

 

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

 

		At December 31,
		2015								2014
		Fair				Notional				Fair				Notional
		Value				Value				Value				Value
		(In thousands)
Derivative assets:
Cash flow hedges:
Interest rate swaps		$	180				30,000				—				—
Non-hedging derivatives:
Mortgage loan interest rate lock commitments			1,246				143,318				1,122				106,440
Mortgage loan forward sales commitments			340				31,513				567				27,292
Mortgage-backed securities forward sales commitments			179				105,014				—				—
Total derivative assets		$	1,945				309,845				1,689				133,732
Derivative liabilities:
Non-hedging derivatives:
Interest rate swaps		$	306				10,000				530				20,000
Mortgage-backed securities forward sales commitments			—				—				506				93,000
Total derivative liabilities		$	306				10,000				1,036				113,000

 

Non-Designated Hedges

 

Derivative Loan Commitments and Forward Sales Commitments

 

The Company enters into mortgage loan commitments that are also referred to as derivative loan commitments, if the loan that will result from exercise of the commitment will be held for sale upon funding. The Company enters into commitments to fund residential mortgage loans at specified rates and times in the future, with the intention that these loans will subsequently be sold in the secondary market.

 

Outstanding derivative loan commitments expose the Company to the risk that the price of the loans arising from exercise of the loan commitment might decline from inception of the rate lock to funding of the loan due to increases in mortgage interest rates. If interest rates increase, the value of these loan commitments typically decreases. Conversely, if interest rates decrease, the value of these loan commitments typically increases.

 

To protect against the price risk inherent in derivative loan commitments, the Company utilizes both “mandatory delivery” and “best efforts” forward loan sale commitments to mitigate the risk of potential decreases in the values of loans that would result from the exercise of the derivative loan commitments.

 

With a “mandatory delivery” contract, the Company commits to deliver a certain principal amount of mortgage loans to an investor at a specified price on or before a specified date. If the Company fails to deliver the amount of mortgages necessary to fulfill the commitment by the specified date, it is obligated to pay a “pair-off” fee, based on then-current market prices, to the investor to compensate the investor for the shortfall.

With a “best efforts” contract, the Company commits to deliver an individual mortgage loan of a specified principal amount and quality to an investor if the loan to the underlying borrower closes. Generally, the price the investor will pay the seller for an individual loan is specified prior to the loan being funded (e.g., on the same day the lender commits to lend funds to a potential borrower). The Company expects that these forward loan sale commitments will experience changes in fair value opposite to the change in fair value of derivative loan commitments.

 

Derivatives related to these commitments are recorded as either a derivative asset or a derivative liability on the balance sheet and are measured at fair value. Both the interest rate lock commitments and the forward commitments are reported at fair value, with adjustments recorded in current period earnings in mortgage banking income within the noninterest income in the consolidated statements of operations.

 

Interest Rate Swaps

 

The Company enters into interest rate swaps that do not meet the hedge accounting requirements and are recorded at fair value as a derivative asset or liability. Interest rate swaps that are not designated as hedges are primarily used to more closely match the interest rate characteristics of assets and liabilities and to mitigate the risks arising from timing mismatches between assets and liabilities including duration mismatches. Fair value changes are recognized in noninterest income as “fair value adjustment on interest rate swaps”. As of December 31, 2015, the Company had two outstanding stand-alone interest rate derivatives with a notional value of $10.0 million and a weighted average remaining term of 7.18 years.

 

Cash Flow Hedges of Interest Rate Risk

 

The Company’s objectives in using certain interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.

 

The Company has entered into forward starting interest rate swaps to reduce the exposure to variability in interest-related cash outflows attributable to changes in forecasted LIBOR based FHLB borrowings. These derivative instruments are designated as cash flow hedges. The hedged item is the LIBOR portion of the series of future short-term fixed rate borrowings over the term of the interest rate swap. Accordingly, changes to the amount of interest payment cash flows for the hedged transactions attributable to a change in credit risk are excluded from our assessment of hedge effectiveness. The Company tests for hedging effectiveness on a quarterly basis. The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. The Company has not recorded any hedge ineffectiveness since inception.

 

As of December 31, 2015, the Company had two outstanding interest rate derivatives with a notional value of $30.0 million that were designated as cash flow hedges of interest rate risk with a weighted average remaining term of 9.84 years.

 

Risk Management Objective of Using Derivatives

 

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

NOTE 6 - LOANS RECEIVABLE, NET

 

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

 

		At December 31,
		2015								2014
						% of Total								% of Total
		Amount				Loans				Amount				Loans
		(Dollars in thousands)
Loans secured by real estate:
One-to-four family		$	343,686				37.23	%			252,819				32.48	%
Home equity			23,303				2.52	%			27,547				3.54	%
Commercial real estate			342,395				37.10	%			317,912				40.85	%
Construction and development			91,713				9.94	%			92,008				11.82	%
Consumer loans			5,181				0.56	%			5,675				0.73	%
Commercial business loans			116,737				12.65	%			82,305				10.58	%
Total gross loans receivable			923,015				100.00	%			778,266				100.00	%
Less:
Allowance for loan losses			10,141								9,035
Deferred fees, net			292								1,109
Total loans receivable, net		$	912,582								768,122

Included in the loan totals at December 31, 2015 and 2014 were $64.1 million and $80.2 million, respectively, in acquired loans. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk. Subsequent to the purchase date and after any credit discounts have been fully used, the methods utilized to estimate the required allowance for loan losses are the same as originated loans.

 

See Note 2 “Business Combinations” for additional information regarding acquired loans.

 

The composition of gross loans outstanding by rate type is as follows:

 

		At December 31,
		2015								2014
		(Dollars in thousands)
Variable rate loans		$	399,108				43.24	%			337,802				43.40	%
Fixed rate loans			523,907				56.76	%			440,464				56.60	%
Total loans outstanding		$	923,015				100.00	%			778,266				100.00	%

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

 

Allowance for loan losses:		At December 31, 2015
		Loans Secured by Real Estate
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				Development				Consumer				business				Unallocated				Total
		(In thousands)
Balance at January 1, 2015		$	2,888				221				3,283				1,069				30				1,430				114				9,035
Provision for loan losses			489				(220	)			(231	)			(320	)			(21	)			(3	)			306				—
Charge-offs			(1,050	)			—				—				(90	)			(20	)			(70	)			—				(1,230	)
Recoveries			576				150				350				479				38				743				—				2,336
Balance at December 31, 2015		$	2,903				151				3,402				1,138				27				2,100				420				10,141
		At December 31, 2014
		Loans Secured by Real Estate
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				Development				Consumer				business				Unallocated				Total
		(In thousands)
Balance at January 1, 2014		$	2,472				231				2,855				1,418				42				339				734				8,091
Provision for loan losses			338				(10	)			356				(634	)			(59	)			629				(620	)			—
Charge-offs			(80	)			—				(28	)			(172	)			(24	)			(59	)			—				(363	)
Recoveries			158				—				100				457				71				521				—				1,307
Balance at December 31, 2014		$	2,888				221				3,283				1,069				30				1,430				114				9,035

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

 

		Loans Secured by Real Estate
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				Development				Consumer				business				Unallocated				Total
		(In thousands)
At December 31, 2015:
Allowance for loan losses ending balances:
Individually evaluated for impairment		$	15				—				343				120				—				9				—				487
Collectively evaluated for impairment			2,888				151				3,059				1,018				27				2,091				420				9,654
		$	2,903				151				3,402				1,138				27				2,100				420				10,141
Loans receivable ending balances:
Individually evaluated for impairment		$	3,968				—				12,499				500				65				482				—				17,514
Collectively evaluated for impairment			339,718				23,303				329,896				91,213				5,116				116,255				—				905,501
Total loans receivable		$	343,686				23,303				342,395				91,713				5,181				116,737				—				923,015
At December 31, 2014:
Allowance for loan losses ending balances:
Individually evaluated for impairment		$	364				—				30				90				1				—				—				485
Collectively evaluated for impairment			2,524				221				3,253				979				29				1,430				114				8,550
		$	2,888				221				3,283				1,069				30				1,430				114				9,035
Loans receivable ending balances:
Individually evaluated for impairment		$	3,249				63				11,606				267				30				1,730				—				16,945
Collectively evaluated for impairment			249,570				27,484				306,306				91,741				5,645				80,575				—				761,321
Total loans receivable		$	252,819				27,547				317,912				92,008				5,675				82,305				—				778,266

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

 

		At and for the Year Ended December 31, 2015
						Unpaid								Average				Interest
		Recorded				Principal				Related				Recorded				Income
		Investment				Balance				Allowance				Investment				Recognized
		(In thousands)
With no related allowance recorded:
Loans secured by real estate:
One-to-four family		$	3,175				5,572				—				3,106				225
Home equity			—				28				—				59				32
Commercial real estate			10,681				11,226				—				11,003				698
Construction and development			25				1,863				—				225				1
Consumer loans			65				362				—				181				40
Commercial business loans			473				1,668				—				1,304				208
			14,419				20,719				—				15,878				1,204
With an allowance recorded:
Loans secured by real estate:
One-to-four family			793				793				15				522				25
Home equity			—				—				—				—				—
Commercial real estate			1,818				1,818				343				838				24
Construction and development			475				475				120				245				12
Consumer loans			—				—				—				—				—
Commercial business loans			9				9				9				66				3
			3,095				3,095				487				1,671				64
Total:
Loans secured by real estate:
One-to-four family			3,968				6,365				15				3,628				250
Home equity			—				28				—				59				32
Commercial real estate			12,499				13,044				343				11,841				722
Construction and development			500				2,338				120				470				13
Consumer loans			65				362				—				181				40
Commercial business loans			482				1,677				9				1,370				211
		$	17,514				23,814				487				17,549				1,268

		At and for the Year Ended December 31, 2014
						Unpaid								Average				Interest
		Recorded				Principal				Related				Recorded				Income
		Investment				Balance				Allowance				Investment				Recognized
		(In thousands)
With no related allowance recorded:
Loans secured by real estate:
One-to-four family		$	2,008				3,731				—				5,144				128
Home equity			63				410				—				4				1
Commercial real estate			11,346				11,892				—				16,939				1,293
Construction and development			—				1,733				—				348				(26	)
Consumer loans			29				506				—				23				11
Commercial business loans			1,730				2,927				—				2,405				275
			15,176				21,199				—				24,863				1,682
With an allowance recorded:
Loans secured by real estate:
One-to-four family			1,241				1,241				364				673				29
Home equity			—				—				—				—				—
Commercial real estate			260				260				30				265				19
Construction and development			267				267				90				184				1
Consumer loans			1				1				1				4				1
Commercial business loans			—				—				—				—				—
			1,769				1,769				485				1,126				50
Total:
Loans secured by real estate:
One-to-four family			3,249				4,972				364				5,817				157
Home equity			63				410				—				4				1
Commercial real estate			11,606				12,152				30				17,204				1,312
Construction and development			267				2,000				90				532				(25	)
Consumer loans			30				507				1				27				12
Commercial business loans			1,730				2,927				—				2,405				275
		$	16,945				22,968				485				25,989				1,732

The Company was not committed to advance additional funds in connection with impaired loans as of December 31, 2015 or 2014.

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

 

		At December 31, 2015
		Real estate loans
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				Development				Consumer				business				Total
		(In thousands)
30-59 days past due		$	—				—				—				—				1				50				51
60-89 days past due			275				—				182				—				—				—				457
90 days or more past due			1,960				—				235				499				25				—				2,719
Total past due			2,235				—				417				499				26				50				3,227
Current			341,451				23,303				341,978				91,214				5,155				116,687				919,788
Total loans receivable		$	343,686				23,303				342,395				91,713				5,181				116,737				923,015
		At December 31, 2014
		Real estate loans
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				Development				Consumer				business				Total
		(In thousands)
30-59 days past due		$	336				18				260				60				21				27				722
60-89 days past due			188				—				—				—				6				—				194
90 days or more past due			1,589				—				333				267				6				—				2,195
Total past due			2,113				18				593				327				33				27				3,111
Current			250,706				27,529				317,319				91,681				5,642				82,278				775,155
Total loans receivable		$	252,819				27,547				317,912				92,008				5,675				82,305				778,266

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

 

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

 

		At December 31,
		2015				2014
		(In thousands)
Loans secured by real estate:
One-to-four family		$	2,032				1,720
Home equity			—				63
Commercial real estate			1,686				333
Construction and development			499				267
Consumer loans			50				12
Commercial business loans			35				39
		$	4,302				2,434

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

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

 

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

 

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

 

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

 

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

 

The Company uses the following definitions:

 

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

 

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

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

 

		At December 31, 2015
		Real estate loans
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				Development				Consumer				business				Total
		(In thousands)
Internal Risk Rating Grades:
Pass		$	340,905				23,303				332,320				91,051				5,133				115,664				908,376
Special Mention			535				—				8,242				172				—				919				9,868
Substandard			2,246				—				1,833				490				48				154				4,771
Total loans receivable		$	343,686				23,303				342,395				91,713				5,181				116,737				923,015
Performing		$	341,654				23,303				340,709				91,214				5,131				116,702				918,713
Nonperforming:
90 days or more and still accruing			—				—				—				—				—				—				—
Nonaccrual			2,032				—				1,686				499				50				35				4,302
Total nonperforming			2,032				—				1,686				499				50				35				4,302
Total loans receivable		$	343,686				23,303				342,395				91,713				5,181				116,737				923,015
		At December 31, 2014
		Real estate loans
		One-to-								Commercial				Construction
		four				Home				real				and								Commercial
		family				equity				estate				Development				Consumer				business				Total
		(In thousands)
Internal Risk Rating Grades:
Pass		$	249,781				27,484				307,283				91,441				5,662				81,499				763,150
Special Mention			1,318				—				10,037				300				1				217				11,873
Substandard			1,720				63				592				267				12				589				3,243
Total loans receivable		$	252,819				27,547				317,912				92,008				5,675				82,305				778,266
Performing		$	251,099				27,484				317,579				91,741				5,663				82,266				775,832
Nonperforming:
90 days or more and still accruing			—				—				—				—				—				—				—
Nonaccrual			1,720				63				333				267				12				39				2,434
Total nonperforming			1,720				63				333				267				12				39				2,434
Total loans receivable		$	252,819				27,547				317,912				92,008				5,675				82,305				778,266

Activity in loans to officers, directors and other related parties for the years ended December 31, 2015 and 2014 is summarized as follows:

 

		At December 31,
		2015				2014
		(In thousands)
Balance at beginning of year		$	12,233				12,932
New loans			5,986				3,735
Repayments			(6,352	)			(4,434	)
Balance at end of year		$	11,867				12,233

 

In management’s opinion, related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with an unrelated person and generally do not involve more than the normal risk of collectability.

 

Loans serviced for the benefit of others under loan participation arrangements amounted to $1.5 million and $1.7 million at December 31, 2015 and 2014, respectively.

 

Troubled Debt Restructurings

 

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

 

During the year ended December 31, 2014, one commercial business loan was designated as a troubled debt restructuring due to a modification to extend terms on the note. The pre-modification and post-modification balance was $589,000.

 

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

 

At December 31, 2015, there were $13.3 million in loans designated as troubled debt restructurings of which $13.2 million were accruing. At December 31, 2014, there were $14.3 million in loans designated as troubled debt restructurings of which $14.3 million were accruing.

NOTE 7 - PREMISES AND EQUIPMENT, NET

 

Premises and equipment, net at December 31, 2015 and 2014 consists of the following:

 

		At December 31,
		2015				2014
		(In thousands)
Land		$	8,735				7,859
Buildings			20,772				19,311
Furniture, fixtures and equipment			13,300				12,437
Construction in process			110				678
Total premises and equipment			42,917				40,285
Less: accumulated depreciation			(10,355	)			(9,210	)
Premises and equipment, net		$	32,562				31,075

Depreciation expense included in operating expenses for the years ended December 31, 2015 and 2014 amounted to $1.8 million and $1.2 million, respectively. Remaining estimated costs for completion of the construction in process are expected to be approximately $50,000. There was no interest capitalized during fiscal 2015 and 2014.

 

NOTE 8 – REAL ESTATE ACQUIRED THROUGH FORECLOSURE

 

Transactions in other real estate owned for the years ended December 31, 2015 and 2014 are summarized below:

 

		At December 31,
		2015				2014
		(In thousands)
Balance at beginning of year		$	3,239				6,273
Additions			1,307				1,461
Sales			(2,172	)			(3,969	)
Write downs			—				(526	)
Balance at end of year		$	2,374				3,239

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

 

		At December 31,
		2015				2014
		(In thousands)
Real estate loans:
One-to-four family		$	773				245
Commercial real estate			484				954
Construction and development			1,117				2,040
		$	2,374				3,239

NOTE 9 – MORTGAGE SERVICING RIGHTS

 

Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The value of mortgage servicing rights is included on the Company’s consolidated balance sheets. The unpaid principal balances of loans serviced for others were $2.0 billion and $1.9 billion, respectively, at December 31, 2015 and 2014.

 

The economic estimated fair values of mortgage servicing rights were $17.6 million and $15.7 million, respectively, at December 31, 2015 and 2014.

 

The estimated fair value of servicing rights at December 31, 2015 were determined using a net servicing fee of 0.26%, discount rates ranging from 11.86% to 12.86%, constant prepayment rate (“CPR”) from 7.93% to 8.82%, depending upon the stratification of the specific servicing right, and a weighted average delinquency rate of 1.36% as determined by a third party. The estimated fair value of servicing rights at December 31, 2014 were determined using a net servicing fee of 0.26%, discount rates ranging from 11.73% to 12.73%, constant prepayment rate (“CPR”) ranging from 10.00% to 11.10%, depending upon the stratification of the specific servicing right, and a weighted average delinquency rate of 1.35% as determined by a third party.

 

During 2014, servicing rights related to approximately $147.7 million of unpaid loan principal serviced for others were sold resulting in a net gain on sale of $775,000. No servicing rights previously held were sold in 2015.

 

The following summarizes the activity in mortgage servicing rights, along with the aggregate activity in the related valuation allowances, for the years ended December 31, 2015 and 2014:

 

		December 31,
		2015				2014
		(In thousands)
MSR beginning balance		$	10,181				10,908
Amount capitalized			3,238				1,868
Amount sold			—				(800	)
Amount amortized			(1,986	)			(1,795	)
MSR ending balance		$	11,433				10,181

There was no allowance for loss in fair value in mortgage servicing rights for the years ended December 31, 2015 and 2014.

 

Estimated amortization expense is presented below for the following subsequent years ended (in thousands):

 

Year 1		$	2,115
Year 2			2,115
Year 3			1,829
Year 4			1,591
Year 5			1,514
After Year 5			2,269
Total		$	11,433

The estimated amortization expense is based on current information regarding future loan payments and prepayments. Amortization expense could change in future periods based on changes in the volume of prepayments and economic factors.

 

At December 31, 2015 and 2014, servicing related impound funds of approximately $22.8 million, and $26.1 million, respectively, representing both principal and interest due investors and escrows received from borrowers, are on deposit in custodial accounts and are included in noninterest-bearing deposits in the accompanying financial statements.

 

At December 31, 2015 and 2014, the Company had blanket bond and errors and omissions coverages of $5.0 million each.

NOTE 10 - DEPOSITS

 

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

 

		At December 31,
		2015				2014
		(In thousands)
Noninterest-bearing demand accounts		$	163,054				142,900
Interest-bearing demand accounts			158,581				183,550
Savings accounts			39,147				36,630
Money market accounts			223,906				246,116
Certificates of deposit:
Less than $250,000			428,067				335,740
$250,000 or more			18,773				19,254
Total certificates of deposit			446,840				354,994
Total deposits		$	1,031,528				964,190

The aggregate amount of brokered certificates of deposit was $97.1 million and $77.3 million at December 31, 2015 and 2014, respectively. Brokered certificates of deposit are included in the table above under certificates of deposit less than $250,000. The aggregate amount of institutional certificates of deposit was $51.5 million and $44.8 million at December 31, 2015 and 2014, respectively.

 

The amounts and scheduled maturities of certificates of deposit at December 31, 2015 and 2014 are as follows:

 

		At December 31,
		2015				2014
		(In thousands)
Maturing within one year		$	231,315				157,849
Maturing one through three years			131,625				96,029
Maturing after three years			83,900				101,116
		$	446,840				354,994

Included in the schedules above were deposits assumed as part of branch acquisitions during 2014. See Note 2 “Business Combinations” for further details regarding the types and balances of deposits assumed.

 

The Company has pledged $13.4 million of securities as of December 31, 2015 to secure public agency funds.

NOTE 11 – SHORT-TERM BORROWED FUNDS

 

Short-term borrowed funds at December 31, 2015 and 2014 are summarized as follows:

 

		At December 31,
		2015						2014
						Interest						Interest
		Balance				Rate		Balance				Rate
		(Dollars in thousands)
Short-term FHLB advances		$	120,000			0.28%-0.64%			57,500			0.19%-0.56%
Subordinated debenture, due 2015			—			—			300			2.68%
Total short-term borrowed funds		$	120,000						57,800

Lines of credit with the FHLB are based upon FHLB-approved percentages of Bank assets, but must be supported by appropriate collateral to be available. The Company has pledged first lien residential mortgage, second lien residential mortgage, residential home equity line of credit, commercial mortgage and multifamily mortgage portfolios under blanket lien agreements resulting in approximately $273.6 million of collateral for these advances. In addition, at December 31, 2015, the Company has pledged securities with a fair value of $76.4 million for these advances. At December 31, 2015, the Company had FHLB advances of $208 million outstanding with excess collateral pledged to the FHLB during those periods that would support additional borrowings of approximately $77.4 million.

 

Lines of credit with the Federal Reserve Bank (“FRB”) are based on collateral pledged. The Company has pledged approximately $168.5 million of certain non-mortgage commercial, acquisition and development, and lot loan portfolios under blanket lien agreements to the FRB. At December 31, 2015 the Company had lines available with the FRB for $84.3 million. At December 31, 2015 the Company had no FRB advances outstanding.

NOTE 12 – LONG-TERM DEBT

 

Long-term debt at December 31, 2015 and 2014 are summarized as follows:

 

		December 31, 2015
						Interest
		Balance				Rate
		(Dollars in thousands)
Long-term FHLB advances, due 2017 through 2021		$	88,000				0.35%-4.00	%
Subordinated debentures issued to Carolina Financial Capital Trust I, due 2032			5,155				3.75	%
Subordinated debentures issued to Carolina Financial Capital Trust II, due 2034			10,310				3.38	%
Total long-term debt		$	103,465
		December 31, 2014
						Interest
		Balance				Rate
		(Dollars in thousands)
Long-term FHLB advances, due 2016 through 2021		$	45,000				1.20%-4.00	%
Subordinated debentures, due 2016 through 2020			1,275				2.68	%
Subordinated debentures issued to Carolina Financial Capital Trust I, due 2032			5,155				3.75	%
Subordinated debentures issued to Carolina Financial Capital Trust II, due 2034			10,310				3.28	%
Total long-term debt		$	61,740

The following table presents the scheduled repayments of long-term debt as of December 31, 2015.

 

2016		$	—
2017			45,000
2018			18,000
2019			5,000
2020			—
Thereafter			35,465
Total		$	103,465

As of December 31, 2015, there were no principal amounts callable by the FHLB on advances.

 

At December 31, 2015 and 2014, statutory business trusts (“Trusts”) created by the Company had outstanding trust preferred securities with an aggregate par value of $15.0 million. The trust preferred securities have floating interest rates ranging from 3.38% to 3.75% at December 31, 2015 and maturities ranging from December 31, 2032 to January 7, 2034. The principal assets of the Trusts are $15.5 million of the Company’s subordinated debentures with identical rates of interest and maturities as the trust preferred securities. The Trusts have issued $465,000 of common securities to the Company.

 

The trust preferred securities, the assets of the Trusts and the common securities issued by the Trusts are redeemable in whole or in part beginning on or after December 31, 2008, or at any time in whole but not in part from the date of issuance on the occurrence of certain events. The obligations of the Company with respect to the issuance of the trust preferred securities constitutes a full and unconditional guarantee by the Company of the Trusts’ obligations with respect to the trust preferred securities. Subject to certain exceptions and limitations, the Company may elect from time to time to defer subordinated debenture interest payments, which would result in a deferral of distribution payments on the related trust preferred securities.

As currently defined by the FRB, the Company had $15.0 million of long-term debt that qualified as Tier 1 capital at December 31, 2015 and 2014. The Company had $675,000 of long-term debt that qualified as Tier 2 capital at December 31, 2014. There was no long-term debt that qualified as Tier 2 capital at December 31, 2015.

 

NOTE 13 - INCOME TAXES

 

Income tax expense for the years ended December 31, 2015 and 2014 consists of the following:

 

		For the Years
		Ended December 31,
		2015				2014
		(In thousands)
Current income tax expense
Federal		$	6,722				2,331
State			645				229
			7,367				2,560
Deferred income tax expense (benefit)
Federal			(307	)			752
State			—				136
			(307	)			888
Total income tax expense		$	7,060				3,448

A reconciliation from expected Federal tax expense to actual income tax expense for the years ended December 31, 2015 and 2014 using the base federal tax rates of 35% follows:

 

		For the Years
		Ended December 31,
		2015				2014
		(In thousands)
Computed federal income taxes		$	7,518				4,116
State income tax, net of federal benefit			391				190
Tax exempt interest			(731	)			(497	)
Change in valuation allowance			44				73
Cash surrender value of life insurance			(254	)			(256	)
Other, net			92				(178	)
Total income tax expense		$	7,060				3,448

The following is a summary of the tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31, 2015 and 2014:

 

		At December 31,
		2015				2014
		(In thousands)
Deferred tax assets:
Loan loss reserve		$	3,722				3,204
Tax vs. book gain on loans held for sale			13				46
Debt issuance costs			85				86
Net operating loss carryforwards			289				246
Reserve for mortgage repurchase losses			1,448				1,827
OREO write-downs			264				368
Stock based compensation			295				144
Loan fees			(56	)			171
Reserve for miscellaneous losses			209				223
Other			947				392
			7,216				6,707
Valuation allowance			(289	)			(245	)
Total gross deferred tax assets			6,927				6,462
Deferred tax liabilities:
Depreciation			(1,454	)			(1,296	)
Unrealized gain on securities available for sale			(200	)			(451	)
Total gross deferred tax liabilities			(1,654	)			(1,747	)
Deferred tax assets, net		$	5,273				4,715

 

Deferred tax assets are recognized for future deductible amounts resulting from differences in the financial statement and tax bases of assets and liabilities and operating loss carry forwards. A valuation allowance is then established to reduce that deferred tax asset to the level that it is “more likely than not” that the tax benefit will be realized. The realization of a deferred tax benefit by the Company depends upon having sufficient taxable income of an appropriate character in the future periods.

 

A portion of the annual change in the net deferred income tax asset relates to unrealized gains and losses on debt and equity securities. The deferred income tax (benefit) related to the unrealized gains and losses on debt and equity securities of ($251,000) and $1.8 million for the years ended December 31, 2015 and 2014, respectively, was recorded directly to stockholders’ equity as a component of accumulated other comprehensive income. The balance of the change in the net deferred tax asset of $307,000 of deferred tax and $888,000 of deferred tax for the years ended December 31, 2015 and 2014, respectively, is reflected as a deferred income tax expense in the consolidated statement of operations. The valuation allowances relate to state net operating loss carry-forwards. It is management’s belief that the realization of the remaining net deferred tax assets is more likely than not. The Company’s federal income tax returns were examined for the years 2008 through 2010. No changes were proposed. Tax returns for 2012 and subsequent years are subject to examination by taxing authorities. The Company has analyzed the tax positions taken or expected to be taken on its tax returns and concluded it has no liability related to uncertain tax positions in accordance with ASC Topic 740.

NOTE 14 - COMMITMENTS AND CONTINGENCIES

 

The Company has entered into agreements to lease certain office facilities under non-cancellable operating lease agreements expiring on various dates through the year 2021. Some of these leases provide for the payment of property taxes and insurance and contain various renewal options. The exercise of the renewal options are dependent on future events. Accordingly, the following summary does not reflect possible additional payments due if renewal options are exercised.

 

Future minimum lease payments (in thousands), by year and in the aggregate, under non-cancellable operating leases with initial or remaining terms in excess of on year are as follows:

 

Year 1		$	1,013
Year 2			870
Year 3			831
Year 4			568
Year 5			458
After Year 5			69
Total		$	3,809

The Company’s rental expense for its office facilities for the years ended December 31, 2015, and 2014 totaled $1.0 million, and $729,000, respectively

 

In the course of ordinary business, the Company is, from time to time, named a party to legal actions and proceedings, primarily related to the collection of loans and foreclosed assets. In accordance with generally accepted accounting principles, the Company establishes reserves for litigation and regulatory matters when those matters present loss contingencies that are both probable and estimable. When loss contingencies are not both probable and estimable, the Company does not establish reserves.

 

NOTE 15 – STOCK-BASED COMPENSATION

 

Compensation cost is recognized for stock options and restricted stock awards issued to employees. Compensation cost is measured as the fair value of these awards on their date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used as the fair value of restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period for stock option awards and as the restriction period for restricted stock awards. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.

 

On January 15, 2015, the Board of Directors of the Company declared a two-for-one stock split to stockholders of record dated February 10, 2015, payable on February 28, 2015.

 

On October 15, 2015, the Board of Directors of the Company declared an additional two-for-one stock split to stockholders of record as of October 31, 2015, payable on November 14, 2015.

 

On June 22, 2015, the Board of Directors of the Company declared a six-for-five stock split representing a 20% stock dividend to stockholders of record as of July 15, 2015, payable on July 31, 2015.

 

All share, earnings per share, and per share data have been retroactively adjusted to reflect this stock split for all periods presented in accordance with generally accepted accounting principles. In addition, all stock options and restricted stock awards have been retroactively adjusted for the stock splits.

The Company has adopted the 2002 Stock Option Plan for issuance by the Company upon the grant of stock options or limited rights, of which 3,360 are outstanding. The plan provided for the grant of options to key employees and Directors as determined by the Board of Directors. No additional options can be awarded under this plan and all options have vested. The options vest ratably over a five-year period and have a ten-year term, both of which begin at the date of grant.

 

The Company adopted the 2006 Recognition and Retention Plan under which an aggregate of 288,000 shares of common stock have been reserved for issuance by the Company. The plan provides for the grant of stock to key employees and Directors of the Company and its subsidiaries. The non-vested common stock vests ratably over a five-year period. No restricted common stock of the Company was granted during fiscal 2014 and 2015 from this plan. As of December 31, 2015, a total of 271,200 shares have been awarded under the plan, of which all have vested.

 

The Company has adopted a 2013 Equity Incentive Plan under which an aggregate of 1,200,000 shares of common stock have been reserved for issuance by the Company. The plan provides for the grant of stock options and restricted stock awards to our officers, employees, directors, advisors, and consultants. The options are granted at an exercise price at least equal to the fair value of the common stock at the date of grant and expire ten years from the date of the grant. The vesting period for both option grants, restricted stock grants, and restricted stock units will vary based on the timing of the grant. As of December 31, 2015 a total of 453,022 shares were remaining in the plan to be issued.

 

The expense recognition of employee stock option, restricted stock awards, and restricted stock units resulted in net expense of approximately $874,000, and $617,000 during the twelve months ended December 31, 2015, and 2014, respectively.

 

Information regarding the 2015 grants as well as other relevant disclosure related to the share-based compensation plans of the Company is presented below.

 

Stock Options

 

Activity in the Company’s stock option plans is summarized in the following table. All information has been retroactively adjusted for stock splits.

 

		At and For the Years Ended December 31,
		2015								2014
						Weighted								Weighted
						Average								Average
						Exercise								Exercise
		Shares				Price				Shares				Price
Outstanding at beginning of year			148,881			$	4.53				153,633			$	4.33
Granted			56,705				11.68				6,576				8.54
Exercised			(14,016	)			3.46				(11,328	)			4.72
Forfeited or expired			—				—				—				—
Outstanding at end of year			191,570			$	6.61				148,881			$	4.53
Options exercisable at end of year			131,578			$	4.37				79,841			$	4.48

The aggregate intrinsic value of 191,570 and 148,881 stock options outstanding at December 31, 2015 and 2014 was $2.1 million and $1.1 million, respectively. The aggregate intrinsic value of 131,578 and 79,841 stock options exercisable at December 31, 2015 and 2014 was $1.8 million and $574,000, respectively. Intrinsic value represents the amount by which the fair market value of the underlying stock exceeds the exercise price of the stock option.

Information pertaining to options outstanding at December 31, 2015 and 2014, is as follows:

 

				At December 31, 2015
				Options Outstanding												Options Exercisable
								Weighted Avg.				Weighted								Weighted
				Number				Remaining Years				Average				Number				Average
Exercise Prices				Outstanding				Contractual Life				Exercise Price				Outstanding				Exercise Price
$	4.17				124,930				7.3			$	4.17				124,930			$	4.17
$	8.03				3,360				0.8				8.03				3,360				8.03
$	8.54				6,576				8.3				8.54				3,288				8.54
$	11.58				55,504				9.1				11.58				—				—
$	16.19				1,200				9.6				16.19				—				—
					191,570				7.8			$	6.61				131,578			$	4.37
				At December 31, 2014
				Options Outstanding												Options Exercisable
								Weighted Avg.				Weighted								Weighted
				Number				Remaining Years				Average				Number				Average
Exercise Prices				Outstanding				Contractual Life				Exercise Price				Outstanding				Exercise Price
$	4.17				124,930				8.3			$	4.17				62,465			$	4.17
$	5.00				14,015				0.4				5.00				14,016				5.00
$	8.03				3,360				1.8				8.03				3,360				8.03
$	8.54				6,576				9.3				8.54				—				8.54
					148,881				7.5			$	4.53				79,841			$	4.48

The fair value of options is estimated at the date of grant using the Black-Scholes option pricing model and expensed over the options’ vesting period. The following weighted-average assumptions were used in valuing options issued during 2015 and 2014:

 

		2015				2014
Dividend yield			1	%			1	%
Expected life			6 years				8 years
Expected volatility			32	%			32	%
Risk-free interest rate			1.51	%			2.42	%

As of December 31, 2015, there was $148,000 of total unrecognized compensation cost related to non-vested stock option grants under the plans. The cost is expected to be recognized over a weighted-average period of 1.84 years as of December 31, 2015.

 

Restricted Stock Grants

 

The Company from time-to-time also grants shares of restricted stock to key employees and non-employee directors. These awards help align the interests of these employees and directors with the interests of the stockholders of the Company by providing economic value directly related to increases in the value of the Company’s stock. These awards typically hold service requirements over various vesting periods. The value of the stock awarded is established as the fair market value of the stock at the time of the grant. The Company recognizes expense, equal to the total value of such awards, ratably over the vesting period of the stock grants.

All restricted stock agreements are conditioned upon continued employment. Termination of employment prior to a vesting date, as described below, would terminate any interest in non-vested shares. Prior to vesting of the shares, as long as employed by the Company, the key employees and non-employee directors will have the right to vote such shares and to receive dividends paid with respect to such shares. All restricted shares will fully vest in the event of change in control of the Company.

 

Nonvested restricted stock for the year ended December 31, 2015 and 2014 is summarized in the following table. All information has been retroactively adjusted for stock splits.

 

		At and For the Years Ended December 31,
		2015								2014
						Weighted								Weighted
						Average								Average
						Grant- Date								Grant- Date
Restricted stock grants		Shares				Fair Value				Shares				Fair Value
Nonvested at January 1			352,680			$	4.86				411,840			$	4.41
Granted			48,890				12.05				73,274				8.62
Vested			(104,365	)			5.54				(130,034	)			5.83
Forfeited			(11,400	)			4.94				(2,400	)			4.17
Nonvested at December 31			285,805			$	5.87				352,680			$	4.86

The vesting schedule of these shares as of December 31, 2015 is as follows:

 

		Shares
2016			101,535
2017			151,435
2018			25,835
2019			7,000
2020			—
Thereafter			—
			285,805

As of December 31, 2015, there was $966,000 of total unrecognized compensation cost related to nonvested restricted stock granted under the plans. The cost is expected to be recognized over a weighted-average period of 1.7 years as of December 31, 2015.

 

Restricted Stock Units

 

The Company from time-to-time also grants performance restricted stock units (“RSUs”) to key employees. These awards help align the interests of these employees with the interests of the shareholders of the Company by providing economic value directly related to the performance of the Company. Performance RSU grants contain a two year performance period. The Company communicates the specific threshold, target, and maximum performance RSU awards and performance targets to the applicable key employees at the beginning of a performance period. Dividends are not paid in respect to the awards and the holder does not have the right to vote the shares during the performance period. The value of the RSUs awarded is established as the fair market value of the stock at the time of the grant. The Company recognizes expenses on a straight-line basis typically over the period the performance target is to be achieved.

Nonvested RSUs for the year ended December 31, 2015 is summarized in the following table.

 

		At and For the Years Ended
		December 31, 2015
						Weighted
						Average
						Grant- Date
Restricted stock units		Shares				Fair Value
Nonvested at January 1			—			$	—
Granted			25,392				11.58
Vested			—				—
Forfeited			(480	)			11.58
Nonvested at December 31			24,912			$	11.58

As of December 31, 2015, there was $151,000 of total unrecognized compensation cost related to nonvested RSUs granted under the plan. This cost is expected to be recognized over a weighted-average period of 1.0 years as of December 31, 2015. There were no RSUs granted prior to 2015.

NOTE 16 – ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS

 

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

 

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

 

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

 

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

 

Level 1

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

 

Level 2

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

 

Level 3

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

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

 

Interest-bearing cash - The carrying amount of these financial instruments approximates fair value.

 

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

 

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

 

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

 

Loans receivable - The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Further adjustments are made to reflect current market conditions. There is no discount for liquidity included in the expected cash flow assumptions. Loans receivable are classified within Level 3 of the valuation hierarchy.

 

Accrued interest receivable - The fair value approximates the carrying value.

 

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

 

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

 

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

 

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

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

 

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

 

Derivative instruments not related to mortgage banking activities interest rate swap agreements. Fair values for these instruments are based on quoted market prices, when available. As such, the fair value adjustments for derivatives with fair values based on quoted market prices are recurring Level 1.

 

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

 

Accrued interest payable - The fair value approximates the carrying value.

 

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

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

 

		At December 31, 2015
		Carrying				Fair Value
		Amount				Total				Level 1				Level 2				Level 3
		(In thousands)
Financial assets:
Cash and due from banks		$	10,206				10,206				10,206				—				—
Interest-bearing cash			16,421				16,421				16,421				—				—
Securities available for sale			306,474				306,474				—				306,474				—
Securities held to maturity			17,053				17,965				—				17,965				—
Federal Home Loan Bank stock			9,919				9,919				—				—				9,919
Other investments			3,273				3,273				—				—				3,273
Derivative assets			1,945				1,945				180				1,765				—
Loans held for sale			41,774				41,774				—				41,774				—
Loans receivable, net			912,582				917,043				—				—				917,043
Cash value life insurance			28,082				28,082				—				28,082				—
Accrued interest receivable			4,333				4,333				—				4,333				—
Mortgage servicing rights			11,433				17,564				—				17,564				—
Financial liabilities:
Deposits			1,031,528				1,029,406				—				1,029,406				—
Short-term borrowed funds			120,000				119,880				—				119,880				—
Long-term debt			103,465				105,551				—				105,551				—
Derivative liabilities			306				306				306				—				—
Accrued interest payable			333				333				—				333				—
		At December 31, 2014
		Carrying				Fair Value
		Amount				Total				Level 1				Level 2				Level 3
		(In thousands)
Financial assets:
Cash and due from banks		$	10,453				10,453				10,453				—				—
Interest-bearing cash			10,694				10,694				10,694				—				—
Securities available-for-sale			251,717				251,717				—				251,717				—
Securities held-to-maturity			25,544				27,385				—				17,652				9,733
Federal Home Loan Bank stock			5,405				5,405				—				—				5,405
Other investments			2,309				2,309				—				—				2,309
Derivative assets			1,689				1,689				—				1,689				—
Loans held for sale			40,912				39,729				—				39,729				—
Loans receivable, net			768,122				785,109				—				—				785,109
Cash value life insurance			21,532				21,532				—				21,532				—
Accrued interest receivable			3,628				3,628				—				3,628				—
Mortgage servicing rights			10,181				15,730				—				15,730				—
Financial liabilities:
Deposits			964,190				962,763				—				962,763				—
Short-term borrowed funds			57,800				57,745				—				57,745				—
Long-term debt			61,740				65,516				—				65,516				—
Derivative liabilities			1,036				1,036				530				506				—
Accrued interest payable			312				312				—				312				—

		At December 31,
		2015								2014
		Notional				Estimated				Notional				Estimated
		Amount				Fair Value				Amount				Fair Value
		(In thousands)
Off-Balance Sheet Financial Instruments:
Commitments to extend credit		$	70,365				—				68,181				—
Standby letters of credit			1,357				—				1,982				—

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

 

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

 

Investment Securities Available-for-sale

 

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

 

Mortgage loans held for sale

 

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

 

Impaired Loans

 

Loans that are considered impaired are recorded at fair value on a non-recurring basis. Once a loan is considered impaired, the fair value is measured using one of several methods, including collateral liquidation value, market value of similar debt and discounted cash flows. Those impaired loans not requiring a specific charge against the allowance represent loans for which the fair value of the expected repayments or collateral meet or exceed the recorded investment in the loan. At December 31, 2015, substantially all of the total impaired loans were evaluated based on the fair value of the underlying collateral. Loans which are deemed to be impaired are primarily valued on a nonrecurring basis at the fair value of the underlying real estate collateral. Such fair values are obtained using independent appraisals, which the Company considers to be Level 3 inputs.

Derivative Assets and Liabilities

 

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

 

Derivative instruments not related to mortgage banking activities include interest rate swap agreements. Fair values for these instruments are based on quoted market prices, when available. As such, the fair value adjustments for derivatives with fair values based on quoted market prices in an active market are recurring Level 1.

 

Other Real Estate Owned (OREO)

 

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

 

Mortgage Servicing Rights

 

A mortgage servicing right asset represents the amount by which the present value of the estimated future net cash flows to be received from servicing loans are expected to more than adequately compensate the Company for performing the servicing. The Company initially measures servicing assets and liabilities retained related to the sale of residential loans held for sale (“mortgage servicing rights”) at fair value, if practicable. For subsequent measurement purposes, the Company measures servicing assets and liabilities based on the lower of cost or market on a quarterly basis. The quarterly determination of fair value of servicing rights is provided by a third party and is estimated using a present value cash flow model. The most important assumptions used in the valuation model are the anticipated rate of the loan prepayments and discount rates. Although some assumptions in determining fair value are based on standards used by market participants, some are based on unobservable inputs and therefore are classified in Level 3 of the valuation hierarchy. See Note 9 for a description of inputs for fair value of servicing rights as of December 31, 2015 and 2014.

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

 

		Quoted market price				Significant other				Significant other
		in active markets				observable inputs				unobservable inputs
		(Level 1)				(Level 2)				(Level 3)
		(In thousands)
December 31, 2015
Available-for-sale investment securities:
Municipal securities		$	—				62,475				—
US government agencies			—				7,096				—
Collateralized loan obligations			—				38,758				—
Trust preferred securities							8,754
Mortgage-backed securities:
Agency			—				113,855				—
Non-agency			—				75,536				—
Loans held for sale			—				41,774				—
Derivative assets:
Cash flow hedges:
Interest rate swaps			180				—				—
Non-hedging derivatives:
Mortgage loan interest rate lock commitments			—				1,246				—
Mortgage loan forward sales commitments			—				340				—
Mortgage-backed securities forward sales commitments			—				179				—
Derivative liabilities:
Non-hedging derivatives:
Interest rate swaps			306				—				—
Total		$	486				350,013				—
December 31, 2014
Available-for-sale investment securities:
Municipal securities		$	—				44,717				—
US government agencies			—				4,748				—
Collateralized loan obligations			—				25,872
Mortgage-backed securities:
Agency			—				125,542				—
Non-agency			—				50,838				—
Loans held for sale			—				39,729				—
Derivative assets:
Non-hedging derivatives:
Mortgage loan interest rate lock commitments			—				1,122				—
Mortgage loan forward sales commitments			—				567				—
Derivative liabilities:			—				—				—
Non-hedging derivatives:
Mortgage-backed securities forward sales commitments			—				506				—
Interest rate swaps			530				—				—
Total		$	530				293,641				—

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

 

		Quoted market price				Significant other				Significant other
		in active markets				observable inputs				unobservable inputs
		(Level 1)				(Level 2)				(Level 3)
		(In thousands)
December 31, 2015
Impaired loans:
Loans secured by real estate:
One-to-four family		$	—				—				3,953
Commercial real estate			—				—				12,156
Construction and development			—				—				380
Consumer loans			—				—				65
Commercial business loans			—				—				473
Real estate owned:
One-to-four family			—				—				773
Commercial real estate			—				—				484
Construction and development			—				—				1,117
Mortgage servicing rights			—				—				17,564
Total		$	—				—				36,965
December 31, 2014
Impaired loans:
Loans secured by real estate:
One-to-four family		$	—				—				2,885
Home equity			—				—				63
Commercial real estate			—				—				11,576
Construction and development			—				—				177
Consumer loans			—				—				29
Commercial business loans			—				—				1,730
Real estate owned:
One-to-four family			—				—				245
Commercial real estate			—				—				954
Construction and development			—				—				2,040
Mortgage servicing rights			—				—				15,730
Total		$	—				—				35,429

 

The Company predominantly lends with real estate serving as collateral on a substantial majority of loans. Loans that are deemed to be impaired are primarily valued at fair values of the underlying real estate collateral.

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

 

		December 31, 2015 and 2014
				Significant		Significant Unobservable
		Valuation Technique		Observable Inputs		Inputs
Impaired Loans		Appraisal Value		Appraisals and or sales of comparable properties		Appraisals discounted 10% to 20% for sales commissions and other holding costs
Real estate owned		Appraisal Value/ Comparison Sales/ Other estimates		Appraisals and or sales of comparable properties		Appraisals discounted 10% to 20% for sales commissions and other holding costs
Mortgage Servicing Rights		Discounted cash flows		Comparable sales		Discount rates 12% - 13% - 2015 and 2014 Prepayment rate 8% - 9% - 2015 Prepayment rate 10% - 11% - 2014

 

NOTE 17 - OFF-BALANCE SHEET FINANCIAL INSTRUMENTS AND CONCENTRATIONS OF CREDIT RISK

 

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

 

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments as for on-balance sheet instruments. At December 31, 2015 and 2014, the Company had commitments to extend credit in the amount of $70.4 million and $68.2 million, respectively. At December 31, 2015 and 2014, the Company had standby letters of credit in the amount of $1.4 million and $2.0 million, respectively.

 

Standby letters of credit obligate the Company to meet certain financial obligations of its customers, if, under the contractual terms of the agreement, the customers are unable to do so. Payment is only guaranteed under these letters of credit upon the borrower’s failure to perform its obligations to the beneficiary. The Company can seek recovery of the amounts paid from the borrower and the letters of credit are generally not collateralized. Commitments under standby letters of credit are usually one year or less. At December 31, 2015, the Company has recorded no liability for the current carrying amount of the obligation to perform as a guarantor; as such amounts are not considered material. The maximum potential of undiscounted future payments related to standby letters of credit at December 31, 2015 was approximately $1.4 million.

 

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 a payment of a fee. Since commitments may expire without being drawn upon, the total commitments do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include inventory, property and equipment, residential real estate and income producing commercial properties.

 

The Company’s primary uses of derivative instruments are related to the mortgage banking activities. As such, the Company holds derivative instruments, which consist of rate lock agreements related to expected funding of fixed-rate mortgage loans to customers (interest rate lock commitments) and forward commitments to sell mortgage-backed securities and individual fixed-rate mortgage loans. The Company’s objective in obtaining the forward commitments is to mitigate the interest rate risk associated with the interest rate lock commitments and the mortgage loans that are held for sale. Derivative instruments not related to mortgage banking activities primarily relate to interest rate swap agreements.

The Company’s derivative positions are presented with discussion in Note 5 - Derivatives.

 

NOTE 18 - EMPLOYEE BENEFIT PLANS

 

The Company maintains a 401(k) plan that covers substantially all employees of CresCom Bank, Carolina Services (“CFC Participants”) and Crescent Mortgage (“CMC Participants”). Participants may contribute up to the maximum allowed by the regulation. During fiscal 2015 and 2014, the Company matched 75% of an employee’s contribution up to 6.00% of the participant’s compensation of the CFC Participants and the CMC Participants. For the years ended December 31, 2015, and 2014, the Company made matching contributions of $474,000 and $415,000, respectively.

 

The Company had an arrangement with two executives whereby the Company made payments to an insurance company on behalf of the executives. The advance is treated as a loan to the executive and the cash surrender value of the payment to the insurance company is included in other assets in the accompanying consolidated statements of financial condition. The cash surrender value of the advance at December 31, 2015 and 2014 is $253,000 and $427,000, respectively. The executive is entitled to the increase in cash value above the Company’s original cash value insurance contributions. The executive pays the Company imputed interest on the loan balance and the increase in the cash value is recorded as compensation to the executives. The insurance policy premiums are paid in full by the executives. The executive is entitled to receive a $1.0 million death benefit and the Company will receive a $1.8 million death benefit. Since the executive pays the insurance premiums, the insurance proceeds would be taxable to the Company. During 2015, one of the executives ended their participation in the plan and received their portion of the cash value.

 

The Company incurred an aggregate payment of $40,000 and $180,000 paid on behalf of the executives for the period ended December 31, 2015 and 2014, respectively.

NOTE 19 - EARNINGS PER COMMON SHARE

 

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

 

On January 15, 2015, the Board of Directors of the Company declared a two-for-one stock split to stockholders of record dated February 10, 2015, payable on February 28, 2015.

 

On October 15, 2015, the Board of Directors of the Company declared an additional two-for-one stock split to stockholders of record as of October 31, 2015, payable on November 14, 2015.

 

On June 22, 2015, the Board of Directors of the Company declared a six-for-five stock split representing a 20% stock dividend to stockholders of record as of July 15, 2015, payable on July 31, 2015.

 

All share, earnings per share, and per share data have been retroactively adjusted to reflect this stock split for all periods presented in accordance with generally accepted accounting principles.

 

The following is a summary of the reconciliation of average shares outstanding for the years ended December 31, 2015 and 2014:

 

		December 31,
		2015								2014
		Basic				Diluted				Basic				Diluted
Weighted average shares outstanding			9,537,358				9,537,358				9,314,048				9,314,048
Effect of dilutive securities			—				180,998				—				193,377
Average shares outstanding			9,537,358				9,718,356				9,314,048				9,507,425

The average market price used in calculating the dilutive securities under the treasury stock method for the years ended December 31, 2015 and 2014 $13.60 and $9.50, respectively.

 

For the years ended December 31, 2015 and 2014, 56,705 and 6,576 option shares, respectively, were excluded from the calculation of diluted earnings per share during the period because the exercise prices were greater than the average market price of the common shares, and therefore were deemed not to be dilutive.

 

The following is a summary of the reconciliation of shares issued and outstanding and unvested restricted stock awards as of December 31, 2015 and 2014 used for computing book value and tangible book value:

 

		As of December 31,
		2015				2014
Issued and outstanding shares			12,023,557				9,717,043
Less nonvested restricted stock awards			(285,805	)			(365,160	)
Period end dilutive shares			11,737,752				9,351,883

On December 14, 2015, the Company closed a public offering of 2,262,296 shares of its common stock with net proceeds of approximately $32.1 million after deducting underwriting discounts, commissions and offering expenses incurred by the Company.

NOTE 20 - CAPITAL REQUIREMENTS AND OTHER RESTRICTIONS

 

The Company and the Bank are subject to various federal and state regulatory requirements, including regulatory capital requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions that if undertaken could have a direct material effect on the Company’s and the Bank’s financial statements.

 

In 2013, federal bank regulatory agencies issued a final rule that revises their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with agreements that were reached by the Basel Committee on Banking Supervision (“Basel III”) and certain provisions of the Dodd-Frank Act.

 

The rule imposes higher risk-based capital and leverage requirements than those in place at the time the rule was issued. Specifically, the rule imposes the following minimum capital requirements:

 

●

A new Common Equity Tier 1 risk-based capital ratio of 4.5%

 

●

A Tier 1 risk-based capital ratio of 6% (increased from the previous 4% requirement),

 

●

A total risk-based capital ratio of 8% (unchanged from previous requirement),

 

●

A leverage ratio of 4% and

 

●

A new supplementary leverage ratio of 3% applicable to advanced approaches banking organizations resulting in a leverage ratio requirement of 7% for such institutions

 

The rule also includes changes in what constitutes regulatory capital, some of which are subject to a transition period. These changes include the phasing-out of certain instruments as qualifying capital. In addition, Tier 2 capital is no longer limited to the amount of Tier 1 capital included in total capital. Mortgage servicing rights, certain deferred tax assets and investments in unconsolidated subsidiaries over designated percentages of common stock are required to be deducted from capital, subject to a transition period. Finally, Common Equity Tier 1 capital includes accumulated other comprehensive income (which includes all unrealized gains and losses on available for sale debt and equity securities), subject to a transition period and a one-time opt-out election. The Bank elected to opt-out of this provision. As such, accumulated comprehensive income is not included in the Bank’s Tier 1 capital.

 

The rule also includes changes in the risk-weights of assets to better reflect credit risk and other risk exposures. These include a 150% risk weight (up from 100%) for certain high volatility commercial real estate acquisition, development and construction loans and non-residential mortgage loans that are 90 days past due or otherwise on nonaccrual status, a 20% (up from 0%) credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable, a 250% risk weight (up from 100%) for mortgage servicing rights and deferred tax assets that are not deducted from capital and increased risk-weights (from 0% to up to 600%) for equity exposures.

 

Finally, the rule limits capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of 2.5% of Common Equity Tier 1 capital to risk-weighted assets in addition to the amount necessary to meet its minimum risk-based capital requirements.

 

The final rule became effective on January 1, 2015, and the requirements in the rule will be fully phased-in by January 1, 2019. While the ultimate impact of the fully phased-in capital standards on the Company and the Bank is being reviewed, we currently do not believe Basel III will have a material impact once fully implemented.

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

 

																		To Be Well
										Minimum Required								Capitalized Under
										For Capital								Prompt Corrective
		Actual								Adequacy Purposes								Action Regulations
		Amount				Ratio				Amount				Ratio				Amount				Ratio
		(Dollars in thousands)
December 31, 2015
Carolina Financial Corporation
CET1 capital (to risk weighted assets)		$	138,213				13.97	%			44,527				4.50	%			N/A				N/A
Tier 1 capital (to risk weighted assets)			153,213				15.48	%			59,370				6.00	%			N/A				N/A
Total capital (to risk weighted assets)			163,353				16.51	%			79,160				8.00	%			N/A				N/A
Tier 1 capital (to total average assets)			153,213				11.23	%			54,557				4.00	%			N/A				N/A
CresCom Bank
CET1 capital (to risk weighted assets)			139,025				14.08	%			44,442				4.50	%			64,194				6.50	%
Tier 1 capital (to risk weighted assets)			139,025				14.08	%			59,256				6.00	%			79,008				8.00	%
Total capital (to risk weighted assets)			149,165				15.10	%			79,008				8.00	%			98,760				10.00	%
Tier 1 capital (to total average assets)			139,025				10.21	%			54,466				4.00	%			68,082				5.00	%
December 31, 2014
Carolina Financial Corporation
Tier 1 capital (to risk weighted assets)		$	104,613				12.03	%			34,787				4.00	%			N/A				N/A
Total risk based capital (to risk weighted assets)			114,323				13.15	%			69,574				8.00	%			N/A				N/A
Tier 1 capital (to total average assets)			104,613				9.49	%			44,079				4.00	%			N/A				N/A
CresCom Bank
Tier 1 capital (to risk weighted assets)			103,319				11.90	%			34,716				4.00	%			52,074				6.00	%
Total risk based capital (to risk weighted assets)			113,029				13.02	%			69,433				8.00	%			86,791				10.00	%
Tier 1 capital (to total average assets)			103,319				9.40	%			43,985				4.00	%			54,981				5.00	%

A South Carolina state bank may not pay dividends from capital. All dividends must be paid out of undivided profits then on hand, after deducting expenses, including reserves for losses and bad debts. Unless otherwise instructed by the South Carolina Board of Financial Institutions, the Bank is generally permitted under South Carolina state banking regulations to pay cash dividends of up to 100% of net income in any calendar year without obtaining the prior approval of the South Carolina Board of Financial Institutions. In addition, under the Federal Deposit Insurance Corporation Improvement Act, the Bank may not pay a dividend if, after paying the dividend, the Bank would be undercapitalized. The FRB may also prevent the payment of a dividend by the Bank if it determines that the payment would be an unsafe and unsound banking practice.

 

During the year ended December 31, 2015 and 2014, the Company paid dividend payments of $780,000 and $606,000 to stockholders.

 

NOTE 21 – SUPPLEMENTAL SEGMENT INFORMATION

 

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

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

 

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

 

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

 

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

 

		Community				Mortgage
For the Year Ended December 31, 2015		Banking				Banking				Other				Eliminations				Total
		(In thousands)
Interest income		$	47,701				1,819				16				68				49,604
Interest expense			6,017				100				587				(100	)			6,604
Net interest income (expense)			41,684				1,719				(571	)			168				43,000
(Recovery of) provision for loan losses			(67	)			67				—				—				—
Noninterest income from external customers			6,598				21,080				1				—				27,679
Intersegment noninterest income			4				81				7,072				(7,157	)			—
Noninterest expense			25,497				15,789				7,913				—				49,199
Intersegment noninterest expense			6,112				964				—				(7,076	)			—
Income (loss) before income taxes			16,744				6,060				(1,411	)			87				21,480
Income tax expense (benefit)			5,342				2,228				(544	)			34				7,060
Net income (loss)		$	11,402				3,832				(867	)			53				14,420
Assets		$	1,404,681				75,926				156,774				(227,712	)			1,409,669
Loans receivable, net			908,227				17,783				—				(13,428	)			912,582
Loans held for sale			3,466				38,308				—				—				41,774
Deposits			1,047,671				—				—				(16,143	)			1,031,528
Borrowed funds			208,000				12,748				15,465				(12,748	)			223,465
		Community				Mortgage
For the Year Ended December 31, 2014		Banking				Banking				Other				Eliminations				Total
		(In thousands)
Interest income		$	36,075				1,455				16				110				37,656
Interest expense			5,061				28				541				(28	)			5,602
Net interest income (expense)			31,014				1,427				(525	)			138				32,054
(Recovery of) provision for loan losses			(61	)			61				—				—				—
Noninterest income from external customers			4,084				17,017				47				—				21,148
Intersegment noninterest income			—				136				6,146				(6,282	)			—
Noninterest expense			19,548				14,946				6,949				—				41,443
Intersegment noninterest expense			5,186				960				—				(6,146	)			—
Income (loss) before income taxes			10,425				2,613				(1,281	)			2				11,759
Income tax expense (benefit)			3,157				762				(472	)			1				3,448
Net income (loss)		$	7,268				1,851				(809	)			1				8,311
Assets		$	1,192,419				67,952				111,096				(172,450	)			1,199,017
Loans receivable, net			764,881				10,808				—				(7,567	)			768,122
Loans held for sale			1,547				39,365				—				—				40,912
Deposits			966,309				—				—				(2,119	)			964,190
Borrowed funds			104,076				6,800				15,465				(6,801	)			119,540

NOTE 22 - PARENT COMPANY FINANCIAL INFORMATION

 

The condensed financial statements for the parent company are presented below:

 

Carolina Financial Corporation

Condensed Statements of Financial Condition

 

		At December 31,
		2015				2014
		(In thousands)
Assets:
Cash and cash equivalents		$	13,240				519
Investment in bank subsidiary			140,672				107,407
Investment in non-bank subsidiaries			1,036				850
Investment in unconsolidated statutory business trusts			465				465
Securities available for sale			1				1
Other assets			519				295
Total assets		$	155,933				109,537
Liabilities and stockholders’ equity:
Accrued expenses and other liabilities			609				372
Long-term debt			15,465				15,465
Stockholders’ equity			139,859				93,700
Total liabilities and stockholders’ equity		$	155,933				109,537

Carolina Financial Corporation

Condensed Statements of Operations

 

		For the Years
		Ended December 31,
		2015				2014
		(In thousands)
Dividend income from banking subsidiary		$	1,700				800
Interest income			16				16
Total income			1,716				816
Interest expense			587				541
General and administrative expenses			733				578
Total expenses			1,320				1,119
Income (loss) before income taxes and equity in undistributed earnings of subsidiaries			396				(303	)
Income tax benefit			(501	)			(415	)
Income before equity in undistributed earnings of subsidiaries			897				112
Equity in undistributed earnings of CresCom Bank			13,587				8,320
Equity in undistributed (losses) of Carolina Services			(64	)			(121	)
Total equity in undistributed earnings of subsidiaries			13,523				8,199
Net income		$	14,420				8,311

 

Carolina Financial Corporation

Condensed Statements of Cash Flows

 

		For the Years
		Ended December 31,
		2015				2014
		(In thousands)
Cash flows from operating activities:
Net income		$	14,420				8,311
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in undistributed earnings in subsidiaries			(13,523	)			(8,199	)
Stock-based compensation			874				617
Stock awards			—				65
Vested stock awards surrendered in cashless exercise			(86	)			—
Increase in other assets			(224	)			(130	)
Increase in other liabilities			237				200
Excess tax benefit in connection with equity awards			189				126
Net cash provided by operating activities			1,887				990
Cash flows from investing activities:
Equity contribution in bank subsidiaries			(20,000	)			—
Equity contribution in non-bank subsidiaries			(250	)			—
Net cash used in financing activities			(20,250	)			—
Cash flows from financing activities:
Proceeds from issuance of common stock			32,156				—
Proceeds from exercise of stock options			70				50
Cash dividends paid on common stock			(1,142	)			(855	)
Net cash used in financing activities			31,084				(805	)
Net increase in cash and cash equivalents			12,721				185
Cash and cash equivalents, beginning of year			519				334
Cash and cash equivalents, end of year		$	13,240				519

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

None.

 

Item 9A. Controls and Procedures

 

Evaluation of disclosure controls and procedures. As of the end of the period covered by this Annual Report on Form 10-K, the Company carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply judgment in evaluating its controls and procedures. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, were effective as of the end of the period covered by this report.

 

Changes in internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended December 31, 2015, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

As of December 31, 2015, management assessed the effectiveness of the Company’s internal control over financial reporting based on the criteria for effective internal control over financial reporting established in “Internal Control-Integrated Framework,” issued by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission in 2013. This assessment included controls over the preparation of the schedules equivalent to the basic financial statements in accordance with the instructions for the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C) to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act. Based on the assessment management determined that the Company maintained effective internal control over financial reporting as of December 31, 2015.

 

Elliott Davis Decosimo, LLC, the independent registered public accounting firm, audited the consolidated financial statements of the Company included in this Annual Report on Form 10-K. Their report is included in Part III, Item 15. Exhibits and Financial Statements under the heading “Report of Independent Registered Public Accounting Firm.” This Annual Report on Form 10-K does not include an attestation report of the Company’s registered public accounting firm due to a transition period established by rules of the Securities and Exchange Commission for an Emerging Growth Company.

 

Item 9B. Other Information

 

None

PART III

 

Item 10. Directors, Executive Officers and Corporate Governance.

 

In response to this Item, this information is contained in our Proxy Statement for the Annual Meeting of Shareholders to be held on May 3, 2016 and is incorporated herein by reference.

 

Item 11. Executive Compensation.

 

In response to this Item, this information is contained in our Proxy Statement for the Annual Meeting of Shareholders to be held on May 3, 2016 and is incorporated herein by reference.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters.

 

In response to this Item, the information required by Item 201(d) is contained in Item 5 of this report. The other information required by this item is contained in our Proxy Statement for the Annual Meeting of Shareholders to be held on May 3, 2016 and is incorporated herein by reference.

 

Item 13. Certain Relationships and Related Transactions.

 

The information is contained in our Proxy Statement for the Annual Meeting of Shareholders to be held on May 3, 2016 is incorporated herein by reference.

 

Item 14. Principal Accounting Fees and Services.

 

In response to this Item, this information is contained in our Proxy Statement for the Annual Meeting of Shareholders to be held on May 3, 2016 and is incorporated herein by reference.

 

Item 15. Exhibits, Financial Statement Schedules

 

(a) (1)

Financial Statements

The following consolidated financial statements are located in Item 8 of this report.

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets as of December 31, 2015 and 2014

Consolidated Statements of Income for the years ended December 31, 2015 and 2014

Consolidated Statements of Comprehensive Income for the years ended December 31, 2015 and 2014

Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2015 and 2014

Consolidated Statements of Cash Flows for the years ended December 31, 2015 and 2014

Notes to the Consolidated Financial Statements

(2)

Financial Statement Schedules

These schedules have been omitted because they are not required, are not applicable or have been included in our consolidated financial statements.

 

(3)

Exhibits

See the “Exhibit Index” immediately following the signature page of this report.

SIGNATURES

 

Pursuant to the requirements of Section 12 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

	CAROLINA FINANCIAL CORPORATION
Date: March 14, 2016	By:	/s/ Jerold L. Rexroad
		Jerold L. Rexroad
		Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:

 

Signature		Title		Date
/s/ Jerold L. Rexroad		Chief Executive Officer and Director		March 14, 2016
Jerold L. Rexroad		(Principal Executive Officer)
/s/ William A. Gehman, III		Chief Financial Officer		March 14, 2016
William A. Gehman, III		(Principal Financial Officer
		and Principal Accounting Officer)
/s/ G. Manly Eubank		Chairman of the Board of Directors		March 14, 2016
G. Manly Eubank
/s/ Howell V. Bellamy, Jr.		Director		March 14, 2016
Howell V. Bellamy, Jr.
/s/ W. Scott Brandon		Director		March 14, 2016
W. Scott Brandon
/s/ Robert G. Clawson, Jr.		Director		March 14, 2016
Robert G. Clawson, Jr.
/s/ Jeffery L. Deal		Director		March 14, 2016
Jeffery L. Deal, M.D.
/s/ Michael P. Leddy		Director		March 14, 2016
Michael P. Leddy
/s/ Robert M. Moïse		Director		March 14, 2016
Robert M. Moïse, CPA
/s/ David L. Morrow		Director		March 14, 2016
David L. Morrow
/s/ Thompson E. Penney		Director		March 14, 2016
Thompson E. Penney
/s/ Benedict P. Rosen		Director		March 14, 2016
Benedict P. Rosen
/s/ Claudius E. Watts IV		Director		March 14, 2016
Claudius E. Watts IV
/s/ Bonum S. Wilson, Jr.		Director		March 14, 2016
Bonum S. Wilson, Jr.

EXHIBIT INDEX

 

Exhibit
No.		Description
3.1		Restated Certificate of Incorporation filed on August 31, 2015 (1)
3.3		Restated Bylaws (2)
4.1		See Exhibits 3.1 through 3.3 for provisions in Carolina Financial Corporation’s Certificate of Incorporation and Bylaws defining the rights of holders of common stock (1) (2)
4.2		Form of certificate of common stock (3)
10.1		Amended and Restated Employment Agreement by and between Crescent Bank and M.J. Huggins, III dated as of December 24, 2008 (3)(4)
10.2		First Amendment to the Amended and Restated Employment Agreement between CresCom Bank and M.J. Huggins, III dated September 21, 2012 (3)(4)
10.3		Amended and Restated Supplemental Executive Agreement by and between Carolina Financial Corporation and M.J. Huggins, III dated as of December 24, 2008 (3)(4)
10.4		Amended and Restated Employment Agreement by and between Crescent Bank and David Morrow dated as of December 24, 2008 (3)(4)
10.5		First Amendment to the Amended and Restated Employment Agreement between CresCom Bank and David Morrow dated as of September 19, 2012 (3)(4)
10.6		Amended and Restated Supplemental Executive Agreement by and between Carolina Financial Corporation and David Morrow dated as of December 24, 2008 (1)(2)
10.7		Employment Agreement by and between Carolina Financial Corporation and Jerold L. Rexroad dated as of May 1, 2008 (3)(4)
10.8		First Amendment to the Employment Agreement between Carolina Financial Corporation and Jerold L. Rexroad dated as of September 19, 2012 (3)(4)
10.9		Carolina Financial Corporation 2002 Stock Option Plan (3)
10.10		Carolina Financial Corporation 2006 Recognition and Retention Plan (3)(4)
10.11		Carolina Financial Corporation 2014 Equity Incentive Plan (3)(4)
10.12		Form of Carolina Financial Corporation Elite LifeComp Agreement (3)(4)
10.13		Subservicing Agreement by and between Cenlar FSB and Crescent Mortgage Company dated January 1, 2004(3)
10.14		First Amendment to Subservicing Agreement by and between Cenlar FSB and Crescent Mortgage Company
		dated as of February 19, 2004 (3)
10.15		Second Amendment to Subservicing Agreement by and between Cenlar FSB and Crescent Mortgage Company dated as of February 1, 2006 (3)
10.16		Third Amendment to Subservicing Agreement by and between Cenlar FSB and Crescent Mortgage Company dated as of January 1, 2011 (1)
21.1		Subsidiaries of Carolina Financial Corporation (1)
23		Consent of Independent Registered Public Accounting Firm—Elliott Davis Decosimo, LLC
31.1		Rule 13a-14(a) Certification of the Chief Executive Officer
31.2		Rule 13a-14(a) Certification of the Chief Financial Officer
32		Section 1350 Certifications
101		The following materials from the Company’s Annual Report on Form 10-K for the year ended December 31, 2015, formatted in eXtensible Business Reporting Language (XBRL): (i) the Consolidated Balance Sheets as December 31, 2015 and December 31, 2014; (ii) Consolidated Statements of Operations for the years ended December 31, 2015 and 2014; (iii) Consolidated Statements of Comprehensive Income for the years ended December 31, 2015 and 2014 ; (iv) Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2015 and 2014; (v) Consolidated Statements of Cash Flows for the years ended December 31, 2015 and 2014; and (vi) Notes to the Consolidated Financial Statements.

 

(1)

Incorporated by reference from the Company’s Registration Statement on Form S-3 filed on August 31, 2015

(2)

Incorporated by reference from the Company’s Registration Statement on Form S-4 filed on February 9, 2016

(3)

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

(4)

Indicates management contracts or compensatory plans or arrangements.