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EX-32 - CAROLINA FINANCIAL CORPe00273_ex32.htm
EX-31.1 - CAROLINA FINANCIAL CORPe00273_ex31-1.htm
EX-31.2 - CAROLINA FINANCIAL CORPe00273_ex31-2.htm
EX-10 - CAROLINA FINANCIAL CORPe00273_ex10.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

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

 

For the Quarterly Period Ended March 31, 2016

 

OR

 

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

 

For the Transition Period from         to

 

Commission file number 001-10897

 

 

Carolina Financial Corporation

(Exact name of registrant as specified in its charter)

 

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

 

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

 

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

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes 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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 12,035,184 shares of common stock, par value $0.01 per share, were issued and outstanding as of May 9, 2016

 

 
 

TABLE OF CONTENTS

 

    Page
PART 1 – FINANCIAL INFORMATION  
     

Item 1.

Financial Statements

3
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 39
     
Item 3. Quantitative and Qualitative Disclosure about Market Risks 62
     
Item 4. Controls and Procedures 62
     
PART II -    OTHER INFORMATION 62
     
Item 1. Legal Proceedings 62
     
Item 1A. Risk Factors 62
     
Item 2. Unregistered Sale of Equity Securities and Use of Proceeds 62
     
Item 3. Defaults Upon Senior Securities 62
     
Item 4. Mine Safety Disclosures 62
     
Item 5. Other Information

62

     
Item 6. Exhibits

62 

 

 2 
 

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED BALANCE SHEETS

 

   March 31, 2016  December 31, 2015
   (Unaudited)  (Audited)
   (In thousands, except share data)
ASSETS          
Cash and due from banks  $10,894    10,206 
Interest-bearing cash   19,413    16,421 
Cash and cash equivalents   30,307    26,627 
Securities available-for-sale (cost of $314,079 at March 31, 2016 and $305,972 at December 31, 2015)   314,323    306,474 
Securities held-to-maturity (fair value of $18,029 at March 31, 2016 and $17,965 at December 31, 2015)   16,995    17,053 
Federal Home Loan Bank stock, at cost   7,769    9,919 
Other investments   3,519    3,273 
Derivative assets   2,434    1,945 
Loans held for sale   31,804    41,774 
Loans receivable, net of allowance for loan losses of $10,233 at March 31, 2016 and $10,141 at December 31, 2015   953,788    912,582 
Premises and equipment, net   32,507    32,562 
Accrued interest receivable   4,504    4,333 
Real estate acquired through foreclosure, net   1,091    2,374 
Deferred tax assets, net   5,995    5,273 
Mortgage servicing rights   11,946    11,433 
Cash value life insurance   28,330    28,082 
Core deposit intangible   2,875    2,961 
Other assets   4,853    3,004 
Total assets  $1,453,040    1,409,669 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY          
Liabilities:          
Noninterest-bearing deposits  $200,743    163,054 
Interest-bearing deposits   927,029    868,474 
Total deposits   1,127,772    1,031,528 
Short-term borrowed funds   70,000    120,000 
Long-term debt   98,465    103,465 
Derivative liabilities   2,432    306 
Drafts outstanding   1,695    2,154 
Advances from borrowers for insurance and taxes   974    641 
Accrued interest payable   350    333 
Reserve for mortgage repurchase losses   3,605    3,876 
Dividends payable to stockholders   362    361 
Accrued expenses and other liabilities   4,995    7,146 
Total liabilities   1,310,650    1,269,810 
Commitments and contingencies          
Stockholders’ equity:          
Preferred stock, par value $.01; 1,000,000 shares authorized at March 31, 2016 and December 31, 2015; no shares issued or outstanding   —      —   
Common stock, par value $.01; 15,000,000 shares authorized at March 31, 2016 and December 31, 2015; 12,051,615 and 12,023,557 issued and outstanding at March 31, 2016 and December 31, 2015, respectively   121    120 
Additional paid-in capital   56,803    56,418 
Retained earnings   86,110    82,859 
Accumulated other comprehensive (loss) income, net of tax   (644)   462 
Total stockholders’ equity   142,390    139,859 
Total liabilities and stockholders’ equity  $1,453,040    1,409,669 

 

See accompanying notes to consolidated financial statements.

 

 3 
 

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

   For the Three Months
   Ended March 31,
   2016  2015
   (In thousands, except share data)
Interest income          
Loans  $11,085    9,463 
Investment securities   2,152    1,894 
Dividends from FHLB   97    78 
Other interest income   26    22 
Total interest income   13,360    11,457 
Interest expense          
Deposits   1,367    961 
Short-term borrowed funds   105    66 
Long-term debt   615    473 
Total interest expense   2,087    1,500 
Net interest income   11,273    9,957 
Provision for loan losses   —      —   
Net interest income after provision for loan losses   11,273    9,957 
Noninterest income          
Mortgage banking income   3,175    4,017 
Deposit service charges   862    840 
Net loss on extinguishment of debt   (9)   —   
Net gain on sale of securities   417    471 
Fair value adjustments on interest rate swaps   (281)   (595)
Net increase in cash value life insurance   229    178 
Mortgage loan servicing income   1,388    1,308 
Other   495    371 
Total noninterest income   6,276    6,590 
Noninterest expense          
Salaries and employee benefits   7,150    6,963 
Occupancy and equipment   1,842    1,784 
Marketing and public relations   385    402 
FDIC insurance   168    165 
Provision for mortgage loan repurchase losses   (250)   (250)
Legal expense   49    177 
Other real estate expense, net   20    67 
Mortgage subservicing expense   423    395 
Amortization of mortgage servicing rights   532    460 
Merger related expenses   186    —   
Other   1,763    2,012 
Total noninterest expense   12,268    12,175 
Income before income taxes   5,281    4,372 
Income tax expense   1,638    1,359 
Net income  $3,643    3,013 
           
Earnings per common share:          
Basic  $0.31    0.32 
Diluted  $0.30    0.31 
Weighted average common shares outstanding:          
Basic   11,746,574    9,366,172 
Diluted   11,978,801    9,612,035 

 

See accompanying notes to consolidated financial statements.

 

 4 
 

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

   For the Three Months
   Ended March 31,
   2016  2015
   (In thousands)
       
Net income  $3,643    3,013 
           
Other comprehensive income (loss), net of tax:          
Unrealized gain on securities   179    630 
Tax effect   (64)   (227)
           
Reclassification adjustment for gains included in earnings   (417)   (471)
Tax effect   150    170 
           
Unrealized loss on interest rate swaps designated as cash flow hedges   (1,490)   —   
Tax effect   536    —   
           
Transfer from held-to-maturity to available for sale securities   —      1,171 
Tax effect   —      (422)
           
Accretion of unrealized losses on held-to-maturity securities previously recognized in other comprehensive income   —      64 
Tax effect   —      (23)
           
Other comprehensive income (loss), net of tax   (1,106)   892 
           
Comprehensive income  $2,537    3,905 

 

See accompanying notes to consolidated financial statements.

 

 5 
 

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

FOR THE THREE MONTHS ENDED MARCH 31, 2016 AND 2015

(Unaudited)

 

               Accumulated   
         Additional     Other   
   Common Stock  Paid-in  Retained  Comprehensive   
   Shares  Amount  Capital  Earnings  Income (Loss)  Total
   (In thousands, except share data)
Balance, December 31, 2014   9,717,043   $97    23,194    69,625    784    93,700 
Stock awards   26,166    —      —      —      —      —   
Stock options exercised   6,528    —      33    —      —      33 
Stock-based compensation expense, net   —      —      225    —      —      225 
Net income   —      —      —      3,013    —      3,013 
Dividends declared to stockholders   —      —      —      (244)   —      (244)
Other comprehensive income, net of tax   —      —      —      —      892    892 
Balance, March 31, 2015   9,749,737   $97    23,452    72,394    1,676    97,619 
                               
Balance, December 31, 2015   12,023,557   $120    56,418    82,859    462    139,859 
Stock awards   29,994    1    —      —      —      1 
Vested stock awards surrendered in cashless exercise   (1,936)   —      —      (30)   —      (30)
Excess tax benefit in connection with equity awards   —      —      15    —      —      15 
Stock-based compensation expense, net   —      —      370    —      —      370 
Net income   —      —      —      3,643    —      3,643 
Dividends declared to stockholders   —      —      —      (362)   —      (362)
Other comprehensive loss, net of tax   —      —      —      —      (1,106)   (1,106)
Balance, March 31, 2016   12,051,615   $121    56,803    86,110    (644)   142,390 

 

See accompanying notes to consolidated financial statements.

 

 6 
 

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

   For the Three Months
   Ended March 31,
   2016  2015
   (In thousands)
Cash flows from operating activities:          
Net income  $3,643    3,013 
Adjustments to reconcile net income to net cash provided by (used in) operating activities:          
Amortization of unearned discount/premiums on investments, net   903    735 
Amortization of deferred loan fees   (122)   (251)
Amortization of core deposit intangibles   86    86 
Gain on sale of available-for-sale securities, net   (417)   (471)
Mortgage banking income   (3,175)   (4,017)
Originations of loans held for sale   (204,477)   (244,143)
Proceeds from sale of loans held for sale   217,622    236,018 
Loss on extinguishment of debt   9    —   
Provision for mortgage loan repurchase losses   (250)   (250)
Mortgage loan losses paid, net of recoveries   (21)   (78)
Fair value adjustments on interest rate swaps   281    595 
Stock-based compensation   370    225 
Increase in cash surrender value of bank owned life insurance   (229)   (178)
Depreciation   472    427 
(Gain) loss on disposals of premises and equipment   (1)   9 
(Gain) loss on sale of real estate acquired through foreclosure   (5)   27 
Originations of mortgage servicing rights   (1,045)   (640)
Amortization of mortgage servicing rights   532    460 
(Increase) decrease in:          
Accrued interest receivable   (171)   (405)
Other assets   (2,423)   1,208 
Increase (decrease) in:          
Accrued interest payable   17    20 
Dividends payable to stockholders   1    1 
Accrued expenses and other liabilities   (1,823)   (5,778)
Cash flows provided by (used in) operating activities   9,777    (13,387)

 

Continued

 

 7 
 

CAROLINA FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED

(Unaudited)

 

   For the Three Months
   Ended March 31,
   2016  2015
   (In thousands)
Cash flows from investing activities:          
Activity in available-for-sale securities:          
Purchases  $(55,688)   (69,191)
Maturities, payments and calls   12,665    12,628 
Proceeds from sales   34,478    27,151 
Activity in held-to-maturity securities:          
Purchases   —      (497)
Maturities, payments and calls   —      167 
Increase in other investments   (228)   (334)
Decrease (increase) in Federal Home Loan Bank stock   2,150    (2,368)
Increase in loans receivable, net   (41,084)   (26,319)
Purchase of premises and equipment   (417)   (1,081)
Proceeds from disposals of premises and equipment   1    34 
Proceeds from sale of real estate acquired through foreclosure   1,288    246 
Purchase of bank owned life insurance   (25)   (203)
Distribution of bank owned life insurance   —      175 
Cash flows used in investing activities   (46,860)   (59,592)
           
Cash flows from financing activities:          
Net increase in deposit accounts   96,244    25,459 
Net (decrease) increase in Federal Home Loan Bank advances   (55,009)   53,000 
Net increase in other short-term borrowed funds   —      36 
Principal repayment of subordinated debt   —      (75)
Net decrease in drafts outstanding   (459)   (283)
Net increase in advances from borrowers for insurance and taxes   333    306 
Cash dividends paid on common stock   (361)   (244)
Net increase in excess tax benefit in connection with equity awards   15    —   
Proceeds from exercise of stock options   —      33 
Cash flows provided by financing activities   40,763    78,232 
Net increase in cash and cash equivalents   3,680    5,253 
Cash and cash equivalents, beginning of period   26,627    21,147 
Cash and cash equivalents, end of period  $30,307    26,400 
           
Supplemental disclosure:          
Cash paid for:          
Interest on deposits and borrowed funds  $2,070    1,480 
Income taxes paid, net of refunds   1,931    219 
           
Noncash investing and financing activities:          
Transfer of loans receivable to real estate acquired through foreclosure  $—      200 
Transfer of held-to-maturity securities to available-for-sale securities   —      10,471 

 

See accompanying notes to consolidated financial statements.

 

 8 
 

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 subsidiary, 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 March 31, 2016 and December 31, 2015, statutory business trusts (“Trusts”) created by the Company had outstanding trust preferred securities with an aggregate par value of $15,000,000. The principal assets of the Trusts are $15,465,000 of the Company’s subordinated debentures with identical rates of interest and maturities as the trust preferred securities. The Trusts have issued $465,000 of common securities to the Company and are included in other investments in the accompanying consolidated balance sheets. The Trusts are not consolidated subsidiaries of the Company.

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015 as filed with the Securities and Exchange Commission on March 14, 2016. There have been no significant changes to the accounting policies as disclosed in the Company’s Form 10-K.

Management’s Estimates

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

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

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

 9 
 

Earnings Per Share

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

On 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.

Subsequent Events

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

On May 3, 2016, the stockholders of the Company approved an increase in the number of authorized common shares from 15,000,000 to 25,000,000.

On May 3, 2016, the Company declared a $0.03 per share dividend to stockholders of record on June 22, 2016, payable July 11, 2016.

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 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.

 10 
 

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 were effective for the Company for fiscal years that begin after December 15, 2015. The Company applied 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. These amendments did not have a material effect on the 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 were 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. These amendments did not have a material effect on the financial statements.

In August 2015, the FASB issued amendments to the Interest topic of the ASC 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 ASC 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 amended the Leases topic of the ASC to revise certain aspects of recognition, measurement, presentation, and disclosure of leasing transactions. The amendments will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.

 

In March 2016, the FASB amended the Revenue from Contracts with Customers topic of the ASC to clarify the implementation guidance on principal versus agent considerations and address how an entity should assess whether it is the principal or the agent in contracts that include three or more parties. The amendments will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.

 

In March 2016, the FASB issued guidance to simplify several aspects of the accounting for share-based payment award transactions including the income tax consequences, the classification of awards as either equity or liabilities, and the classification on the statement of cash flows. In addition to other changes, the guidance changes the accounting for excess tax benefits and tax deficiencies from generally being recognized in additional paid-in capital to recognition as income tax expense or benefit in the period they occur. For public business entities, the amendments are effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted for any entity in any interim or annual period. The Company expects to adopt the new guidance in the second quarter of 2016 and expects the impact to increase diluted earnings per share by $0.02 to $0.03 per diluted share in the second quarter of 2016 with minimal impact during the remainder of 2016. These amendments are not expected to have a material impact to the Company’s financial position and cash flows.

 

 11 
 

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

 

NOTE 2 - SECURITIES

The amortized cost, gross unrealized gains, gross unrealized losses and fair value of investments securities available-for-sale and held-to-maturity at March 31, 2016 and December 31, 2015 follows:

   March 31, 2016  December 31, 2015
      Gross  Gross        Gross  Gross  
   Amortized  Unrealized  Unrealized  Fair  Amortized  Unrealized  Unrealized  Fair
   Cost  Gains  Losses  Value  Cost  Gains  Losses  Value
Securities available-for-sale:  (In thousands)
Municipal securities  $60,302    2,704    (13)   62,993    60,603    1,885    (13)  62,475
US government agencies   —      —      —      —      7,015    81    —     7,096
Collateralized loan obligations   60,777    38    (134)   60,681    38,957    8    (207)  38,758
Mortgage-backed securities:                                     
Agency   107,342    1,719    (115)   108,946    112,608    1,370    (123)  113,855
Non-agency   74,296    407    (765)   73,938    75,415    580    (459)  75,536
Total mortgage-backed securities   181,638    2,126    (880)   182,884    188,023    1,950    (582)  189,391
Trust preferred securities   11,362    831    (4,428)   7,765    11,374    1,145    (3,765)  8,754
Total  $314,079    5,699    (5,455)   314,323    305,972    5,069    (4,567)  306,474
                                      
Securities held-to-maturity:                                     
Municipal securities  $16,995    1,034    —      18,029    17,053    912    —     17,965

 

 12 
 

The amortized cost and fair value of debt securities by contractual maturity at March 31, 2016 follows:

   At March 31, 2016
   Amortized  Fair
   Cost  Value
   (In thousands)
 Securities available-for-sale:          
 Less than one year  $—      —   
 One to five years   236    239 
 Six to ten years   34,339    34,660 
 After ten years   279,504    279,424 
 Total  $314,079    314,323 
           
 Securities held-to-maturity:          
 Less than one year  $—      —   
 One to five years   428    443 
 Six to ten years   4,922    5,048 
 After ten years   11,645    12,538 
 Total  $16,995    18,029 

 

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

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

 

   For the Three Months
   Ended March 31,
   2016  2015
   (In thousands)
       
Proceeds  $34,478    27,151 
           
Realized gains  $534    474 
Realized losses   (117)   (3)
Total investment securities gains, net  $417    471 

 

At March 31, 2016, the Company had pledged with a market value of $57.4 million of securities for Federal Home Loan Bank (“FHLB”) advances.

At March 31, 2016, the Company has pledged $12.2 million of securities to secure public agency funds.

 13 
 

The gross unrealized losses and fair value of the Company’s investments available-for-sale with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2016 are as follows:

   At March 31, 2016
   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  $2,027    2,014    (13)   —      —      —      2,027    2,014    (13)
Collateralized loan obligations   16,932    16,853    (79)   13,205    13,150    (55)   30,137    30,003    (134)
Mortgage-backed securities:                                             
Agency   13,031    12,932    (99)   1,519    1,503    (16)   14,550    14,435    (115)
Non-agency   27,291    26,790    (501)   11,407    11,143    (264)   38,698    37,933    (765)
Total mortgage-backed securities   40,322    39,722    (600)   12,926    12,646    (280)   53,248    52,368    (880)
Trust preferred securities   1,405    1,289    (116)   8,764    4,452    (4,312)   10,169    5,741    (4,428)
Total  $60,686    59,878    (808)   34,895    30,248    (4,647)   95,581    90,126    (5,455)

 

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 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.

As of March 31, 2016, trust preferred securities had an amortized cost of $11.4 million and a fair value of $7.8 million. For each trust preferred security, impairment testing is performed on a quarterly basis using a detailed cash flow analysis. The major assumptions used during the quarterly impairment testing are described in the subsequent paragraph.

 14 
 

In 2009, the Company adopted a four year “burst” scenario for its modeled default rates (2010 - 2013) that replicated the default rates for the banking industry from the four peak years of the savings and loan crisis, which then reduced to 0.25% annually. The elevated default rate ended in 2013, and the constant default rate used by the Company is now 0.25% annually. All issuers that are currently in deferral were presumed to be in default. Additionally, all defaults are assumed to have a 15% recovery after two years and 1% of the pool is presumed to prepay annually. If this analysis results in a present value of expected cash flows that is less than the book value of a security (that is, a credit loss exists), OTTI is considered to have occurred. If there is no credit loss, any impairment is considered temporary. The cash flow analysis we performed used discount rates equal to the credit spread at the time of purchase for each security and then added the current three-month LIBOR forward interest rate curve. Based on the cash flow analysis performed at period end, management believes that there are no additional securities other-than-temporarily impaired at March 31, 2016.

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.

As of March 31, 2016, $0.7 million of the pooled trust preferred securities were investment grade and $7.1 million were below investment grade. 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. In terms of risk-based capital calculation, the Company allocates additional risk-based capital to the below investment grade securities.

As of March 31, 2016, senior tranches represent $0.7 million of the Company’s pooled securities, while mezzanine tranches represented $7.1 million. All of the $7.1 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, 2015, senior tranches represent $0.8 million 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.

 

At March 31, 2016 and December 31, 2015, the Company had 43 and 45, 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 2016 or 2015.

 

Management believes that there are no additional securities other-than-temporarily impaired at March 31, 2016. 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.

 15 
 

NOTE 3 – 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 March 31, 2016 and December 31, 2015 are as follows:

   At March 31,  At December 31,
   2016  2015
   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   2,022    141,084    1,246    143,318 
Mortgage loan forward sales commitments   412    23,691    340    31,513 
Mortgage-backed securities forward sales commitments   —      —      179    105,014 
Total derivative assets  $2,434    164,775    1,945    309,845 
                     
Derivative liabilities:                    
Cash flow hedges:                    
Interest rate swaps  $1,310    30,000    —      —   
Non-hedging derivatives:                    
Interest rate swaps   676    10,000    306    10,000 
Mortgage-backed securities forward sales commitments   446    97,000    —      —   
Total derivative liabilities  $2,432    137,000    306    10,000 

 

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.

 

 16 
 

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”.

 

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 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 adjustable 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.

  

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.

 

 17 
 

NOTE 4 - LOANS RECEIVABLE, NET

Loans receivable, net at March 31, 2016 and December 31, 2015 are summarized by category as follows:

   At March 31,  At December 31,
   2016  2015
      % of Total     % of Total
   Amount  Loans  Amount  Loans
   (Dollars in thousands)
 Loans secured by real estate:                  
 One-to-four family  $361,338    37.47%   343,686   37.23 %
 Home equity   26,063    2.70%   23,303   2.52 %
 Commercial real estate   352,775    36.58%   342,395   37.10 %
 Construction and development   99,513    10.32%   91,713   9.94 %
 Consumer loans   5,476    0.57%   5,181   0.56 %
 Commercial business loans   119,201    12.36%   116,737   12.65 %
 Total gross loans receivable   964,366    100.00%   923,015   100.00 %
 Less:                  
 Allowance for loan losses   10,233         10,141    
 Deferred fees, net   345         292    
 Total loans receivable, net  $953,788         912,582    

 

Included in the loan totals were $61.6 million and $64.1 million in loans acquired through branch acquisitions at March 31, 2016 and December 31, 2015, respectively. No allowance for loan losses related to the acquired loans is recorded on the acquisition date because the fair value of the loans acquired incorporates assumptions regarding credit risk.

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

   At March 31,  At December 31,
   2016  2015
   (Dollars in thousands)
             
Variable rate loans  $418,544    43.40%   399,108    43.24%
Fixed rate loans   545,822    56.60%   523,907    56.76%
Total loans outstanding  $964,366    100.00%   923,015    100.00%

 

 18 
 

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

Allowance for loan losses:  For the Three Months Ended March 31, 2016
   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, 2016  $2,903    151    3,402    1,138    27    2,100    420    10,141 
Provision for loan losses   (98)   1    (37)   90    (2)   66    (20)   —   
Charge-offs   —      —      —      —      (2)   —      —      (2)
Recoveries   58    —      —      3    6    27    —      94 
Balance at March 31, 2016  $2,863    152    3,365    1,231    29    2,193    400    10,233 

 

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

 

 19 
 

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

 

   Loans Secured by Real Estate            
   One-to-     Commercial  Construction            
   four  Home  real  and     Commercial      
   family  equity  estate  development  Consumer  business  Unallocated  Total
   (In thousands)
At March 31, 2016:                                        
Allowance for loan losses ending balances:                                        
Individually evaluated for impairment  $13    —      243    120    —      165    —      541 
Collectively evaluated for impairment   2,850    152    3,122    1,111    29    2,028    400    9,692 
   $2,863    152    3,365    1,231    29    2,193    400    10,233 
                                         
Loans receivable ending balances:                                        
Individually evaluated for impairment  $3,577    —      12,347    500    65    474    —      16,963 
Collectively evaluated for impairment   357,761    26,063    340,428    99,013    5,411    118,727    —      947,403 
Total loans receivable  $361,338    26,063    352,775    99,513    5,476    119,201    —      964,366 
                                         
                                         
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 

 

 20 
 

The following table presents impaired loans individually evaluated for impairment in the segmented portfolio categories and the corresponding allowance for loan losses as of March 31, 2016 and December 31, 2015. The recorded investment is defined as the original amount of the loan, net of any deferred costs and fees, less any principal reductions and direct charge-offs. Unpaid principal balance includes amounts previously included in charge-offs.

 

   At March 31, 2016  At December 31, 2015
      Unpaid        Unpaid   
   Recorded  Principal  Related  Recorded  Principal  Related
   Investment  Balance  Allowance  Investment  Balance  Allowance
   (In thousands)
With no related allowance recorded:                              
Loans secured by real estate:                              
One-to-four family  $3,062    5,513    —      3,175    5,572    —   
Home equity   —      28    —      —      28    —   
Commercial real estate   10,690    11,234    —      10,681    11,226    —   
Construction and development   25    1,863    —      25    1,863    —   
Consumer loans   65    362    —      65    362    —   
Commercial business loans   312    1,507    —      473    1,668    —   
    14,154    20,507    —      14,419    20,719    —   
                               
With an allowance recorded:                              
Loans secured by real estate:                              
One-to-four family   515    515    13    793    793    15 
Home equity   —      —      —      —      —      —   
Commercial real estate   1,657    1,657    243    1,818    1,818    343 
Construction and development   475    475    120    475    475    120 
Consumer loans   —      —      —      —      —      —   
Commercial business loans   162    162    165    9    9    9 
    2,809    2,809    541    3,095    3,095    487 
                               
Total:                              
Loans secured by real estate:                              
One-to-four family   3,577    6,028    13    3,968    6,365    15 
Home equity   —      28    —      —      28    —   
Commercial real estate   12,347    12,891    243    12,499    13,044    343 
Construction and development   500    2,338    120    500    2,338    120 
Consumer loans   65    362    —      65    362    —   
Commercial business loans   474    1,669    165    482    1,677    9 
   $16,963    23,316    541    17,514    23,814    487 

 

 21 
 

The following table presents the average recorded investment and interest income recognized on impaired loans individually evaluated for impairment in the segmented portfolio categories for the three months ended March 31, 2016 and 2015.

 

   For the Three Months Ended March 31,
   2016  2015
   Average  Interest  Average  Interest
   Recorded  Income  Recorded  Income
   Investment  Recognized  Investment  Recognized
   (In thousands)
With no related allowance recorded:                    
Loans secured by real estate:                    
One-to-four family  $3,076    11    2,482    69 
Home equity   —      —      62    —   
Commercial real estate   10,753    136    7,856    87 
Construction and development   25    —      245    —   
Consumer loans   65    (4)   37    —   
Commercial business loans   318    4    1,718    73 
    14,237    147    12,400    229 
                     
With an allowance recorded:                    
Loans secured by real estate:                    
One-to-four family   518    5    1,007    —   
Home equity   —      —      —      —   
Commercial real estate   1,671    —      290    3 
Construction and development   475    —      —      —   
Consumer loans   —      —      —      —   
Commercial business loans   198    (1)   —      —   
    2,862    4    1,297    3 
                     
Total:                    
Loans secured by real estate:                    
One-to-four family   3,594    16    3,489    69 
Home equity   —      —      62    —   
Commercial real estate   12,424    136    8,146    90 
Construction and development   500    —      245    —   
Consumer loans   65    (4)   37    —   
Commercial business loans   516    3    1,718    73 
   $17,099    151    13,697    232 

 

 22 
 

A loan is considered past due if the required principal and interest payment has not been received as of the due date. The following schedule is an aging of past due loans receivable by portfolio segment as of March 31, 2016 and December 31, 2015.

 

   At March 31, 2016
   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  $151    —      —      —      16    —      167 
60-89 days past due   555    —      132    —      —      146    833 
90 days or more past due   1,688    —      226    499    25    —      2,438 
Total past due   2,394    —      358    499    41    146    3,438 
Current   358,944    26,063    352,417    99,014    5,435    119,055    960,928 
Total loans receivable  $361,338    26,063    352,775    99,513    5,476    119,201    964,366 

 

   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 

 

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

There were no loans past due 90 days or more and still accruing at March 31, 2016 or December 31, 2015.

 23 
 

The following is a schedule of loans receivable, by portfolio segment, on nonaccrual at March 31, 2016 and December 31, 2015.

 

   At March 31,  At December 31,
   2016  2015
Loans secured by real estate:  (In thousands)
One-to-four family  $2,057    2,032 
Home equity   —      —   
Commercial real estate   1,788    1,686 
Construction and development   499    499 
Consumer loans   50    50 
Commercial business loans   187    35 
   $4,581    4,302 

 

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

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

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

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

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

 

The Company uses the following definitions in the tables below:

 

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

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

 24 
 

The following is a schedule of the credit quality of loans receivable, by portfolio segment, as of March 31, 2016 and December 31, 2015.

   At March 31, 2016
   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  $359,046    26,063    346,253    98,791    5,426    116,866    952,445 
Special Mention   252    —      4,734    232    —      2,173    7,391 
Substandard   2,040    —      1,788    490    50    162    4,530 
Total loans receivable  $361,338    26,063    352,775    99,513    5,476    119,201    964,366 
                                    
Performing  $359,281    26,063    350,987    99,014    5,426    119,014    959,785 
Nonperforming:                                   
90 days or more and still accruing   —      —      —      —      —      —      —   
Nonaccrual   2,057    —      1,788    499    50    187    4,581 
Total nonperforming   2,057    —      1,788    499    50    187    4,581 
Total loans receivable  $361,338    26,063    352,775    99,513    5,476    119,201    964,366 

   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 

 

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.

 25 
 

Troubled Debt Restructurings

 

At March 31, 2016, there were $14.1 million in loans designated as troubled debt restructurings of which $12.4 million were accruing. At December 31, 2015, there were $14.4 million in loans designated as troubled debt restructurings of which $13.2 million were accruing.

 

There were no loans designated as troubled debt restructuring during the three months ended March 31, 2016. There was one relationship totaling fourteen loans designated as a troubled debt restructuring during the three months ended March 31, 2015. All loans within this relationship were designated as troubled debt restructuring due to a change in payment structure. Eleven loans were within the one-to-four family loan segment with a 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.

No loans previously restructured in the twelve months prior to March 31, 2016 and 2015 went into default during the three months ended March 31, 2016 and 2015.

NOTE 5 – REAL ESTATE ACQUIRED THROUGH FORECLOSURE

The following presents summarized activity in other real estate owned for the periods ended March 31, 2016 and December 31, 2015:

   March 31,  December 31,
   2016  2015
   (In thousands)
Balance at beginning of period  $2,374    3,239 
Additions   —      1,307 
Sales   (1,283)   (2,172)
Write downs   —      —   
Balance at end of period  $1,091    2,374 

 

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

 

   At March 31,  At December 31,
   2016  2015
   (In thousands)
Real estate loans:          
One-to-four family  $—      773 
Commercial real estate   —      484 
Construction and development   1,091    1,117 
   $1,091    2,374 

 

 26 
 

NOTE 6 - DEPOSITS

Deposits outstanding by type of account at March 31, 2016 and December 31, 2015 are summarized as follows:

   At March 31,  At December 31,
   2016  2015
   (In thousands)
Noninterest-bearing demand accounts  $200,743    163,054 
Interest-bearing demand accounts   147,393    158,581 
Savings accounts   41,596    39,147 
Money market accounts   257,808    223,906 
Certificates of deposit:          
Less than $250,000   459,789    428,067 
$250,000 or more   20,443    18,773 
Total certificates of deposit   480,232    446,840 
Total deposits  $1,127,772    1,031,528 

 

The aggregate amount of brokered certificates of deposit was $103.6 million and $97.1 million at March 31, 2016 and December 31, 2015, respectively. The aggregate amount of institutional certificates of deposit was $52.8 million and $51.5 million at March 31, 2016 and December 31, 2015, respectively. Brokered certificates of deposit and institutional certificates are included in the table above under certificates of deposit less than $250,000.

 

The Company has pledged $12.2 million of securities as of March 31, 2016 to secure public agency funds.

 

NOTE 7 – ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS

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

 

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

 

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

 

 27 
 

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.

 

 28 
 

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 assets 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.

 

 29 
 

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.

 

 30 
 

The carrying amount and estimated fair value of the Company’s financial instruments at March 31, 2016 and December 31, 2015 are as follows:

   At March 31, 2016
   Carrying  Fair Value
   Amount  Total  Level 1  Level 2  Level 3
Financial assets:  (In thousands)
Cash and due from banks  $10,894    10,894    10,894    —      —   
Interest-bearing cash   19,413    19,413    19,413    —      —   
Securities available-for-sale   314,323    314,323    —      314,323    —   
Securities held-to-maturity   16,995    18,029    —      18,029    —   
Federal Home Loan Bank stock   7,769    7,769    —      —      7,769 
Other investments   3,519    3,519    —      —      3,519 
Derivative assets   2,434    2,434    —      2,434    —   
Loans held for sale   31,804    31,804    —      31,804    —   
Loans receivable, net   953,788    951,622    —      —      951,622 
Cash value life insurance   28,330    28,330    —      28,330    —   
Accrued interest receivable   4,504    4,504    —      4,504    —   
Mortgage servicing rights   11,946    17,113    —      —      17,113 
                          
Financial liabilities:                         
Deposits   1,127,772    1,128,538    —      1,128,538    —   
Short-term borrowed funds   70,000    69,930    —      69,930    —   
Long-term debt   98,465    102,565    —      102,565    —   
Derivative liabilities   2,432    2,432    1,986    446    —   
Accrued interest payable   350    350    —      350    —   

   At December 31, 2015
   Carrying  Fair Value
   Amount  Total  Level 1  Level 2  Level 3
Financial assets:  (In thousands)
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    —   

 

 31 
 

 

   At March 31, 2016  At December 31, 2015
   Notional  Estimated  Notional  Estimated
   Amount  Fair Value  Amount  Fair Value
Off-Balance Sheet Financial Instruments:  (In thousands)
Commitments to extend credit  $76,738    —      70,365    —   
Standby letters of credit   1,473    —      1,357    —   

 

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

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

Investment Securities Available-for-Sale

 

Measurement is on a recurring basis upon quoted market prices, if available. If quoted market prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for prepayment assumptions, projected credit losses, and liquidity. At March 31, 2016 and December 31, 2015, the Company’s investment securities available-for-sale are recurring Level 2.

Mortgage Loans Held for Sale

 

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

Derivative Assets and Liabilities

 

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

 

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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.

 

Impaired Loans

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

Other Real Estate Owned (“OREO”)

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

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.

 33 
 

Assets and liabilities measured at fair value on a recurring basis are as follows as of March 31, 2016 and December 31, 2015:

   Quoted market price  Significant other  Significant other
   in active markets  observable inputs  unobservable inputs
   (Level 1)  (Level 2)  (Level 3)
   (In thousands)
March 31, 2016         
Available-for-sale investment securities:               
Municipal securities  $—      62,993    —   
Collateralized loan obligations   —      60,681    —   
Mortgage-backed securities:               
Agency   —      108,946    —   
Non-agency   —      73,938    —   
Trust Preferred Securities   —      7,765    —   
Loans held for sale   —      31,804    —   
Derivative assets:               
Non-hedging derivatives:               
Mortgage loan interest rate lock commitments   —      2,022    —   
Mortgage loan forward sales commitments   —      412    —   
Derivative liabilities:               
Cash flow hedges:               
Interest rate swaps   1,310    —      —   
Non-hedging derivatives:               
Interest rate swaps   676    —      —   
Mortgage-backed securities forward sales commitments   —      446    —   
Total  $1,986    349,007    —   
                
December 31, 2015               
Available-for-sale investment securities:               
Municipal securities  $—      62,475    —   
US government agencies   —      7,096    —   
Collateralized loan obligations   —      38,758    —   
Mortgage-backed securities:               
Agency   —      113,855    —   
Non-agency   —      75,536    —   
Trust preferred securities   —      8,754    —   
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    —   

 

 34 
 

Assets measured at fair value on a nonrecurring basis are as follows as of March 31, 2016 and December 31, 2015:

 

   Quoted market price  Significant other  Significant other
   in active markets  observable inputs  unobservable inputs
   (Level 1)  (Level 2)  (Level 3)
   (In thousands)
March 31, 2016         
Impaired loans:               
Loans secured by real estate:               
One-to-four family  $—      —      3,564 
Commercial real estate   —      —      12,104 
Construction and development   —      —      380 
Consumer loans   —      —      65 
Commercial business loans   —      —      309 
Real estate owned:               
Construction and development   —      —      1,091 
Mortgage servicing rights   —      —      17,113 
Total  $—      —      34,626 
                
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 

 

For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of March 31, 2016 and December 31, 2015, the significant unobservable inputs used in the fair value measurements were as follows:

  March 31, 2016 and December 31, 2015
      Significant   Significant Unobservable
  Valuation Technique   Observable Inputs   Inputs
Impaired Loans Appraisal Value   Appraisals and or sales of   Appraisals discounted 10% to 20% for
      comparable properties   sales commissions and other holding costs
           
Real estate owned Appraisal Value/   Appraisals and or sales of   Appraisals discounted 10% to 20% for
  Comparison Sales/   comparable properties   sales commissions and other holding costs
  Other estimates        
           
Mortgage Servicing Rights Discounted cash flows   Comparable sales   Discount rates ranges 12% - 13% - 2016 and 2015
          Prepayment rate 10% - 11% - 2016
          Prepayment rate 8% - 9% - 2015

 

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NOTE 8 - EARNINGS PER SHARE

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

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 the stock splits for all periods presented in accordance with GAAP.

The following is a summary of the reconciliation of weighted average shares outstanding for the three months ended March 31, 2016 and 2015:

   For the Three Months Ended March 31,
   2016  2015
   Basic  Diluted  Basic  Diluted
             
Weighted average shares outstanding   11,746,574    11,746,574    9,366,172    9,366,172 
Effect of dilutive securities   —      232,227    —      245,863 
Weighted average shares outstanding   11,746,574    11,978,801    9,366,172    9,612,035 

 

The following is a summary of the reconciliation of shares issued and outstanding and unvested restricted stock awards as of March 31, 2016 and 2015:

   As of March 31,
   2016  2015
       
Issued and outstanding shares   12,051,615    9,749,737 
Less nonvested restricted stock awards   (302,028)   (383,566)
Period end dilutive shares   11,749,587    9,366,171 

 

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NOTE 9 – SUPPLEMENTAL SEGMENT INFORMATION

The Company has three reportable segments: community banking, wholesale mortgage banking (“mortgage banking”) and other. The community banking segment includes traditional banking services offered through CresCom Bank as well as the managerial and operational support provided by Carolina Services. The mortgage banking segment provides wholesale mortgage loan origination and servicing offered through Crescent Mortgage Company. The other segment includes parent company financial information and represents an overhead function rather than an operating segment. The parent company’s most significant assets are its net investments in its subsidiaries.

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

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

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

The following tables present selected financial information for the Company’s reportable business segments for the three months ended March 31, 2016 and 2015:

   Community  Mortgage         
For the Three Months Ended March 31, 2016  Banking  Banking  Other  Eliminations  Total
   (In thousands)
Interest income  $12,944    369    5    42    13,360 
Interest expense   1,939    5    148    (5)   2,087 
Net interest income (expense)   11,005    364    (143)   47    11,273 
Provision for loan losses   —      —      —      —      —   
Noninterest income from external customers   2,133    4,143    —      —      6,276 
Intersegment noninterest income   243    19    —      (262)   —   
Noninterest expense   8,429    3,680    159    —      12,268 
Intersegment noninterest expense   —      241    2    (243)   —   
Income (loss) before income taxes   4,952    605    (304)   28    5,281 
Income tax expense (benefit)   1,539    204    (116)   11    1,638 
Net income (loss)  $3,413    401    (188)   17    3,643 

 

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

 

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The following tables present selected financial information for the Company’s reportable business segments for March 31, 2016 and December 31, 2015:

   Community  Mortgage         
At March 31, 2016  Banking  Banking  Other  Eliminations  Total
   (In thousands)
Assets  $1,448,097    69,642    158,611    (223,310)   1,453,040 
Loans receivable, net   940,817    19,824    —      (6,853)   953,788 
Loans held for sale   2,963    28,841    —      —      31,804 
Deposits   1,141,513    —      —      (13,741)   1,127,772 
Borrowed funds   153,000    6,200    15,465    (6,200)   168,465 

 

   Community  Mortgage         
At December 31, 2015  Banking  Banking  Other  Eliminations  Total
   (In thousands)
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 

 

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

 

The following discussion reviews our results of operations for the three months ended March 31, 2016 as compared to the three months ended March 31, 2015 and assesses our financial condition as of March 31, 2016 as compared to December 31, 2015. You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements and the related notes and the consolidated financial statements and the related notes for the year ended December 31, 2015 included in our Form 10-K for that period. Results for the three months ended March 31, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016 or any future period.

 

Cautionary Warning Regarding Forward-Looking Statements

 

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

 

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

 

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

 

  changes in economic conditions, either nationally or regionally and especially in our primary 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;

 

 39 
 

 

  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 prove 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 our Annual Report on Form10-K for the year ended December 31, 2015. We urge investors to consider all of these factors carefully in evaluating the forward-looking statements contained in this Quarterly Report on Form 10-Q and our other reports filed pursuant to the Securities Exchange Act of 1934. We make these forward-looking statements as of the date of this document and we do not intend, and assume no obligation, to update the forward-looking statements or to update the reasons why actual results could differ from those expressed, implied or projected by us in the forward-looking statements.

 

Company Overview

 

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.

 

CresCom Bank provides a full range of commercial and retail banking financial services designed to meet the financial needs of our customers through its branch network in South Carolina and North Carolina. Crescent Mortgage Company, headquartered in Atlanta, Georgia, is a wholesale mortgage company that provides mortgage banking services in 45 states and partners with community banks, credit unions and mortgage brokers.

  

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

 

 40 
 

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 March 31, 2016, our total assets were $1.5 billion, an increase of $43.4 million, from total assets of $1.4 billion at December 31, 2015. The largest components of our total assets are net loans receivable and securities which were $953.8 million and $331.3 million, respectively at March 31, 2016. Comparatively, our net loans receivable and securities totaled $912.6 million and $323.5 million, respectively, at December 31, 2015. At March 31, 2016 loans held for sale were $31.8 million compared to $41.8 million as of December 31, 2015. Our liabilities and stockholders’ equity at March 31, 2016 totaled $1.3 billion and $142.4 million, respectively, compared to liabilities of $1.3 billion and stockholders’ equity of $139.9 million at December 31, 2015. The principal components of our liabilities are deposits which were $1.1 billion and $1.0 billion at March 31, 2016 and December 31, 2015, respectively.

 

The Company reported net income for the three months ended March 31, 2016 of $3.6 million, or $0.30 per diluted share, as compared to $3.0 million, or $0.31 per diluted share, for the three months ended March 31, 2015. Included in net income for March 31, 2016 were pretax acquisition related expenses of $186,000 relating to the Company’s previously announced acquisition of Congaree Bancshares, Inc., which is expected to close in the second quarter of 2016. The increase in net income from period to period is attributable to the significant growth in loans and deposits. The decrease in earnings per share is the result of a public offering completed in December 2015 where the Company issued 2,262,296 shares of its common stock for net proceeds of approximately $32.1 million.

 

The allowance for loan losses was $10.2 million, or 1.06% of total loans at March 31, 2016, compared to $10.1 million, or 1.10% of total loans, at December 31, 2015. Included in the loan totals were $61.6 million and $64.1 million in loans acquired through previous branch acquisitions at March 31, 2016 and December 31, 2015, 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 $92,000 and $344,000 for the three months ended March 31, 2016 and 2015, respectively. Asset quality has remained relatively consistent since year end, with nonperforming assets to total assets slightly decreasing to 0.39% as of March 31, 2016 as compared to 0.47% as of December 31, 2015. No provision expense for loan losses was recorded during 2016 or 2015 primarily due to the net recoveries experienced.

 

At March 31, 2016, the Company’s regulatory capital ratios exceeded the minimum levels currently required. Stockholders’ equity totaled $142.4 million as of March 31, 2016 compared to $139.9 million at December 31, 2015.

 

Recent Events

 

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.

 

On May 3, 2016, the stockholders of the Company approved an increase in the number of authorized common shares from 15,000,000 to 25,000,000.

On May 3, 2016, the Company declared a $0.03 per share dividend to stockholders of record June 22, 2016 payable on July 11, 2016.

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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 Part I, Item 1 “Financial Statements” elsewhere in this report.

 

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

 

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

 

Other-Than Temporary Impairment. The evaluation and recognition of other-than-temporary impairment, or OTTI, on certain investments including our private label mortgage-backed securities and trust preferred securities requires significant judgment and estimates. Some of the more critical judgments supporting the evaluation of OTTI include projected cash flows including prepayment assumptions, default rates and severities of losses on the underlying collateral within the security. Under different conditions or utilizing different assumptions, the actual OTTI realized by us may be different from the actual amounts recognized in our consolidated financial statements. See notes to our consolidated financial statements in Part I, Item 1 “Financial Statements” for the disclosure of certain assumptions used in the determination of OTTI.

 

Derivatives. The determination of fair value related to derivatives of the Company requires significant judgment and estimates. The primary uses of derivative instruments are related to the mortgage banking activities of the Company. As such, the Company holds derivative instruments, which consist of rate lock agreements related to expected funding of fixed-rate mortgage loans to customers (“interest rate lock commitments”) and forward commitments to sell mortgage-backed securities and individual fixed-rate mortgage loans (“forward commitments”). The Company’s objective in obtaining the forward commitments is to mitigate the interest rate risk associated with the interest rate lock commitments and the mortgage loans that are held for sale. Derivatives related to these commitments are recorded as either a derivative asset or a derivative liability in the balance sheet and are measured at fair value. Both the interest rate lock commitments and the forward commitments are reported at fair value, with adjustments recorded in current period earnings in 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 notes to our consolidated financial statements in Part I, Item 1 “Financial Statements.”

 

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

 

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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, write-downs 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 March 31, 2016 or December 31, 2015.

 

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

 

Results of Operations

Summary

The Company reported net income for the three months ended March 31, 2016 of $3.6 million, or $0.30 per diluted share, as compared to $3.0 million, or $0.31 per diluted share, for the three months ended March 31, 2015. Included in net income for March 31, 2016 were pretax acquisition related expenses of $186,000. The increase in net income from period to period is attributable to the significant growth in loans and securities. The decrease in earnings per share is the result of a public offering completed in December 2015 where the Company issued 2,262,296 shares of its common stock for net proceeds of approximately $32.1 million.

 

Net Interest Income and Margin

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

Net interest income increased to $11.3 million for the three months ended March 31, 2016 from $10.0 million for the three months ended March 31, 2015. The increase in net interest income is a result of the increase in average interest-earning assets balances. The increase in average earnings assets for the three months ended March 31, 2016 compared to the three months ended March 31, 2015 is primarily the result of increased balances of loans receivable and securities.

The growth in 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 its mortgage production. Due to management’s emphasis on growing the Company’s residential mortgage production, loans receivable within the one-to-four family portfolio has increased $89.4 million since March 31, 2015. This growth includes the purchase of a non-conforming residential loan pool during the fourth quarter of 2015 with a balance of $34.7 million as of March 31, 2016.
·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 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 and construction and development increased $50.0 million since March 31, 2015.

 

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·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 originated in other markets 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 $19.4 million since March 31, 2015. As of March 31, 2016, the syndicated loan portfolio outstanding was $79.7 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 March 31, 2016, 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.

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

   For The Three Months Ended March 31,
   2016  2015
      Interest  Average     Interest  Average
   Average  Earned/  Yield/  Average  Earned/  Yield/
   Balance  Paid  Rate  Balance  Paid  Rate
                   
Interest-earning assets:                              
Loans held for sale  $25,454    222    3.51%   30,733    289    3.76%
Loans receivable, net (1)   935,438    10,863    4.67%   779,661    9,174    4.77%
Interest-bearing cash   9,737    14    0.58%   17,988    11    0.25%
Securities available for sale   314,980    2,022    2.57%   260,599    1,735    2.70%
Securities held to maturity   17,026    130    3.05%   25,456    159    2.53%
Dividends from FHLB   8,421    97    4.63%   6,404    78    4.94%
Other investments   3,923    12    1.23%   2,513    11    1.78%
Total interest-earning assets   1,314,979    13,360    4.09%   1,123,354    11,457    4.14%
Non-earning assets   97,799              107,590           
                               
Total assets  $1,412,778              1,230,944           
                               
Interest-bearing liabilities:                              
Demand accounts   136,634    47    0.14%   194,252    56    0.12%
Money market accounts   237,001    137    0.23%   243,687    110    0.18%
Savings accounts   40,741    13    0.13%   36,914    12    0.13%
Certificates of deposit   466,336    1,170    1.01%   360,346    783    0.88%
Short-term borrowed funds   92,967    105    0.45%   85,954    66    0.31%
Long-term debt   95,068    615    2.60%   56,408    473    3.40%
Total interest-bearing liabilities   1,068,747    2,087    0.79%   977,561    1,500    0.62%
Noninterest-bearing deposits   188,739              135,982           
Other liabilities   13,981              20,127           
Stockholders’ equity   141,311              97,274           
                               
Total liabilities and Stockholders’ equity  $1,412,778              1,230,944           
                               
Net interest spread             3.30%             3.52%
Net interest margin   3.44%             3.60%          
                               
Net interest margin (tax-equivalent) (2)   3.53%             3.68%          
Net interest income        11,273              9,957      

 

(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 3.44%, or 3.53% on a tax-equivalent basis, for the three months ended March 31, 2016 compared to 3.60%, or 3.68% on a tax equivalent basis, for the three months ended March 31, 2015. The decrease in our net margin primarily resulted from an increase in average long-term borrowings and certificates of deposits which has increased the rate paid on interest-bearing liabilities. In addition, the Federal Reserve increased interest rates in December of 2015 which has increased the rate paid on our short term borrowings.

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Our net interest spread, which is not on a tax-equivalent basis, was 3.30% for the three months ended March 31, 2016 as compared to 3.52% for the same period in 2015. 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 22 basis point decrease in net interest spread is a result of the 5 basis point decrease in yield on interest-earning assets and a 17 basis point increase in rate paid on interest-bearing liabilities.

Provision for Loan Loss

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

Following is a summary of the activity in the allowance for loan losses during the periods ended March 31, 2016 and 2015.

   For the Three Months
   Ended March 31,
   2016  2015
   (Dollars in thousands)
Balance, beginning of period  $10,141    9,035 
Provision for loan losses   —      —   
Loan charge-offs   (2)   (132)
Loan recoveries   94    476 
Balance, end of period  $10,233    9,379 

 

The Company experienced net recoveries of $92,000 and $344,000 for the three months ended March 31, 2016 and 2015, respectively. Asset quality has remained relatively consistent since year end, with nonperforming assets to total assets slightly decreasing to 0.39% as of March 31, 2016 as compared to 0.47% as of December 31, 2015. No provision expense for loan losses was recorded during 2016 or 2015 primarily due to the net recoveries experienced.

 

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

 46 
 

Noninterest Income and Expense

 

Noninterest income provides us with additional revenues that are significant sources of income. The major components of noninterest income for the three months ended March 31, 2016 and 2015 are presented below:

 

   For the Three Months
   Ended March 31,
   2016  2015
   (In thousands)
Noninterest income:          
Mortgage banking income  $3,175    4,017 
Deposit service charges   862    840 
Net loss on extinguishment of debt   (9)   —   
Net gain on sale of securities   417    471 
Fair value adjustments on interest rate swaps   (281)   (595)
Net increase in cash value life insurance   229    178 
Mortgage loan servicing income   1,388    1,308 
Other   495    371 
Total noninterest income  $6,276    6,590 

 

Noninterest income decreased $314,000 to $6.3 million for the three months ended March 31, 2016 from $6.6 million for the three months ended March 31, 2015. The decrease in noninterest income primarily relates to the decrease in mortgage banking income as a result of decreased originations and margin compression experienced.

 

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”:

   For the Three Months Ended March 31,
   Loan Originations  Mortgage Banking Income  Margin
   2016  2015  2016  2015  2016  2015
   (Dollars in thousands)
Additional segment information:                              
Community banking  $17,679    17,582    420    443    2.38%   2.52%
Wholesale mortgage banking   186,798    225,457    2,755    3,574    1.47%   1.59%
Total mortgage banking income  $204,477    243,039    3,175    4,017    1.55%   1.65%

 

Originations for the three months ended March 31, 2016 decreased 15.9% to $204.5 million compared to $243.0 million for the three months ended March 31, 2015. The new regulatory rules related to TILA-RESPA Integrated Disclosures (“TRID”) have significantly impacted the mortgage banking industry.

The percentage of originations attributable to refinances were 38% for the three months ended March 31, 2016 as compared to 41% for the three months ended March 31, 2015.

During the three months ended March 31, 2016, the Company recognized net gains on sale of available-for-sale securities of $417,000 compared to gains on sale of securities during three months ended March 31, 2015 of $471,000.

 

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The fair value adjustment on interest rate swaps reduced noninterest income by $281,000 for the three months ended March 31, 2016 compared to a reduction of noninterest income of $595,000 for three months ended March 31, 2015. 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.

 

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

 

   For the Three Months
   Ended March 31,
   2016  2015
   (In thousands)
Noninterest expense:          
Salaries and employee benefits  $7,150    6,963 
Occupancy and equipment   1,842    1,784 
Marketing and public relations   385    402 
FDIC insurance   168    165 
Provision for mortgage loan repurchase losses   (250)   (250)
Legal expense   49    177 
Other real estate expense, net   20    67 
Mortgage subservicing expense   423    395 
Amortization of mortgage servicing rights   532    460 
Merger related expenses   186    —   
Other   1,763    2,012 
Total noninterest expense  $12,268    12,175 

 

Noninterest expense represents the largest expense category for the Company. Noninterest expense slightly increased to $12.3 million for the three months ended March 31, 2016 from $12.2 million for the three months ended March 31, 2015. The increase in noninterest expense for the three ended March 31, 2016 compared to the prior period is primarily a result of the additional personnel costs and occupancy expense associated with the full service branch opened in Greenville during the third quarter of 2015. In addition, the Company incurred merger related expenses of $186,000 related to the announced acquisition of Congaree Bancshares, Inc. in January 2016.

Income Tax Expense

Our effective tax rate was 31.0% for three month period ended March 31, 2016, compared to 31.1% for the three month period ended March 31, 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 March 31, 2016, our investment securities portfolio, excluding FHLB stock and other investments, was $331.3 million or approximately 22.8% of our assets. Our available-for-sale investment portfolio included US agency securities, municipal securities, collateralized loan obligations, mortgage-backed securities (agency and non-agency), and trust preferred securities with a fair value of $314.3 million and an amortized cost of $314.1 million for a net unrealized gain of $244,000. Our held-to-maturity portfolio include municipal securities with a fair value of $18.0 million and a cost of $17.0 million for a net unrealized gain of $1.0 million.

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

During 2015, the Company transferred trust preferred securities totaling $11.4 million from available-for-sale to 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. See Note 2 under Item 1 “Financial Statements” herein for additional disclosures related to the Company’s evaluation of securities for OTTI as well as the transfer of held-to-maturity securities to available-for-sale during 2015.

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Loans by Type

 

Since loans typically provide higher interest yields than other types of interest-earning assets, a substantial percentage of our earning assets are invested in our loan portfolio. Loans receivable, net at March 31, 2016 and December 2015 were $953.8 million and $912.6 million, respectively.

Our loan portfolio consists primarily of loans secured by real estate mortgages. As of March 31, 2016, our loan portfolio included $839.7 million, or 87.1%, of gross loans secured by real estate. As of December 31, 2015, our loan portfolio included $801.1 million, or 86.8%, of gross loans secured by real estate. Substantially all of our real estate loans are secured by residential or commercial property. We obtain a security interest in real estate, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans to coincide with the appropriate regulatory guidelines. The Bank’s primary markets are generally concentrated in real estate lending. In order to diversify our lending portfolio, the Bank began a syndicated loan program during 2014. As of March 31, 2016, syndicated loans were $79.7 million and are included within commercial business loans in the table below. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral and business types.

As shown in the table below, gross loans receivable increased $41.4 million since December 31, 2015. The increase in loans receivable primarily relates to the Bank’s focus on growing residential mortgage and commercial lending.

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

   At March 31,  At December 31,
   2016  2015
      % of Total     % of Total
   Amount  Loans  Amount  Loans
   (Dollars in thousands)
Loans secured by real estate:                    
One-to-four family  $361,338    37.47%   343,686    37.23%
Home equity   26,063    2.70%   23,303    2.52%
Commercial real estate   352,775    36.58%   342,395    37.10%
Construction and development   99,513    10.32%   91,713    9.94%
Consumer loans   5,476    0.57%   5,181    0.56%
Commercial business loans   119,201    12.36%   116,737    12.65%
Total gross loans receivable   964,366    100.00%   923,015    100.00%
Less:                    
Allowance for loan losses   10,233         10,141      
Deferred fees, net   345         292      
Total loans receivable, net  $953,788         912,582      

 

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Maturities and Sensitivity of Loans to Changes in Interest Rates

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

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

   At March 31, 2016
      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  $9,512    48,514    303,312    361,338 
 Home equity   6,133    6,283    13,647    26,063 
 Commercial real estate   34,231    262,439    56,105    352,775 
 Construction and development   22,191    62,501    14,821    99,513 
 Consumer loans   1,302    3,389    785    5,476 
 Commercial business loans   13,650    49,908    55,643    119,201 
 Total gross loans receivable   87,019    433,034    444,313    964,366 
 Less:                    
 Deferred fees, net   75    1,076    (806)   345 
 Total loans receivable  $86,944    431,958    445,119    964,021 
                     
 Loans maturing - after one year                    
 Variable rate loans                 $356,965 
 Fixed rate loans                  520,112 
                  $877,077 

 

Nonperforming and Problem Assets

 

Nonperforming assets include loans on which interest is not being accrued, accruing loans that are 90 days or more delinquent and foreclosed property. Foreclosed property consists of real estate and other assets acquired as a result of a borrower’s loan default. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when we believe, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction of principal when received. In general, a nonaccrual loan may be placed back onto accruing status once the borrower has made a minimum of six consecutive payments in accordance with the loan terms. Further, the borrower must show capacity to continue performing into the future prior to restoration of accrual status. As of March 31, 2016 and December 31 2015, 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.

 

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

   At March 31,  At December 31,
   2016  2015
   (In thousands)
Loans receivable:          
 Nonaccrual loans-renegotiated loans  $1,708    1,136 
 Nonaccrual loans-other   2,873    3,166 
 Accruing loans 90 days or more delinquent          
 Real estate acquired through foreclosure, net   1,091    2,374 
 Total Non-Performing Assets  $5,672    6,676 
           
Problem Assets not included in Non-Performing Assets-Accruing renegotiated loans outstanding  $12,372    13,212 

 

At March 31, 2016, nonperforming assets were $5.7 million, or 0.39% of total assets. Comparatively, nonperforming assets were $6.7 million, or 0.47% of total assets, at December 31, 2015. Nonperforming loans were 0.48% and 0.47% of gross loans receivable at March 31, 2016 and December 31, 2015, respectively.

Potential problem loans, which are not included in nonperforming loans, amounted to approximately $12.4 million, or 1.28% of gross loans at March 31, 2016, compared to $13.2 million, or 1.43% of gross loans at December 31, 2015. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms.

Substantially all of the nonaccrual loans, accruing loans 90 days or more delinquent and accruing renegotiated loans at March 31, 2016 and December 31, 2015 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 continue to show improvement 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.

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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 $10.2 million, or 1.06% of total loans at March 31, 2016, compared to $10.1 million, or 1.10% of total loans, at December 31, 2015. Included in the loan totals were $61.6 million and $64.1 million in loans acquired through previous branch acquisitions at March 31, 2016 and December 31, 2015, 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 $92,000 and $344,000 for the three months ended March 31, 2016 and 2015, respectively. Asset quality has remained relatively consistent since year end, with nonperforming assets to total assets slightly decreasing to 0.39% as of March 31, 2016 as compared to 0.47% as of December 31, 2015. No provision expense for loan losses was recorded during 2016 or 2015 primarily due to the net recoveries experienced.

 

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The following table summarizes the activity related to our allowance for loan losses for the three months ended March 31, 2016 and 2015.

   For the Three Months
   Ended March 31,
   2016  2015
   (Dollars in thousands)
Balance, beginning of period  $10,141    9,035 
Provision for loan losses   —      —   
Loan charge-offs:          
 Loans secured by real estate:          
 One-to-four family   —      —   
 Home equity   —      —   
 Commercial real estate   —      —   
 Construction and development   —      (90)
 Consumer loans   (2)   (1)
 Commercial business loans   —      (41)
 Total loan charge-offs   (2)   (132)
Loan recoveries:          
 Loans secured by real estate:          
 One-to-four family   58    175 
 Home equity   —      —   
 Commercial real estate   —      225 
 Construction and development   3    12 
 Consumer loans   6    12 
 Commercial business loans   27    52 
 Total loan recoveries   94    476 
Net loan (charge-offs) recoveries   92    344 
Balance, end of period  $10,233    9,379 
           
Allowance for loan losses as a percentage of loans receivable (end of period)   1.06%   1.17%
Net charge-offs (recoveries) to average loans receivable (annualized)   (0.04)%   (0.18)%

 

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Mortgage Operations

Mortgage Activities and Servicing

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

Loan Servicing

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

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

The Company was servicing $2.0 billion loans for others at March 31, 2016 and December 31, 2015. Mortgage servicing rights asset had a balance of $11.9 million and $11.4 million at March 31, 2016 and December 31, 2015, respectively. The economic estimated fair value of the mortgage servicing rights was $17.1 million and $17.6 million at March 31, 2016 and December 31, 2015, respectively. The amortization expense related to the mortgage servicing rights was $532,000 and $460,000 during the three months ended March 31, 2016 and 2015, respectively.

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Below is a roll-forward of activity in the balance of the servicing assets for the three months ended March 31, 2016 and 2015.

   For the Three Months
   Ended March 31,
   2016  2015
   (In thousands)
MSR beginning balance  $11,433    10,181 
Amount capitalized   1,045    640 
Amount amortized   (532)   (460)
MSR ending balance  $11,946    10,361 

 

Reserve For Mortgage Repurchase Losses

Loans held for sale have primarily been fixed-rate single-family residential mortgage loans under contracts to be sold in the secondary market. In most cases, loans in this category are sold within 30 days of closing. Buyers generally have recourse to return a purchased loan to the Company under limited circumstances. 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 reserve for mortgage repurchase losses for the three months ended March 31, 2016 and 2015.

   For the Three Months
   Ended March 31,
   2016  2015
   (In thousands)
Beginning Balance  $3,876    4,999 
Losses paid   (21)   (78)
Recoveries          
Provision for mortgage repurchase losses   (250)   (250)
Ending balance  $3,605    4,671 

 

For the three months ended March 31, 2016 and 2015, the Company recorded a negative provision for mortgage repurchase losses of $250,000. 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.

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

Deposits

We provide a range of deposit services, including noninterest-bearing demand accounts, interest-bearing demand and savings accounts, money market accounts and time deposits. These accounts generally pay interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. Deposits continue to be our primary funding source. At March 31, 2016 deposits totaled $1.1 billion, an increase of $96.2 million from deposits of $1.0 billion at December 31, 2015.

Our retail deposits represented $971.4 million, or 86.1% of total deposits at March 31, 2016, while our out-of-market, comprised of our brokered and institutional deposits, represented $156.4 million, or 13.9% of our total 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.

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

   For the Three Months
   Ended March 31,
   2016  2015
   Average  Average  Average  Average
   Balance  Rate  Balance  Rate
   (Dollars in thousands)
Interest-bearing demand accounts  $136,634    0.14%   194,252    0.12%
Money market accounts   237,001    0.23%   243,687    0.18%
Savings accounts   40,741    0.13%   36,914    0.13%
Certificates of deposit less than $100,000   262,938    0.96%   225,381    0.85%
Certificates of deposit of $100,000 or more   203,398    1.07%   134,965    0.90%
Total interest-bearing average deposits   880,712         835,199      
                     
Noninterest-bearing deposits   188,739         135,982      
Total average deposits  $1,069,451         971,181      

 

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

   At March 31, 2016
   (In thousands)
      
Three months or less  $33,816 
Over three through six months   30,178 
Over six through twelve months   43,043 
Over twelve months   106,386 
Total certificates of deposits  $213,423 

 

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Borrowings

The followings table outlines our various sources of short-term borrowed funds during the three months ended March 31, 2016 and 2015 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 borrowings 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
   Balance  Rate  Balance  Balance  Rate
At or for the three months ended March 31, 2016  (Dollars in thousands)
Short-term borrowed funds                         
Short-term FHLB advances  $70,000    0.35% - 0.76%   115,000    92,967    0.45%
                          
Long-term borrowed funds                         
Long-term FHLB advances, due 2017 through 2021   83,000    0.63%-4.00%   88,000    79,603    2.35%
Subordinated debentures issued to Carolina Financial Capital Trust I, due 2032   5,155    4.00%   5,155    5,155    4.00%
Subordinated debentures issued to Carolina Financial Capital Trust II, due 2034   10,310    3.67%   10,310    10,310    3.69%

 

         Maximum      
      Period  Month  Average for the
   Ending  End  End  Period
   Balance  Rate  Balance  Balance  Rate
At or for the three months ended March 31, 2015  (Dollars in thousands)
Short-term borrowed funds                         
Unsecured line of credit  $36    4.25%   36    25    4.25%
Short-term FHLB advances   115,500    0.19% - 0.64%   147,500    85,629    0.25%
Subordinated debenture   300    2.71%   300    300    2.71%
                          
Long-term borrowed funds                         
Long-term FHLB advances, due 2017 through 2021   40,000    1.11%-4.00%   40,000    39,669    3.33%
Subordinated debentures, due 2016 through 2020   1,200    2.71%   1,275    1,274    2.71%
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    3.30%   10,310    10,310    3.30%

 

Liquidity

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

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

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Lines of credit with the FHLB of Atlanta are based upon FHLB-approved percentages of Bank assets, but must be supported by appropriate collateral to be available. The Company has pledged first lien residential mortgage, second lien residential mortgage, residential home equity line of credit, commercial mortgage and multifamily mortgage portfolios under blanket lien agreements. At March 31, 2016, the Company had FHLB advances of $153.0 million outstanding with excess collateral pledged to the FHLB during those periods that would support additional borrowings of approximately $155.0 million.

Lines of credit with the FRB are based on collateral pledged. At March 31, 2016, the Company had lines available with the FRB for $95.5 million. At March 31, 2016, 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.

 

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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 March 31, 2016 and December 31, 2015 are as follows:

            To Be Well
         Minimum Required  Capitalized Under
         For Capital  Prompt Corrective
   Actual  Adequacy Purposes  Action Regulations
   Amount  Ratio  Amount  Ratio  Amount  Ratio
   (Dollars in thousands)
                   
March 31, 2016                              
Carolina Financial Corporation                              
CET1 capital (to risk weighted assets)  $141,309    13.88%   45,802    4.50%   N/A    N/A 
Tier 1 capital (to risk weighted assets)   156,309    15.36%   61,070    6.00%   N/A    N/A 
Total capital (to risk weighted assets)   166,542    16.36%   81,427    8.00%   N/A    N/A 
Tier 1 capital (to total average assets)   156,309    11.07%   56,456    4.00%   N/A    N/A 
                               
CresCom Bank                              
CET1 capital (to risk weighted assets)   143,352    14.09%   45,775    4.50%   66,119    6.50%
Tier 1 capital (to risk weighted assets)   143,352    14.09%   61,033    6.00%   81,378    8.00%
Total capital (to risk weighted assets)   153,585    15.10%   81,378    8.00%   101,722    10.00%
Tier 1 capital (to total average assets)   143,352    10.11%   56,698    4.00%   70,872    5.00%
                               
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%

 

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 March 31, 2016, we had issued commitments to extend credit of approximately $78.2 million through various types of lending arrangements. There were 19 standby letters of credit included in the commitments for $1.5 million. Fixed rate commitments were $11.9 million and variable rate commitments were $66.3 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.

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

As of March 31, 2016, 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. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the Consolidated Financial Statements. Therefore, management’s assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. In addition, this analysis does not consider any strategic changes to our balance sheet which management may consider as a result of changes in market conditions.

Interest Rate Scenario     Annualized Hypothetical
Percentage Change in
 
  Change       Prime Rate     Net Interest Income  
  0.00%         3.50%       0.0%  
  1.00%         4.50%       0.5%  
  2.00%         5.50%       0.9%  
  3.00%         6.50%       0.9%  

 

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

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

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

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Accounting, Reporting, and Regulatory Matters

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

Effect of Inflation and Changing Prices

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

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

 

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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

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

 

Item 4. CONTROLS AND PROCEDURES.

 

Evaluation of Disclosure Controls and Procedures

 

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

 

Changes in Internal Control over Financial Reporting

 

There has been no change in the Company’s internal control over financial reporting during the three months ended March 31, 2016, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

Item 1. LEGAL PROCEEDINGS.

 

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

 

Item 1A RISK FACTORS.

 

Investing in shares of our common stock involves certain risks, including those identified and described in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2015, as well as cautionary statements contained in this Form 10-Q, including those under the caption “Cautionary Note Regarding Any Forward-Looking Statement” set forth in Part I, Item 2 of this Form 10-Q, risks and matters described elsewhere in this Form 10-Q and in our other filings with the SEC.

 

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

 

Not applicable

 

Item 3. DEFAULTS UPON SENIOR SECURITIES.

 

Not applicable

 

Item 4. MINE SAFETY DISCLOSURES.

 

Not applicable

 

Item 5. OTHER INFORMATION.

 

Not applicable

 

Item 6. EXHIBITS.

 

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

 

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SIGNATURES

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

 
    CAROLINA FINANCIAL CORPORATION
    Registrant
     
Date: May 9, 2016   /s/ Jerold L. Rexroad
    Jerold L. Rexroad
    President and Chief Executive Officer
    (Principal Executive Officer)
     
Date: May 9, 2016   /s/ William A. Gehman, III
    William A. Gehman III
    Executive Vice President and Chief Financial Officer
    (Principal Financial and Accounting Officer)

 

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INDEX TO EXHIBITS

 

Exhibit
Number
  Description
2.1   Agreement and Plan of Merger, dated January 5, 2016, by and among Carolina Financial Corporation, CBAC, Inc., and Congaree Bancshares, Inc.*
     
10   Employment Agreement, dated January 21, 2015, by and between Crescent Mortgage Company and Fowler Williams.
     
31.1   Rule 13a-14(a) Certification of the Principal Executive Officer.
     
31.2   Rule 13a-14(a) Certification of the Principal Financial Officer.  
     
32   Section 1350 Certifications.
     
101   The following materials from the Quarterly Report on Form 10-Q of Carolina Financial Corporation for the quarter ended March 31, 2016, formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statement of Changes in Stockholders’ Equity, (v) Consolidated Statements of Cash Flows and (vi) Notes to Unaudited Consolidated Financial Statements.

 

*Incorporated by reference from the Company’s Current Report on Form 8-K filed on January 11, 2016.

 

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