SOUTHCOAST FINANCIAL CORP - FORM 10-Q

Attached files

file	filename
EX-31.1 - EXHIBIT 31.1 - SOUTHCOAST FINANCIAL CORP	ex31-1.htm
EX-31.2 - EXHIBIT 31.2 - SOUTHCOAST FINANCIAL CORP	ex31-2.htm
EX-32 - EXHIBIT 32 - SOUTHCOAST FINANCIAL CORP	ex32.htm

U.S. 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

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

For the Transition Period from _________to_________

Commission File No.

0-25933

SOUTHCOAST FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

South Carolina	57-1079460
(State or other jurisdiction	(I.R.S. Employer
of incorporation or organization)	Identification No.)

530 Johnnie Dodds Boulevard

Mt. Pleasant, South Carolina 29464

(Address of principal executive offices)

843-884-0504

(Registrant's telephone number, including area code)

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

YES [ X] NO [ ]

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

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

Large accelerated filer [ ]	Accelerated filer [ ]
Non-accelerated filer [ ] (Do not check if a smaller reporting company)	Smaller reporting company [ X ]

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

YES [ ] NO [ X ]

State the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date.

7,103,751 shares of common stock, no par value, as of April 30, 2016

SOUTHCOAST FINANCIAL CORPORATION

INDEX

PART I - FINANCIAL INFORMATION		Page No.

Item 1.	Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets – March 31, 2016 and December 31, 2015		2

Condensed Consolidated Statements of Income – Three months ended March 31, 2016 and 2015		3

Condensed Consolidated Statements of Comprehensive Income – Three months ended March 31, 2016 and 2015		4

Condensed Consolidated Statements of Changes in Shareholders' Equity – Three months ended March 31, 2016 and 2015		5

Condensed Consolidated Statements of Cash Flows - Three months ended March 31, 2016 and 2015		6

Notes to Condensed Consolidated Financial Statements		7-29

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	30-40

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	40

Item 4.	Controls and Procedures	40

PART II - OTHER INFORMATION

Item 6.	Exhibits	41

Signatures		41

Exhibit Index		42

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Balance Sheets

PART I - FINANCIAL INFORMATION

Item 1 - Financial Statements

(Dollars in thousands)

	March 31, 2016			December 31, 2015
	(Unaudited)
Assets
Cash and cash equivalents:
Cash and due from banks	$	24,400		$	40,944
Federal funds sold		2,196			-
Total cash and cash equivalents		26,596			40,944

Investment securities
Available for sale		31,514			32,035
Federal Home Loan Bank Stock, at cost		3,508			4,291

Loans held for sale		197			1,711

Loans, net of allowance of $4,421 and $4,794		377,456			384,502

Premises and equipment, net		19,653			19,277
Other real estate owned, net		327			327
Company owned life insurance		13,382			13,303
Deferred tax asset, net		3,713			3,783
Other assets		2,685			2,637

Total assets	$	479,031		$	502,810

Liabilities
Deposits
Noninterest-bearing	$	61,942		$	55,755
Interest-bearing		276,366			283,702

Total deposits		338,308			339,457

Federal funds purchased		-			5,396
Securities sold under agreements to repurchase		1,367			1,364
Federal Home Loan Bank Borrowings		72,000			91,000
Junior subordinated debentures		10,310			10,310
Other liabilities		3,891			3,443

Total liabilities		425,876			450,970

Shareholders’ Equity
Common stock (no par value; 20,000,000 shares authorized;7,103,751 shares issued and outstanding)		54,694			54,694
Accumulated deficit		(928	)		(2,138	)
Accumulated other comprehensive loss		(611	)		(716	)

Total shareholders’ equity		53,155			51,840

Total liabilities and shareholders’ equity	$	479,031		$	502,810

See Notes to Condensed Consolidated Financial Statements

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Income

(Unaudited)

(Dollars in thousands)

	For the Three Months Ended March 31,
	2016			2015
Interest income
Loans, including fees	$	4,473		$	4,604
Investment securities		277			252
Cash and federal funds sold		21			8

Total interest income		4,771			4,864

Interest expense
Deposits and borrowings		854			849

Net interest income		3,917			4,015
Provision (credit) for loan losses		(500	)		(900	)

Net interest income after provision (credit) for loan losses		4,417			4,915

Noninterest income
Service fees on deposit accounts		379			388
Gain on sale of mortgage loans held for sale		66			20
Company owned life insurance earnings		79			78
Gain on sale of premises and equipment		56			750
Other		43			45
Total noninterest income		623			1,281

Noninterest expenses
Salaries and employment benefits		1,766			1,830
Occupancy		266			277
Furniture and equipment		443			424
Software		10			13
Insurance		112			132
Professional fees		193			202
Telephone, postage, and supplies		76			87
Gain on sale of other real estate owned		(9	)		(25	)
Other real estate owned impairment provision, and other expenses, net of rental income		6			4
Other operating expenses		295			196

Total noninterest expenses		3,158			3,140

Income before income taxes		1,882			3,056
Income tax expense		672			1,078

Net income	$	1,210		$	1,978

Basic net income per common share	$	.17		$	.28

Diluted net income per common share	$	.17		$	.28

Weighted average shares outstanding
Basic		7,103,751			7,099,979
Diluted		7,103,751			7,099,979

See Notes to Condensed Consolidated Financial Statements

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Comprehensive Income

(Unaudited)

(Dollars in thousands)

	For the Three Months Ended March 31,
	2016			2015
Net income	$	1,210		$	1,978

Other comprehensive income :
Unrealized gains on available for sale securities		163			801
Tax effect		(58	)		(288	)
Total other comprehensive income		105			513

Comprehensive income	$	1,315		$	2,491

See Notes to Condensed Consolidated Financial Statements

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Changes in Shareholders' Equity

For the three months ended March 31, 2016 and 2015

(Unaudited)

(Dollars in thousands)								Accumulated Other
	Common Stock				Accumulated			Comprehensive
	Shares		Amount		Deficit			Loss			Total

Balance, January 1, 2015		7,096,574	$	54,643	$	(6,200	)	$	(1,138	)	$	47,305

Net income for the period						1,978						1,978

Other comprehensive income, net of tax									513			513

Comprehensive income												2,491

Employee stock purchase plan		3,405		24		.-			-			24

Balance, March 31, 2015		7,099,979	$	54,667	$	(4,222	)	$	(625	)	$	49,820

Balance, January 1, 2016		7,103,751	$	54,694	$	(2,138	)	$	(716	)	$	51,840

Net income for the period						1,210						1,210

Other comprehensive income, net of tax									105			105

Comprehensive income		-		-		-			-			1,315

Balance, March 31, 2016		7,103,751	$	54,694	$	(928	)	$	(611	)	$	53,155

See Notes to Condensed Consolidated Financial Statements

SOUTHCOAST FINANCIAL CORPORATION

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(Amounts in thousands)	For the Three Months Ended March 31,
	2016			2015
Operating activities
Net income	$	1,210		$	1,978
Adjustments to reconcile net income to net cash provided by operating activities
Decrease in deferred income taxes		12			921
Provision (credit) for loan losses		(500	)		(900	)
Depreciation and amortization		187			201
Discount accretion and premium amortization		29			34
Gain on sale of other real estate owned		(9	)		(25	)
Change in deferred gain on sale of other real estate owned		-			24
Originations of loans held for sale		(2,895	)		(915	)
Proceeds from sales of loans held for sale		4,475			935
Gain on sale of mortgage loans held for sale		(66	)		(20	)
Gain on sale of premises and equipment		(56	)		(750	)
Company owned life insurance earnings		(79	)		(78	)
Decrease (increase) in other assets		(48	)		61
Increase (decrease) in other liabilities		448			(1,077	)
Net cash provided by operating activities		2,708			389

Investing activities
Calls, maturities, and paydowns of investment securities available-for-sale		655			749
Purchases of Federal Home Loan Bank stock		(1,299	)		(534	)
Sales of Federal Home Loan Bank stock		2,082			965
Net decrease (increase) in loans		7,546			(3,309	)
Purchases of premises and equipment		(1,533	)		(37	)
Proceeds from sales of premises and equipment		1,026			1,294
Proceeds from sales of other real estate owned		9			312
Net cash used by investing activities		8,486			(560	)

Financing activities
Net increase (decrease) in deposits		(1,149	)		23,498
Decrease in federal funds purchased		(5,396	)		(3,065	)
Increase (decrease) in securities sold under agreements to repurchase		3			(387	)
Proceeds from Federal Home Loan Bank Borrowings		30,000			17,000
Paydowns of Federal Home Loan Bank Borrowings		(49,000	)		(23,000	)
Net proceeds from issuances of stock		-			24
Net cash provided (used) by financing activities		(25,542	)		14,070

Increase (decrease) in cash and cash equivalents		(14,348	)		13,899
Cash and cash equivalents, beginning of period		40,944			33,572
Cash and cash equivalents, end of period	$	26,596		$	47,471

Cash paid for:
Interest	$	819		$	1,174
Income Taxes	$	-		$	62
Supplemental noncash investing and financing activities:
Change in unrealized losses on available-for-sale securities	$	(163	)	$	(801	)

See Notes to Condensed Consolidated Financial Statements

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 1 - Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Regulation S-X of the Securities and Exchange Commission. Accordingly they do not include all information and notes required by generally accepted accounting principles for complete financial statements. However, in the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.

Note 2 - Organization

Southcoast Financial Corporation (the “Company”) is a South Carolina corporation organized in 1999 for the purpose of being a holding company for Southcoast Community Bank (the “Bank”). On April 29, 1999, pursuant to a Plan of Exchange approved by the shareholders, all of the outstanding shares of capital stock of the Bank were exchanged for shares of common stock of the Company. The Company presently engages in no business other than that of owning the Bank and another subsidiary, Southcoast Investment Corporation, and has no employees.

On August 14, 2015, the Company entered into a definitive agreement with BNC Bancorp ("BNC") the holding company for Bank of North Carolina, pursuant to which BNC will acquire all of the common stock of the Company in a stock transaction valued at approximately $95.5 million, based on the closing price of BNC common stock on August 13, 2015. Under the terms of the agreement, which has been approved by the Boards of Directors of both companies, the Company's shareholders will receive shares of BNC common stock based upon the volume weighted average price of BNC common stock for a 20-day trading period prior to the closing of the merger ("VWAP"), subject to minimum and maximum exchange ratios as follow: if the VWAP immediately prior to the merger is equal to or greater than $22.00, then each share of the Company’s common stock will be converted into 0.6068 shares of BNC common stock; if the VWAP immediately prior to the merger is less than $22.00 but greater than $19.00, then each share of the Company’s common stock will be converted into $13.35 payable in shares of BNC common stock (with the exchange ratio equal to $13.35 divided by the VWAP); and if the VWAP is equal to or less than $19.00, then each share of the Company’s common stock will be converted into 0.7026 shares of BNC common stock. The transaction, which has received approval of the shareholders of the Company, is subject to regulatory approval, and is expected to close in the second quarter of 2016.

Note 3 - Net Income Per Share

Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. Earnings and dividends per share are restated for all stock splits and stock dividends through the date of issuance of the financial statements, if any. The Company had no potentially dilutive shares during the periods presented in this report.

Note 4 – Recently Issued Accounting Standards

In May 2014, the FASB issued ASU 2014-09 – Revenue from Contracts with Customers (“ASU 2019-09”). ASU 2014-09 provides guidance that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 is effective prospectively, for annual and interim periods, beginning after December 15, 2017. The Company is currently evaluating the impact this standard will have on the Company’s results of operations, financial position or disclosures.

In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10). The amendments in this Update require all equity investments to be measured at fair value with changes in the fair value recognized through net income (other than those accounted for under equity method of accounting or those that result in consolidation of the investee). The amendments in this Update also require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. In addition the amendments in this Update eliminate the requirement to disclose the fair value of financial instruments measured at amortized cost for entities that are not public business entities and the requirement for to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet for public business entities.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 4 – Recently Issued Accounting Standards – (continued)

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The new standard requires the recognition of assets and liabilities arising from lease transactions on the balance sheet and the disclosure of key information about leasing arrangements. Accordingly, a lessee will recognize a lease asset for its right to use the underlying asset and a lease liability for the corresponding lease obligation. Both the asset and liability will initially be measured at the present value of the future minimum lease payments over the lease term. Subsequent measurement, including the presentation of expenses and cash flows, will depend on the classification of the lease as either a finance or an operating lease. Initial costs directly attributable to negotiating and arranging the lease will be included in the asset. For leases with a term of 12 months or less, a lessee can make a policy election by class of underlying asset to not recognize an asset and corresponding liability. Lessees will also be required to provide additional qualitative and quantitative disclosures regarding the amount, timing and uncertainty of cash flows arising from leases. In transition, lessees are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The transition guidance also provides specific guidance for sale and leaseback transactions, build-to-suit leases and amounts previously recognized in accordance with the business combinations guidance for leases. For public companies, ASU 2016-02 is effective prospectively, for annual and interim periods, beginning after December 15, 2018. The Company does not expect this standard to have a material impact on its consolidated financial statements.

Note 5 – Investment Securities

The amortized cost and fair value of investment securities are as follows:

(Amounts in thousands)	March 31, 2016
	Amortized		Gross Unrealized				Estimated
	Cost		Gains		Losses		Fair Value

Available for sale
Mortgage backed
Government sponsored enterprises	$	20,813	$	74	$	42	$	20,845
Municipal securities		3,434		243		-		3,677
Other		8,222		109		1,339		6,992

Total	$	32,469	$	426	$	1,381	$	31,514

	December 31, 2015
	Amortized		Gross Unrealized				Estimated
	Cost		Gains		Losses		Fair Value
Available for sale
Mortgage backed
Government sponsored enterprises	$	21,502	$	7	$	191	$	21,318
Municipal securities		3,433		249		-		3,682
Other		8,218		53		1,236		7,035

Total	$	33,153	$	309	$	1,427	$	32,035

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 5 – Investment Securities – (continued)

The following tables show gross unrealized losses and fair value, aggregated by investment category, and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2016 and December 31, 2015.

Available for Sale

(Amounts in thousands)	March 31, 2016
	Less than				Twelve Months
	Twelve Months				or More				Total
			Unrealized				Unrealized				Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses

Mortgage backed	$	10,168	$	22	$	3,465	$	20	$	13,633	$	42
Other		-		-		2,233		1,339		2,233		1,339

Total	$	10,168	$	22	$	5,698	$	1,359	$	15,866	$	1,381

	December 31, 2015
	Less than				Twelve Months
	Twelve Months				or More				Total
			Unrealized				Unrealized				Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses

Mortgage backed	$	16,896	$	191	$	-	$	-	$	16,896	$	191
Other		-		-		2,332		1,236		2,332		1,236

Total	$	16,896	$	191	$	2,332	$	1,236	$	19,228	$	1,427

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 5 – Investment Securities – (continued)

Securities classified as available-for-sale are recorded at fair market value. Unrealized losses on securities in a continuous loss position for twelve months or more totaled $1,359,000, or 98% of unrealized losses, and $1,236,000, or 87% of unrealized losses, at March 31, 2016 and December 31, 2015, respectively. The majority of the unrealized losses for both periods related to Other securities, which were comprised of two individual securities. It is more likely than not that the Company will not be required to sell these securities before recovery of their amortized cost.

The unrealized loss attributable to Other securities primarily relates to valuations on two individual collateralized debt obligations which consist of pooled trust preferred securities. The Company believes, based on industry analyst reports, credit ratings, and third party other-than-temporary loss impairment evaluations, that the deterioration in the value of these securities is attributable to a combination of the lack of liquidity in both of these securities and credit quality concerns for one of the two securities. These securities are considered Level 3 securities in the fair value hierarchy as they both trade in less than liquid markets.

One of the Company’s collateralized debt obligations with an amortized cost of approximately $1,831,000 and fair value of approximately $1,033,000 is receiving contractual interest payments, while the other with an amortized cost of approximately $1,741,000 and fair value of approximately $1,200,000 received an interest payment in March 2016 after an extended period of deferred interest payments. Due to the over-collateralized credit position and uninterrupted payment stream of the first security, no other-than-temporary impairment was recognized on this security. During the period of deferred interest payments on the second security, payment-in-kind interest was added to the par value of the security in lieu of cash interest payments. The Company did not accrue interest during the deferral period, and will continue to postpone accrual of interest until a sustained pattern of payments has been reestablished and the credit profile of the security has improved substantially. Presently, interest income on this security is recognized as payments are received. The Company recognized interest income on this security totaling approximately $42,000 for the three months ended March 31, 2016.

Payment-in-kind interest was triggered on the second security due to deferrals of interest payments by individual issuers within the pool of issuers. Individual issuers are allowed to defer their interest payments for a period of up to five years. The security is divided into several tranches, with the A tranche securities being the most senior in terms of payment priority and Income Notes being the least senior. The Company owns notes in the C tranche of the security. Each tranche must pass an overcollateralization test in order for note holders in subordinate tranches to receive their contractual interest payments. The overcollateralization test is based on total performing collateral in the pool divided by total outstanding debt within the tranche. The senior most pool failing its overcollateralization test will receive principal paydowns on its outstanding notes in addition to contractual interest payments in order to cure its failure. These additional payments will be diverted from note holders in subordinate tranches who will instead receive payment-in-kind interest. At March 31, 2016, there was $234,128,000 of performing collateral in the pool. The table below summarizes balance and overcollateralization data for the individual tranches at March 31, 2016.

(Amounts in thousands)

Tranche	Current Balance		Required Overcollateralization %			Current Overcollateralization %
A	$	167,114		128.00	%		140.77	%
B		37,587		115.00	%		114.92	%
C		48,675		106.20	%		92.84	%
D		28,837		100.30	%		83.36	%
Income Notes		18,000		N/A			N/A

As shown above, tranches B and below currently fail their overcollateralization test. However, on the March 2016 payment date, there were sufficient collections to cure the Class B overcollateralization test and pay full current interest and a small amount of previously deferred interest to tranche C. According to the structured payment terms as described in the offering circular for this security, interest payments are diverted from subordinated tranches to pay down total principal balances in the senior most tranche failing its overcollateralization test. If and when these payments reduce the principal balance in the senior most failing tranche by enough to pass its overcollateralization requirement, the next most senior tranche securities will begin to receive contractual interest payments, and additional payments will be diverted from subordinate tranches in order to meet its overcollateralization requirement. This payment structure, known as a waterfall, is designed to continue until all tranches meet their overcollateralization requirement. However, this outcome is dependent on the level of future interest deferrals and defaults by individual issuers. Any shortfalls to contractual principal and interest payments due will be borne in reverse order of payment priority, with the most subordinate tranche having the largest loss and the senior most tranche having the smallest loss. As a note holder in the C tranche of this structure, the Company’s principal and interest claims are subordinate to the principal and interest claims of note holders in the A and B tranches. More specifically, the Company and other C note holders would lose 100% of their principal and interest before note holders in the B tranche lost their first dollar, and B note holders would lose 100% of their investment before A note holders experienced any loss.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 5 – Investment Securities – (continued)

The Company engaged a firm specializing in security valuations to evaluate the security receiving payment-in-kind interest for other-than- temporary impairment (“OTTI”). This firm uses the OTTI evaluation model to compare the present value of expected cash flows to the previous estimate to measure whether there are any adverse changes in cash flows during the quarter. The OTTI model considers the structure and term of the trust preferred security and the financial condition of the underlying issuers. Specifically, the model details interest rates, principal balances of note classes and issuers, the timing and amount of interest and principal payments of the underlying issuers, and the allocation of the payments to the note classes. The allocation of payments to the note classes follows the payment priority hierarchy for the individual tranches. The OTTI evaluation prepared as of March 31, 2016 predicts the Company will continue to receive its contractual principal and interest payments for the foreseeable future. These projections are based on assumptions developed from current financial data for the underlying issuers and may change based on future financial data which could alter the assumptions.

The current estimate of expected cash flows is based on the most recent trustee reports and any other relevant information including announcements of interest payment deferrals or defaults of the underlying issuers. The OTTI evaluation model assumes no recoveries on defaults. The result of the firm’s analysis indicated approximately $176,000 of credit loss as of March 31, 2011, which was recognized as an other-than-temporary loss in the first quarter of 2011 and reported in noninterest income. No credit losses had been recognized on these securities prior to 2011, and there have been no changes to credit losses recognized in earnings for any subsequent periods. Total other-than-temporary impairment in accumulated other comprehensive income was $346,000 for the security (Security B in the table below) at March 31, 2016.

The following table provides certain relevant details on each of our collateralized debt obligations as of March 31, 2016, including the book value, fair value, and unrealized losses on the securities, as well as certain information about the overall pools and the current status of their underlying issuers. “Excess Subordination” is a measure of the excess performing collateral in the pool beyond the total level of debt outstanding in the pool with an equal or greater level of preference in the payment structure. It is expressed in the tables below as a percentage of performing collateral. It represents the percentage reduction in performing collateral that would precede an inability of the security to make contractually required payments to the Company.

March 31, 2016
(Amounts in thousands)
	Security A			Security B

Book Value	$	1,831		$	1,741
Fair Value	$	1,033		$	1,200
Unrealized Loss	$	798		$	541
Number of underlying financial institution issuers		45			38
Number of deferrals and defaults		7			11
Additional expected deferrals/ defaults*		N/A			0/1
Excess Subordination as a percentage of performing collateral^		33.36	%		N/A

No assessment of these numbers was made for Security A as it was not modeled for cash flows due to its current payment status and its excess subordination. For Security B, this includes issuers for which there is an estimated probability of deferral or default of 50% or greater. None of the remaining performing collateral was projected as a future deferral or default, due to low Texas ratios; two deferring issuers were projected to default.

^Security B is in a support tranche and has no excess subordination.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 5 – Investment Securities – (continued)

The credit quality of the collateralized debt obligations is directly related to the financial strength and ability to make contractual interest payments of the underlying issuers in these securities, most of which are banks or bank holding companies. As such, these securities may show additional OTTI in future periods if the financial condition of the underlying

issuers further deteriorates.

The amortized costs and fair values of investment securities available for sale at March 31, 2016 by contractual maturity are shown in the following table. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

(Amounts in thousands)	Amortized		Fair
	Cost		Value
Due within one year	$	499	$	511
Due after one but within five years		440		454
Due after five but within ten years		2,252		2,443
Due after ten years		4,315		3,002
Mortgage backed		20,813		20,845
Equity securities with no maturity		4,150		4,259

Total investment securities available-for-sale	$	32,469	$	31,514

Investment securities with an aggregate amortized cost of $19,404,000 and estimated fair value of $19,525,000 at March 31, 2016, were pledged to secure public deposits and for other purposes, as required or permitted by law.

Investment securities with an aggregate amortized cost of $2,051,000 and estimated fair value of $2,047,000 at March 31, 2016, were pledged to secure securities sold under agreements to repurchase.

Investment securities with an aggregate amortized cost of $19,274,000 and estimated fair value of $19,231,000 at December 31, 2015, were pledged to secure public deposits and for other purposes, as required or permitted by law.

Investment securities with an aggregate amortized cost of $2,115,000 and estimated fair value of $2,090,000 at December 31, 2015, were pledged to secure securities sold under agreements to repurchase.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 - Loans

The composition of loans by major loan category is presented below:

(Dollars in thousands)	March 31,			December 31,
	2016			2015
Real estate secured loans:
Residential 1-4 Family	$	238,378		$	241,111
Multifamily		3,802			4,747
Commercial		83,898			85,501
Construction and land development		32,820			34,311

Total real estate secured loans		358,898			365,670
Commercial and industrial		19,868			20,666
Consumer		2,792			2,623
Other		319			337

Total gross loans		381,877			389,296
Allowance for loan losses		(4,421	)		(4,794	)

	$	377,456		$	384,502

The Company uses a numerical grading system from 1 to 9 to assess the credit risk inherent in its loan portfolio, with Grade 1 loans having the lowest credit risk and Grade 9 loans having the highest credit risk. Loans with credit grades from 1 to 5 are considered passing grade, or acceptable, loans. Loans with grades from 6 to 9 are considered to have less than acceptable credit quality. Generally, impaired loans have credit grades of 7 or higher. Following is a listing and brief description of the various risk grades. The grading of individual loans may involve the use of estimates.

Credit Grade		Description
1		Loans secured by cash collateral.
2		Loans secured by readily marketable collateral.
3		Top quality loans with excellent repayment sources and no significant identifiable risk of collection.
4		Acceptable loans with adequate repayment sources and little identifiable risk of collection.
5		Acceptable loans with signs of weakness as to repayment or collateral, but with mitigating factors that minimize the risk of loss.
6		Watch List or Special Mention loans with underwriting tolerances and/or exceptions with no mitigating factors that may, due to economic or other factors, increase the risk of loss.
7		Classified substandard loans inadequately protected by the paying capacity or net worth of the obligor, or of the collateral with weaknesses that jeopardize the liquidation of the debt.
8		Classified doubtful loans in which collection or liquidation in full is highly improbable.
9		Classified loss loans that are uncollectible and of such little value that continuance as an asset is not warranted.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

The following tables provide a summary of our credit risk profile by loan categories as of March 31, 2016 and December 31, 2015 (including nonaccrual loans).

(Dollars in thousands)

Credit Risk Profile by Creditworthiness Category

As of March 31, 2016 and December 31, 2015

	Real Estate Secured
	Residential 1-4 Family				Multi Family				Commercial				Construction and Land Development
	2016		2015		2016		2015		2016		2015		2016		2015
Grade
1	$	-	$	-	$	-	$	-	$	-	$	-	$	-	$	-
2		-		-		-		-		-		-		-		-
3		130,585		130,016		1,329		1,352		20,285		19,079		12,121		14,566
4		56,549		57,945		1,125		1,050		27,301		27,536		11,810		11,561
5		44,048		45,911		1,019		2,014		27,258		30,072		8,213		7,489
6		1,651		1,495		329		331		4,031		4,080		55		57
7		5,356		5,555		-		-		5,023		4,734		621		638
8		189		189		-		-		-		-		-		-
9		-		-		-		-		-		-		-		-

Total	$	238,378	$	241,111	$	3,802	$	4,747	$	83,898	$	85,501	$	32,820	$	34,311

	Non-Real Estate Secured
	Commercial				Consumer				Other				Total
	2016		2015		2016		2015		2016		2015		2016		2015
Grade
1	$	446	$	2,352	$	377	$	448	$	-	$	-	$	823	$	2,800
2		-		-		-		-		-		-		-		-
3		1,675		1,783		806		630		88		89		166,889		167,515
4		9,163		8,301		601		420		214		227		106,763		107,040
5		7,704		7,326		924		1,017		17		21		89,183		93,850
6		6		5		-		-		-		-		6,072		5,968
7		874		899		84		108		-		-		11,958		11,934
8		-		-		-		-		-		-		189		189
9		-		-		-		-		-		-		-		-

Total	$	19,868	$	20,666	$	2,792	$	2,623	$	319	$	337	$	381,877	$	389,296

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

The following tables provide a summary of past due loans by loan category as of March 31, 2016 and December 31, 2015.

(Dollars in thousands)

Past Due Loans

For the Periods Ended March 31, 2016 and December 31, 2015

March 31, 2016	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans Receivable		Recorded Investment > 90 Days and Accruing
Real Estate Secured
1-4 Family Residential	$	2,894	$	757	$	833	$	4,484	$	233,894	$	238,378	$	-
Multifamily Residential		-		-		-		-		3,802		3,802		-
Commercial Real Estate		1,530		48		309		1,887		82,011		83,898		-
Construction and Land Development		120		-		-		120		32,700		32,820		-
Non Real Estate Secured
Commercial and Industrial		97		35		123		255		19,613		19,868		-
Consumer and Other		59		253		-		312		2,799		3,111		-

Total	$	4,700	$	1,093	$	1,265	$	7,058	$	374,819	$	381,877	$	-

December 31, 2015	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans Receivable		Recorded Investment > 90 Days and Accruing
Real Estate Secured
1-4 Family Residential	$	1,429	$	207	$	1,055	$	2,691	$	238,420	$	241,111	$	218
Multifamily Residential		-		-		-		-		4,747		4,747		-
Commercial Real Estate		2,848		49		302		3,199		82,302		85,501		-
Construction and Land Development		81		-		-		81		34,230		34,311		-
Non Real Estate Secured
Commercial and Industrial		220		170		56		446		20,220		20,666		-
Consumer and Other		70		1		-		71		2,889		2,960		-

Total	$	4,648	$	427	$	1,413	$	6,488	$	382,808	$	389,296	$	218

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

The following table provides a summary of nonaccrual loans as of March 31, 2016 and December 31, 2015.

(Dollars in thousands)

	March 31,		December 31,
	2016		2015

1-4 Family Residential	$	2,046	$	2,178
Multifamily Residential		-		-
Commercial Real Estate		416		412
Construction and Land Development		-		-
Commercial and Industrial		573		551
Consumer and Other		18		8

Total	$	3,053	$	3,149

At March 31, 2016 and December 31, 2015, nonaccrual loans totaled $3.1 million and $3.1 million, respectively. The gross interest income that would have been recorded under the original terms of nonaccrual loans totaled $123,000 and $81,000 for the three months ended March 31, 2016 and March 31, 2015, respectively. At March 31, 2016 and December 31, 2015, impaired loans (which include nonaccrual loans and troubled debt restructurings (TDRs)) totaled $3.8 million and $3.8 million, respectively. The recorded investment in impaired loans individually evaluated for impairment, which include nonaccrual loans over $250,000 and TDRs, totaled $2.3 million and $2.3 million at March 31, 2016 and December 31, 2015, respectively. At December 31, 2015 loans over ninety days past due and still accruing interest totaled $218,000. There were no such loans at March 31, 2016.

At March 31, 2016 and December 31, 2015, all TDRs, including those on nonaccrual status, totaled $1.5 million and $1.5 million, respectively. The gross interest income that would have been recognized on TDRs according to the original loan terms during the first quarter of 2016 totaled approximately $10,000; actual interest income recognized on these loans according to the restructured terms totaled $9,000. The gross interest income that would have been recognized on TDRs according to the original loan terms during the year ended December 31, 2015 totaled approximately $40,000; actual interest income recognized on these loans according to the restructured terms totaled approximately $37,000. During the quarter ended March 31, 2016, there were no loans that had their original loan terms restructured, and no loans that had previously had their original terms restructured went into nonaccrual. During the same period, no amounts related to TDR’s paid off or were charged off. TDRs did not have a material effect on the allowance for loan losses as of March 31, 2016 or December 31, 2015.

The following tables provide a year to date analysis of activity within the allowance for loan losses.

(Dollars in thousands)	March 31,			March 31,
	2016			2015

Balance, beginning of year	$	4,794		$	5,602
Provision (credit) for loan losses		(500	)		(900	)
Net (charge offs) recoveries		127			173

Balance, end of quarter	$	4,421		$	4,875

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

	For the Three Months Ended March 31, 2016
	Beginning Balance		Charge Offs		Recoveries		Provisions			Ending Allowance for Loan Losses
(Dollars in thousands)										General Reserves		Specific Reserves		Total
Real Estate Secured
1-4 Family Residential	$	1,303	$	-	$	-	$	95		$	1,357	$	41	$	1,398
Multifamily Residential		27		-		-		(12	)		15		-		15
Commercial Real Estate		1,426		-		-		(496	)		930		-		930
Construction and Land Development		232		-		127		(133	)		226		-		226
Non Real Estate Secured
Commercial and Industrial		429		-		-		(24	)		405		-		405
Consumer and Other		15		-		-		51			66		-		66
Other
Other General Reserves		1,050		-		-		(20	)		1,030		-		1,030
Unallocated		312		-		-		39			351		-		351
Total	$	4,794	$	-	$	127	$	(500	)	$	4,380	$	41	$	4,421

	For the Three Months Ended March 31, 2015
	Beginning Balance		Charge Offs			Recoveries		Provisions			Ending Allowance for Loan Losses
(Dollars in thousands)											General Reserves		Specific Reserves		Total
Real Estate Secured
1-4 Family Residential	$	1,595	$	(35	)	$	-	$	(45	)	$	1,429	$	86	$	1,515
Multifamily Residential		61		-			-		(34	)		27		-		27
Commercial Real Estate		1,424		-			190		(801	)		813		-		813
Construction and Land Development		312		-			17		(117	)		212		-		212
Non Real Estate Secured
Commercial and Industrial		496		-			6		201			599		104		703
Consumer and Other		32		(6	)		1		(6	)		21		-		21
Other
Other General Reserves		1,363		-			-		(88	)		1,275		-		1,275
Unallocated		319		-			-		(10	)		309		-		309
Total	$	5,602	$	(41	)	$	214	$	(900	)	$	4,685	$	190	$	4,875

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

	For the Year Ended December 31, 2015
	Beginning Balance		Charge Offs			Recoveries		Provisions			Ending Allowance for Loan Losses
(Dollars in thousands)											General Reserves		Specific Reserves		Total
Real Estate Secured
1-4 Family Residential	$	1,595	$	(73	)	$	-	$	(219	)	$	1,262	$	41	$	1,303
Multi Family Residential		61		-			155		(189	)		27		-		27
Commercial Real Estate		1,424		-			190		(188	)		1,426		-		1,426
Construction and Land Development		312		-			28		(108	)		232		-		232
Non Real Estate Secured
Commercial and Industrial		496		(261	)		54		140			429		-		429
Consumer and Other		32		(6	)		44		(55	)		15		-		15
Other
Other General Reserves		1,363		-			-		(313	)		1,050		-		1,050
Unallocated		319		-			-		(7	)		312		-		312
Total	$	5,602	$	(340	)	$	471	$	(939	)	$	4,753	$	41	$	4,794

Impaired loans with a balance of $250,000 or more are evaluated individually for impairment. All other loans are collectively evaluated for impairment. The following tables provide summaries and totals of loans individually and collectively evaluated for impairment as of March 31, 2016 and December 31, 2015.

Loans Receivable:	As of March 31, 2016
(Dollars in thousands)	Individually evaluated for impairment		Collectively evaluated for impairment		Total
Real Estate Secured
1-4 Family Residential	$	1,540	$	236,838	$	238,378
Multifamily Residential		-		3,802		3,802
Commercial Real Estate		368		83,530		83,898
Construction and Land Development		-		32,820		32,820
Non Real Estate Secured
Commercial and Industrial		383		19,485		19,868
Consumer and Other		-		3,111		3,111
Total	$	2,291	$	379,586	$	381,877

Loans Receivable:	As of December 31, 2015
(Dollars in thousands)	Individually evaluated for impairment		Collectively evaluated for impairment		Total
Real Estate Secured
1-4 Family Residential	$	1,550	$	239,561	$	241,111
Multifamily Residential		-		4,747		4,747
Commercial Real Estate		362		85,139		85,501
Construction and Land Development		-		34,311		34,311
Non Real Estate Secured
Commercial and Industrial		391		20,275		20,666
Consumer and Other		-		2,960		2,960
Total	$	2,303	$	386,993	$	389,296

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

(Dollars in thousands)

Impaired Loans

For the Three Months ended March 31, 2016

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized

With no related allowance recorded
1-4 Family Residential	$	1,404	$	1,318	$	-	$	86	$	1,324	$	8
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		368		368		-		-		365		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		383		383		-		-		387		-
Consumer and Other		-		-		-		-		-		-

With an allowance recorded
1-4 Family Residential	$	222	$	222	$	41	$	-	$	222	$	-
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		-		-		-		-		105		-
Consumer and Other		-		-		-		-		-		-

Total
1-4 Family Residential	$	1,626	$	1,540	$	41	$	86	$	1,546	$	8
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		368		368		-		-		365		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		383		383		-		-		492		-
Consumer and Other		-		-		-		-		-		-

Total	$	2,377	$	2,291	$	41	$	86	$	2,403	$	8

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 – Loans - (Continued)

(Dollars in thousands)

Impaired Loans

For the Three Months Ended March 31, 2015

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded
1-4 Family Residential	$	1,621	$	1,500	$	-	$	121	$	1,506	$	9
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		1,540		1,540		-		-		1,318		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		425		425		-		-		433		-
Consumer and Other		-		-		-		-		-		-

With an allowance recorded
1-4 Family Residential	$	571	$	536	$	86	$	35	$	637	$	-
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		105		105		104		-		105		-
Consumer and Other		-		-		-		-		-		-

Total
1-4 Family Residential	$	2,192	$	2,036	$	86	$	156	$	2,143	$	9
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		1,540		1,540		-		-		1,318		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		530		530		104		-		538		-
Consumer and Other		-		-		-		-		-		-

Total	$	4,262	$	4,106	$	190	$	156	$	3,999	$	9

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 6 - Loans – (continued)

(Dollars in thousands)

Impaired Loans

For the Year Ended December 31, 2015

	Unpaid Principal Balance		Recorded Investment (1)		Related Allowance		Life to Date Charge offs		Average Recorded Investment		Interest Income Recognized

With no related allowance recorded
1-4 Family Residential	$	1,415	$	1,329	$	-	$	86	$	1,357	$	37
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		362		362		-		-		380		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		391		391		-		-		416		-
Consumer and Other		-		-		-		-		-		-

With an allowance recorded
1-4 Family Residential	$	221	$	221	$	41	$	-	$	222	$	-
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		-		-		-		-		-		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		-		-		-		-		-		-
Consumer and Other		-		-		-		-		-		-

Total
1-4 Family Residential	$	1,636	$	1,550	$	41	$	86	$	1,579	$	37
Multifamily Residential		-		-		-		-		-		-
Commercial Real Estate		362		362		-		-		380		-
Construction and Land Development		-		-		-		-		-		-
Commercial and Industrial		391		391		-		-		416		-
Consumer and Other		-		-		-		-		-		-

Total	$	2,389	$	2,303	$	41	$	86	$	2,375	$	37

(1) Impaired balance; excludes accrued interest receivable and deferred fees and costs due to immateriality.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 7 – Deferred Taxes

The Company maintains a valuation allowance of $286,000 related to its holding company net operating loss carryforward for state income taxes. Throughout the Company’s history, the holding company has consistently produced operating losses on a stand alone basis, and the realizability of this loss carryforward is considered unlikely. As of March 31, 2016, gross deferred tax assets totaled approximately $4.0 million, while deferred tax assets net of the valuation allowance totaled approximately $3.7 million.

During the three months ended March 31, 2016 and March 31, 2015, the Company recognized $672,000 and $1,078,000, respectively, of income tax expense. Of these amounts, $585,000 and $978,000 were for Federal income taxes. Due to the Company’s net operating loss carryforward, the majority of Federal income tax expense during the three months ended March 31, 2015 directly reduced the Company’s deferred tax asset, while the majority of Federal income tax expense during the three months ended March 31, 2016 were accrued to income taxes payable. The deferred tax asset attributable to the Company’s net operating loss carryforward totaled approximately $196,000 and $1.9 million at December 31, 2015 and December 31, 2014, respectively. Also during the three months ended March 31, 2016 and March 31, 2015, the Company’s gross unrealized securities losses declined by approximately $163,000 and $801,000, respectively, which decreased the deferred tax asset related to unrealized available for sale securities losses by approximately $58,000 and $288,000, respectively.

Note 8 – Fair Value Measurements

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Generally accepted accounting principles also establish a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1 - Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as U.S. Treasuries, and money market funds.

Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments, mortgage backed securities, municipal bonds, corporate debt securities, and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.

Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, real estate appraisals, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. For example, this category generally includes certain private equity investments, asset- backed securities in less liquid markets, retained residual interests in securitizations, residential mortgage servicing rights, and other real estate owned when adjusting for selling costs, and impaired loans.

The Company used the following methods and assumptions to estimate fair value:

Available for Sale Investment Securities

Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available (Leve1 1). If quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Securities classified as Level 3 include asset-backed securities in less liquid markets. The fair values of level 3 available for sale investment securities are determined by a third party pricing service and reviewed by the Company’s Chief Financial Officer for reasonableness. The fair value of the trust preferred securities is computed based upon discounted cash flows estimated using interest rates, principal balances of note classes and underlying issuers, the timing and amount of interest and principal payments of the underlying issuers, and the allocation to the note classes. Current estimates of expected cash flows are based on the most recent trustee reports and any other relevant market information, including announcements of interest payment deferrals or defaults of underlying issuers. The payment, default and recovery assumptions are believed to reflect the assumptions of market participants. Cash flows are discounted at appropriate market rates, including consideration of credit spreads and illiquidity discounts.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

Loans Held for Sale

Mortgage loans held for sale are carried at the lower of cost or market value. The fair value of mortgage loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, the Company categorizes loans subjected to nonrecurring fair value adjustments as Level 2. There were no fair value adjustments to mortgage loans held for sale as of March 31, 2016 and December 31, 2015.

Impaired Loans

Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Impaired loans are carried at the lesser of their principal balance or their fair value. The Company considers problem loans with principal balances of $250,000 or greater individually for impairment. The fair value of loans individually evaluated for impairment is estimated using one of several methods, including the present value of expected cash flows, market price of the loan, if available, or fair value of the underlying collateral less estimated costs to sell. At March 31, 2016, all impaired loans deemed collateral dependent were evaluated based on the fair value of the underlying collateral less estimated costs to sell, while those not deemed collateral dependent were evaluated based on the present value of expected cash flows. Those impaired loans not requiring a specific allowance for loan losses allocation represent loans with fair values exceeding their recorded investments. Impaired loans for which a specific allowance is established based on the fair value of collateral require classification in the fair value hierarchy. If the fair value of an impaired loan is based on an observable market price of the loan, the Company records the impaired loan as nonrecurring Level 2. When the fair value of an impaired loan is based on discounted cash flows or the fair value of the underlying collateral less estimated cost to sell, the Company records the impaired loan as nonrecurring Level 3.

Other real estate owned

Assets acquired through or instead of loan foreclosure are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at the lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals.

For both collateral dependent impaired loans and other real estate owned the Company uses appraisals prepared by certified appraisal professionals whose qualifications and licenses have been reviewed and verified by the Company. These appraisals may utilize a single valuation approach or a combination of approaches, including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically lead to a Level 3 classification of the inputs for determining fair value. Once the Company receives an appraisal on an impaired loan, the Chief Credit Officer and Chief Financial Officer review the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics, as well as the Company’s own loss experience. For appraisals received on other real estate owned, the Chief Financial Officer and Chief Operating Officer use a similar approach. The Company may take additional discounts against the appraisals based on the circumstances surrounding individual properties.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

Assets measured at fair value on a recurring basis are as follows as of March 31, 2016 and December 31, 2015 (dollars in thousands):

	March 31, 2016
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Available-for-sale investment securities
Mortgage backed
Government sponsored enterprises	$	-	$	20,845	$	-	$	20,845
Municipals		-		3,677		-		3,677
Other		-		4,259		2,733		6,992

Total assets at fair value	$	-	$	28,781	$	2,733	$	31,514

	December 31, 2015
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Available-for-sale investment securities
Mortgage backed
Government sponsored enterprises	$	-	$	21,318	$	-	$	21,318
Municipals		-		3,682		-		3,682
Other		-		4,203		2,832		7,035

Total assets at fair value	$	-	$	29,203	$	2,832	$	32,035

Investments in collateralized debt obligations and a single-issue trust preferred security comprise the Company’s Level 3 assets as shown above. Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.

There were no transfers between Level 1 and Level 2 during 2016 or 2015.

The Company has no liabilities carried at fair value or measured at fair value on a recurring basis.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

The following table reconciles the changes in recurring Level 3 financial instruments for the three months ended March 31, 2016 and 2015 (dollars in thousands):

	March 31,			March 31,
	2016			2015

Beginning of Year Balance	$	2,832		$	2,008
Discount Accretion		4			2
Unrealized gain (loss)		(103	)		696

Ending Balance	$	2,733		$	2,706

The following table presents quantitative information about Level 3 fair value measurements at March 31, 2016 (dollars in thousands):

Security Type

Fair Value

Valuation Technique

Unobservable Input

Rates

Collateralized Debt Obligations

2,233

Discounted cash flows and recent trade

Discount rate

Approximately 7%

Weighted default probability for deferring issuers

Approximately 21%

Recovery rate on deferring issuers

10%

15%

Default probability for current issuers

0.33%

7.50%

Trust Preferred Security

500

Discounted cash flows

Discount rate

Approximately 4%

The significant unobservable inputs used in the fair value measurement of the Company’s collateralized debt obligations investments are prepayment rates, probability of default, and loss severity in the event of default. Significant increases/(decreases) in any of those inputs in isolation would result in a significantly lower/(higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.

In addition to the collateralized debt obligations included in the table above, the Company owns a trust preferred security backed by a single issuer for which meaningful pricing data is not readily available. The security’s book value of $500,000 is assumed to equal its fair value. The discount rate shown for the security in the table above approximates the security’s yield at March 31, 2016.

No changes in unrealized gains and losses for Level 3 asssets were recorded in earnings for either of the three month periods ended March 31, 2016 or March 31, 2015.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

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

	March 31, 2016
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Impaired Loans
1 - 4 Family Residential	$	-	$	-	$	1,387	$	1,387
Commercial Real Estate		-		-		332		332
Other Real Estate Owned
Construction and Land Development		-		-		54		54

Total assets at fair value	$	-	$	-	$	1,773	$	1,773

	December 31, 2015
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Impaired Loans
1 - 4 Family Residential	$	-	$	-	$	1,398	$	1,398
Commercial Real Estate		-		-		324		324
Other Real Estate Owned
Construction and Land Development		-		-		54		54

Total assets at fair value	$	-	$	-	$	1,776	$	1,776

Impaired loans measured for impairment using the fair value of the collaeral had a recorded investment of $1,640,000 with a valuation allowance of $41,000 at March 31, 2016, with no additional provision for loan losses for the three months ended March 31, 2016. Impaired loans measured for impairment using the fair value of the collateral had a recorded investment of $1,643,000 with a valuation allowance of $ 41,000 at December 31, 2015, with no additional provision for loan losses for the year ended December 31, 2015.

Impaired loans measured at fair value had a recorded investment of $3,402,000 with a valuation allowance of $161,000 at March 31, 2015, resulting in an additional provision for loan losses of $105,000 for the three months ended March 31, 2015. This additional provision related entirely to a Commercial and Industrial loan for which a full reserve was established.

Other real estate owned measured at fair value less estimated costs to sell had a net carrying amount of $50,000, which was made up of the outstanding balance of $165,000, net of a valuation allowance of $115,000 at March 31, 2016 and December 31, 2015. The valuation allowance at March 31, 2016 and December 31, 2015 did not include any impairment provisions made during either the three months ended March 31, 2016 or during the year ended December 31, 2015.

The Company has no liabilities carried at fair value or measured at fair value on a nonrecurring basis.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at March 31, 2016 and December 31, 2015:

	Valuation Techniques	Unobservable Inputs	Range
Impaired Loans

1 - 4 Family Residential	Sales comparison approach	Bank Owned Discount	10%	-	20%
Multifamily Residential
Construction and Land Development

Commercial Real Estate	Sales comparison approach	Bank Owned Discount	10%	-	20%
	Income approach	Capitalization Rate	8%	-	12%

Other Real Estate Owned

Commercial Office Properties	Sales comparison approach	Bank Owned Discount	10%	-	20%
	Income approach	Capitalization Rate	8%	-	12%

Commercial Lots	Sales comparison approach	Bank Owned Discount	10%	-	20%
Residential 1 – 4 Family Lots
Residential 1 – 4 Family Homes
Residential 1 – 4 Under Construction
Multifamily Residential

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

The estimated fair values of the Company’s financial instruments are as follows (dollars in thousands):

	Fair Value Measurements at March 31, 2016 Using:
	Carrying
	Amount		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	26,596	$	26,596	$	-	$	-	$	26,596
Available for sale investment securities		31,514		-		28,781		2,733		31,514
Federal Home Loan Bank Stock		3,508		N/A		N/A		N/A		N/A
Loans held for sale		197		-		197		-		197
Loans, net		377,456		-		-		380,328		380,328
Accrued interest receivable		1,223		-		81		1,142		1,223

Financial liabilities
Deposits		338,308		242,602		95,803		-		338,405
Short term borrowings		1,367		-		1,367		-		1,367
Advances from Federal Home Loan Bank		72,000		-		75,676		-		75,676
Junior subordinated debentures		10,310		-		-		6,376		6,376
Accrued interest payable		359		2		356		1		359

	Fair Value Measurements at December 31, 2015 Using:
	Carrying
	Amount		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	40,944	$	40,944	$	-	$	-	$	40,944
Available for sale investment securities		32,035		-		29,203		2,832		32,035
Federal Home Loan Bank Stock		4,291		N/A		N/A		N/A		N/A
Loans held for sale		1,711		-		1,711		-		1,711
Loans, net		384,502		-		-		384,755		384,755
Accrued interest receivable		1,149		-		85		1,064		1,149

Financial liabilities
Deposits		339,457		235,860		103,652		-		339,512
Short term borrowings		6,760		-		6,760		-		6,760
Advances from Federal Home Loan Bank		91,000		-		94,004		-		94,004
Junior subordinated debentures		10,310		-		-		6,301		6,301
Accrued interest payable		324		2		321		1		324

Valuation Methodologies – Assets and Liabilities not recorded at Fair Value

The following is a description of the valuation methodologies used for assets and liabilities that are not recorded at fair value, but whose fair value must be estimated and disclosed:

Cash and Cash Equivalents

The carrying amounts of cash and short-term instruments approximate fair values and are classified Level 1.

FHLB Stock

It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

SOUTHCOAST FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 8 – Fair Value Measurements – (continued)

Loans

Fair values of loans, excluding loans held for sale, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values, resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality, resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors, resulting in a Level 2 classification.

Deposits

The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount), resulting in a Level 1 classification. The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date, resulting in a Level 1 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits, resulting in a Level 2 classification.

Short-term Borrowings

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings, generally maturing within ninety days, approximate their fair values, resulting in a Level 2 classification.

Other Borrowings

The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements, resulting in a Level 2 classification.

The fair values of the Company’s Subordinated Debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements, resulting in a Level 3 classification.

Accrued Interest Receivable/Payable

The carrying amounts of accrued interest are assigned Levels 1, 2, or 3 classifications commensurate with the assets or liabilities with which they are associated.

Off-balance Sheet Instruments

Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material.

SOUTHCOAST FINANCIAL CORPORATION

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

The following discussion and analysis should be read in conjunction with the financial statements and related notes appearing herein and in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015. Results of operations for the period ending March 31, 2016 are not necessarily indicative of the results to be attained for any other period.

Statements included in this report which are not historical in nature are intended to be, and are hereby identified as “forward looking statements” for purposes of the safe harbor provided by Section 21E of the Securities Exchange Act of 1934, as amended. Words such as “may,” “will,” “anticipate,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “seek,” “estimate,” “continue,” “plan,” “point to,” “project,” “predict,” “could,” “intend,” “target,” “potential,” and other similar words and expressions of the future identify forward-looking statements. The Company cautions readers that forward looking statements, including without limitation, those relating to the Company’s future business prospects, revenues, working capital, adequacy of the allowance for loan losses, liquidity, capital needs, interest costs, income, new offices, and the economy, are subject to certain risks and uncertainties that could cause actual results to differ from those indicated in the forward looking statements, due to several important factors identified in this report, among others, and other risks and factors identified from time to time in the Company’s other reports filed with the Securities and Exchange Commission.

These forward-looking statements are based on our current expectations, estimates and projections about our industry, management’s beliefs, and assumptions made by management. Such information includes, without limitation, discussions as to estimates, expectations, beliefs, plans, strategies, objectives, goals, anticipations, and intentions concerning the Company’s future financial and operating performance. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict, particularly in light of the fact that the Company is a relatively new company with limited operating history. Therefore, actual results may differ materially from those expressed or forecasted in such forward-looking statements. The risks and uncertainties include, but are not limited to:

the potential negative economic impacts of the recent historic flooding in our market area on the homes and businessesof our borrowers;

future economic and business conditions;

lack of sustained growth and disruptions in the economy of the Greater Charleston area, including, but not limited to, falling real estate values and increasing levels of unemployment;

government monetary and fiscal policies;

the effects of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the valuesof loan collateral, securities, and interest sensitive assets and liabilities;

the effects of competition from a wide variety of local, regional, national and other providers of financial, investment, and insurance services, as well as competitors that offer banking products and services by mail, telephone,computer and/or the Internet;

the effects of credit rating downgrades on the value of investment securities issued or guaranteed by variousgovernments and government agencies, including the United States of America;

credit risks;

higher than anticipated levels of defaults on loans;

perceptions by depositors about the safety of their deposits;

the failure of assumptions underlying the establishment of the allowance for loan losses and other estimates, including the value of collateral securing loans;

changes in assumptions underlying allowances on deferred tax assets;

changes in assumptions underlying, or accuracy of, analysis relating to other-than-temporary impairment of assets;

accuracy of fair value measurements and the methods and assumptions used to estimate fair value;

the risks of opening new offices, including, without limitation, the related costs and time of building customer relationships and integrating operations as part of these endeavors and the failure to achieve expected gains,revenue growth and/or expense savings from such endeavors;

changes in laws and regulations, including tax, banking and securities laws and regulations and deposit insurance assessments;

the effect of agreements with regulatory authorities, which restrict various activities and impose additionaladministrative requirements without commensurate benefits;

changes in the requirements of regulatory agencies;

changes in accounting policies, rules and practices;

changes in technology or products that may be more difficult or costly, or less effective than anticipated;

cybersecurity risk related to our dependence on internal security systems and the technology of outside service providers, as well as the potential impacts of third party security breaches;

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

the effects of war or other conflicts, acts of terrorism or other catastrophic events that may affect general economic conditions and economic confidence;

loss of consumer or investor confidence;

risks relating to the proposed merger between the Company and BNC Bancorp, including disruption of the Company’s business operations and customer relationships and employee relationships, diversion of management’s time, as wellas the impact of such disruptions and the expenses incurred in connection with the merger if the merger is notcompleted; and

other factors and information described in any of the reports that we file with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

All forward-looking statements are expressly qualified in their entirety by this cautionary notice. The Company has no obligation, and does not undertake, to update, revise or correct any of the forward-looking statements after the date of this report. The Company has expressed its expectations, beliefs, and projections in good faith and believes they have a reasonable basis. However, there is no assurance that these expectations, beliefs or projections will result or be achieved or accomplished.

Results of Operations

The Company’s net income for the three months ended March 31, 2016 was $1,210,000 or $0.17 per basic share, compared to net income of $1,978,000, or $0.28 per basic share, for the three months ended March 31, 2015. The average number of basic shares outstanding for the three months ended March 31, 2016 was 7,103,751 compared to 7,099,979 for the three months ended March 31, 2015.

Net Interest Income

Net interest income is the difference between the interest earned on interest earning assets and the interest paid for funds acquired to support those assets, and is the principal source of the Company’s earnings. Net interest income was approximately $3.9 million for the three months ended March 31, 2016, compared to approximately $4.0 million for the three months ended March 31, 2015.

Changes that affect net interest income include changes in the average rate earned on interest earning assets, changes in the average rate paid on interest bearing liabilities, and changes in the volumes of interest earning assets and interest bearing liabilities. The decrease in the Company’s net interest income for the three months ended March 31, 2016 compared to the same period of 2015 was primarily due to decreased interest income between the two periods. The decrease in interest income was primarily related to recoveries of interest income on nonaccrual loans which paid off during the three months ended March 31, 2015. These recoveries provided an additional $241,000 of interest income when compared to recoveries of interest income on nonaccrual loans paid off during the three months ended March 31, 2016. Also contributing to the decrease in interest income was a change in the Company’s loan portfolio mix, as lower yielding residential mortgage loans comprised approximately 57.3% of average loans during the three months ended March 31, 2016, compared to approximately 54.2% of average loans during the three months ended March 31, 2015. Mortgage loan yields were 4.18% and 4.19% for the three months ended March 31, 2016 and March 31, 2015, respectively. Loan fees for the three months ended March 31, 2016 and March 31, 2015 were $91,000 and $151,000, respectively. The decrease of $60,000 in loan fees for the three months ended March 31, 2016 compared to the three months ended March 31, 2015 also contributed to the decrease in loan yields between the two periods.

Average earning assets for the three months ended March 31, 2016 increased 4.8 percent to $435.2 million from the $415.3 million reported for the three months ended March 31, 2015. The increase was attributable to an increase of $21.6 million in average loans, partially offset by a $1.7 million decrease in average total investments, cash, and federal funds sold. The increase in average loans between the two periods was primarily due to growth in the Company’s residential mortgage loan portfolio, partially offset by a decrease in commercial loans. The decrease in the Company’s average investments and federal funds sold was primarily due to paydowns on mortgage backed securities.

Average interest bearing liabilities for the three months ended March 31, 2016 increased 2.1 percent to $368.2 million from the $360.7 million reported for the three months ended March 31, 2015. The increase was primarily attributable to increases of $15.7 million and $10.6 million in average savings and transaction accounts and other borrowings, respectively, partially offset by an $18.8 million decrease in average time deposits. The increase in savings and transaction accounts was primarily attributable to an increase of $10.3 million in average money market accounts. Of this amount, approximately $4.1 million was attributable to an increase in average municipal money market accounts. The decrease in average time deposits was attributable to decreases of $12.3 million and $6.5 million in brokered time deposits and retail time deposits, respectively.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Net Interest Income – (continued)

The following table compares the average balances, yields and rates for the interest sensitive segments of the Company’s balance sheets for the three months ended March 31, 2016 and 2015.

(Dollars in thousands)	For the three months ended							For the three months ended
	March 31, 2016							March 31, 2015
	Average		Income/		Yield/			Average		Income/		Yield/
	Balance		Expense		Rate⁽¹⁾			Balance		Expense		Rate⁽¹⁾
Assets
Cash and Federal funds sold	$	16,937	$	21		0.50	%	$	15,015	$	8		0.20	%
Investments – taxable		33,235		244		2.93			36,364		214		2.36
Investments - nontaxable		3,433		52		6.03			3,924		59		6.04

Total investments and federal funds sold		53,605		317		2.37			55,303		281		2.04

Loans ⁽²⁾⁽³⁾		381,614		4,473		4.70			360,012		4,604		5.12

Total earning assets/interest income		435,219		4,790		4.41	%		415,315		4,885		4.72	%
Other assets		45,955							53,849

Total assets	$	481,174						$	469,164

Liabilities
Savings and transaction accounts	$	177,719		152		0.34	%	$	162,087		154		0.38	%
Time deposits		102,749		187		0.73			121,580		204		0.67
Other borrowings		77,391		462		2.39			66,704		447		2.69
Subordinated debt		10,310		53		2.07			10,310		44		1.71

Total interest bearing liabilities/interest expense		368,169		854		0.93	%		360,681		849		0.94	%

Non-interest bearing liabilities		60,507							59,921

Total liabilities		428,676							420,602

Equity		52,498							48,562

Total liabilities and equity	$	481,174						$	469,164

Net interest income/margin ⁽⁴⁾			$	3,936		3.62	%			$	4,036		3.89	%

Net interest spread ⁽⁵⁾						3.48	%						3.78	%

(1) Annualized

(2) Does not include nonaccruing loans.

(3) Income includes loan fees of $91,000 in 2016 and $151,000 in 2015.

(4) Net interest income divided by total earning assets.

(5) Total interest earning assets yield less interest bearing liabilities rate.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Net Interest Income – (continued)

As shown above, for the three months ended March 31, 2016 the average yield on earning assets was 4.41 percent, while the average cost of interest bearing liabilities was 0.93 percent. For the three months ended March 31, 2015 the average yield on earning assets was 4.72 percent and the average cost of interest-bearing liabilities was 0.94 percent. The decrease in the overall asset yield is due to lower loan yields. The slight decrease in the cost of average interest bearing liabilities was due to decreases in average rates paid on other borrowings and savings and transaction accounts, partially offset by higher rates paid on time deposits and subordinated debt. The net interest margin was 3.62 percent and 3.89 percent for the three months ended March 31, 2016 and 2015, respectively. The decrease in the net interest margin was attributable to a decrease of $100,000 in net interest income, which was comprised of a decrease in interest income of $95,000 and an increase in interest expense of $5,000. The decrease in interest income was due to a $131,000 decrease in interest income on loans, partially offset by a $36,000 increase in interest income on investments and federal funds sold. The increase in interest expense was attributable to increases of $15,000 and $9,000 for other borrowings and subordinated debt, respectively, partially offset by decreases of $17,000 and $2,000 for time deposits and savings and transaction accounts, respectively.

The following tables present changes in the Company’s net interest income which are primarily a result of changes in the volume and rates of its interest-earning assets and interest-bearing liabilities.

(Dollars in thousands)	Analysis of Changes in Net Interest Income
	For the three months ended March 31, 2016
	Versus three months ended March 31, 2015 ⁽¹⁾
	Volume			Rate			Net Change
Interest income:

Cash and Federal funds sold	$	1		$	12		$	13
Investments - taxable		(18	)		48			30
Investments - non taxable		(7	)		-			(7	)

Total investments and federal funds sold		(24	)		60			36

Net loans ⁽²⁾⁽³⁾		272			(403	)		(131	)

Total interest income		248			(343	)		(95	)

Interest expense:

Savings and transaction accounts		14			(16	)		(2	)
Time deposits		(31	)		14			(17	)
Other borrowings		71			(56	)		15
Subordinated debt		-			9			9

Total interest expense		54			(49	)		5

Net interest income	$	194		$	(294	)	$	(100	)

(1)

Changes in rate/volume have been allocated to each category on a consistent basis between rate and volume.

(2)

Income includes loan fees of $91,000 in 2016 and $151,000 in 2015.

(3)

Does not include nonaccruing loans.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Noninterest Income and Expenses

Noninterest income for the three months ended March 31, 2016 was $623,000, compared to $1,281,000 for the three months ended March 31, 2015, a decrease of $658,000. The decrease was primarily due to a $694,000 decrease in gains recognized on the sale of premises and equipment. Also contributing to the decrease in noninterest income were decreases of $9,000 and $2,000 in service fees on deposit accounts and other income, respectively. Partially offsetting these decreases were increases of $46,000 and $1,000 in gain on sale of mortgage loans held for sale and company owned life insurance earnings, respectively.

Noninterest expenses for the three months ended March 31, 2016 were $3,158,000, compared to $3,140,000 for the three months ended March 31, 2015, an increase of $18,000. The largest contributing factor to this increase was a $98,000 increase in other expenses. This increase was primarily attributable to a $95,000 credit to the Allowance for Unfunded Commitments which was taken during the three months ended March 31, 2015. During the three months ended March 31, 2016, there was no provision or credit to the Allowance for Unfunded Commitments. Partially offsetting the increase in other expenses was a decrease of $64,000 in salaries and employee benefits. This decrease occurred due to a slight reduction in the number of employees between the two periods.

Income Taxes

The Company’s income tax expense for the three months ended March 31, 2016 totaled $672,000, comprised of $585,000 for Federal income taxes and $87,000 for South Carolina income taxes. The Company’s income tax expense for the three months ended March 31, 2015 totaled $1,078,000, comprised of $978,000 for Federal income taxes and $100,000 for South Carolina income taxes. The effective tax rates for these periods were 35.7% and 35.3% for the three months ended March 31, 2016 and March 31, 2015, respectively.

Liquidity

Liquidity is the ability to meet current and future obligations through liquidation or maturity of existing assets or the acquisition of additional liabilities. Adequate liquidity is necessary to meet the requirements of customers for loans and deposit withdrawals in the most timely and economical manner. Some liquidity is ensured by maintaining assets which may be immediately converted into cash at minimal cost (amounts due from banks and federal funds sold). However, the most manageable sources of liquidity are composed of liabilities, with the primary focus of liquidity management being on the ability to obtain deposits within the Bank’s service area. Core deposits (total deposits less certificates of deposit $250,000 or more, wholesale and brokered deposits) provide a relatively stable funding base, and were equal to 98.0% of total deposits as of March 31, 2016. Asset liquidity is provided from several sources, including amounts due from banks and federal funds sold and funds from maturing loans. The Bank is a member of the Federal Home Loan Bank of Atlanta (”FHLBA”) and, as such has the ability to borrow against pledges of its 1-4 family residential mortgage loans and its commercial real estate loans. Available borrowings under this line totaled $53.1 million at March 31, 2016. The Company also has federal funds accommodations of $10 million with Alostar Bank of Commerce, $10 million with Zion’s Bank, $5 million with Center State Bank, and $8 million with First Tennessee Bank. These accommodations may be withdrawn at any time at the sole discretion of these institutions. Additionally, the Company has a borrowing line with the Federal Reserve Bank of Richmond’s discount window. The Company has pledged its portfolios of construction and land development loans, and commercial and industrial loans against this borrowing line. Total available borrowings under this line were $27.2 million at March 31, 2016.

Loans

Gross loans totaled approximately $381,877,000 and $389,296,000 at March 31, 2016 and December 31, 2015, respectively. At March 31, 2016, the Company had $3.1 million of nonaccrual loans and no loans 90 days delinquent and still accruing interest. Of these, $2.5 million are secured by real estate. The primary risk of loss on these loans is a potential deterioration of real estate collateral values. At December 31, 2015, the Company had $3.1 million of nonaccrual loans and $218,000 of loans 90 days past due and still accruing interest. At March 31, 2015, the Company had $5.2 million of nonaccrual loans and $45,000 of loans 90 days past due and still accruing interest. The allowance for loan losses was 1.16 percent of loans as of March 31, 2016, compared to 1.23 percent as of December 31, 2015 and 1.33 percent as of March 31, 2015.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Loans – (continued)

For three months ended March 31, 2016 the Company credited its loan loss provision for $500,000. For the three months ended March 31, 2015 the Company credited its loan loss provision for $900,000. Net recoveries for the three months ended March 31, 2016 and March 31, 2015 totaled approximately $127,000 and $173,000, respectively. The need for future loan loss provisions will be influenced by loan defaults, loan delinquency levels, loan chargeoffs beyond what has already been provided for on individual loans, the level of loans with credit grades of 6 through 9, and the need for additional specific reserves on loans individually evaluated for impairment, among other factors. In reviewing the adequacy of the allowance for loan losses at each quarter end, management takes into consideration the historical loan losses we experienced, current levels of past due loans by loan type, the historical severity of loan losses by loan type, loan to value exceptions in our loan portfolio, potential repayment risk for floating and adjustable rate loans due to the potential for rising interest rates, risks posed by unseasoned loans during periods of growth in the loan portfolio, and collateral values of impaired loans deemed to be collateral dependent. As referenced in Note 6 to the Condensed Consolidated Financial Statements included in Part I, Item 1 of this Form 10-Q, the Company’s general reserves portion of its allowance for loan losses decreased by $373,000 during the three months ended March 31, 2016, from $4,753,000 at December 31, 2015 to $4,380,000 at March 31, 2016. The main factor leading to the loan loss provision credit of $500,000 for the three months ended March 31, 2016 was a $496,000 reduction in required general reserves for Commercial Real Estate loans. General reserves for Commercial Real Estate loans totaled $930,000 at March 31, 2016, compared to $1,426,000 at December 31, 2015, a reduction of approximately 35%. This reduction was primarily attributable to a reduction in delinquencies, as delinquent commercial real estate loans at March 31, 2016 totaled $1,887,000, compared to$3,199,000 at December 31, 2015, a reduction of $1,312,000, or approximately 41%. The Company’s net recoveries of $127,000 for the three months ended Mach 31, 2016 were also a contributing factor to the loan loss provision credit of $500,000. Partially offsetting these reductions in required general reserves was a $95,000 increase in general reserves for 1-4 family residential loans, which was due primarily to a $1.8 million increase in delinquencies.

For the three months ended March 31, 2016, net recoveries to average loans outstanding totaled 0.13% on an annualized basis while the allowance for loan losses to gross loans totaled 1.16% at March 31, 2016. For the three months ended March 31, 2015, net recoveries to average loans outstanding totaled 0.19% on an annualized basis while the allowance for loan losses to gross loans totaled 1.33% at March 31, 2015.

Management identifies and maintains a list of potential problem loans. These are loans that are internally risk graded substandard or below but which are not included in nonaccrual status and are not past due 90 days or more. A loan is added to the potential problem list when management becomes aware of information about possible credit problems of the borrower which raises serious doubts as to the ability of such borrower to comply with the current loan repayment terms. At March 31, 2016 potential problem loans totaled $9.3 million, comprised of $621,000 of construction and land development real estate loans, $4.6 million of nonfarm, nonresidential real estate loans, $3.7 million of 1-4 family residential loans, and $345,000 of various loan types not secured by real estate, primarily commercial and industrial loans. At December 31, 2015 potential problem loans totaled $9.1 million, comprised of $638,000 of construction and land development real estate loans, $4.3 million of nonfarm, nonresidential real estate loans, $3.7 million of 1-4 family residential loans, and $367,000 of various loan types not secured by real estate, primarily commercial and industrial loans. As the majority of potential problem loans are real estate secured, management closely tracks the current values of real estate collateral when assessing the collectibility of these loans.

Other Real Estate Owned

Other real estate owned totaled approximately $327,000 as of March 31, 2016 and December 31, 2015, and $3.4 million as of March 31, 2016, net of a valuation reserve. Sales of other real estate owned totaled approximately $9,000 and $312,000 for the three months ended March 31, 2016 and 2015, respectively. The Company did not make any loans to facilitate the sales of other real estate owned during either of the three months ended March 31, 2016 or March 31, 2015. There were no impairment charges on other real estate owned for either of the three months ended March 31, 2016 or 2015.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Deposits

Deposits decreased $1.1 million during the first three months of 2016 to $338.3 million at March 31, 2016. Included in this amount was a decrease of $7.3 million in interest bearing deposits, partially offset by an increase of $6.2 million in noninterest bearing accounts. The decrease in interest bearing deposits was due to decreases of $7.9 million and $291,000 in retail time deposits, and savings and money market demand accounts, respectively, partially offset by an $846,000 increase in interest bearing transaction accounts. There were no brokered or wholesale time deposits at March 31, 2016 or December 31, 2015.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations – continued

Federal Home Loan Bank Borrowings

Other borrowings are primarily comprised of FHLBA advances. FHLBA advances are collateralized by pledged FHLBA stock and certain residential mortgage and commercial real estate loans. FHLBA advances outstanding at March 31, 2016 and December 31, 2015 are summarized as follows:

March 31, 2016
(Dollars in Thousands)
Maturity	Rate			Balance

April 2016		0.42	%	$	5,000
April 2016		0.40	%		10,000
April 2016		0.34	%		5,000
May 2016		0.75	%		2,000
March 2017		2.31	%		2,000
May 2017		1.07	%		2,000
March 2018		2.33	%		5,000
April 2018		3.03	%		5,000
May 2018		1.38	%		2,000
March 2019		3.56	%		5,000
March 2019		3.51	%		5,000
May 2019		1.69	%		2,000
May 2020		2.01	%		2,000
March 2021		3.71	%		5,000
March 2021		3.74	%		5,000
March 2021		3.80	%		5,000
March 2021		3.87	%		5,000

Balance				$	72,000

December 31, 2015
(Dollars in Thousands)
Maturity	Rate			Balance

January 2016		0.40	%	$	15,000
January 2016		0.38	%		5,000
March 2016		2.04	%		10,000
March 2016		0.49	%		9,000
May 2016		0.75	%		2,000
March 2017		2.31	%		2,000
May 2017		1.07	%		2,000
March 2018		2.33	%		5,000
April 2018		3.03	%		5,000
May 2018		1.38	%		2,000
March 2019		3.56	%		5,000
March 2019		3.51	%		5,000
May 2019		1.69	%		2,000
May 2020		2.01	%		2,000
March 2021		3.71	%		5,000
March 2021		3.74	%		5,000
March 2021		3.80	%		5,000
March 2021		3.87	%		5,000

Balance				$	91,000

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations – continued

Junior Subordinated Debentures

On August 5, 2005 Southcoast Capital Trust III (the "Capital Trust"), a non-consolidated subsidiary of the Company, issued and sold a total of 10,310 floating rate securities, with a $1,000 liquidation amount per security (the "Capital Securities"). Institutional buyers bought 10,000 of the Capital Securities denominated as preferred securities and the Company bought the other 310 Capital Securities which are denominated as common securities. The proceeds of those sales, $10.3 million, were used by the Capital Trust to buy $10.3 million of junior subordinated debentures from the Company which are reported on its consolidated balance sheets. The Capital Securities mature or are mandatorily redeemable upon maturity on September 30, 2035, or upon earlier optional redemption as provided in the indenture. Since September 30, 2010, the Company has had the right to redeem the Capital Securities in whole or in part. See Note 11 to the consolidated financial statements for the year ended December 31, 2015, and the information set forth in Exhibit 13 under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations- Junior Subordinated Debentures” filed with our Form 10-K for the year ended December 31, 2015, for more information about the terms of the junior subordinated debentures.

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations – continued

Capital Resources

The Company’s total shareholders’ equity increased by approximately $1.3 million during the first three months of 2016, primarily due to net income of $1,210,000, and other comprehensive income of $105,000. The Company’s Tier 1 capital to average assets ratio was 13.05 percent as of March 31, 2016 compared to 12.77 percent as of December 31, 2015.

The Federal Reserve Board and other bank regulatory agencies require bank holding companies and financial institutions to maintain capital at adequate levels based on a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 100%. Under the risk-based standard, capital is classified into two tiers. The Company’s and the Bank’s Tier 1 capital consists of common shareholders’ equity minus a portion of deferred tax assets plus, in the case of the Company, junior subordinated debt subject to certain limitations. Tier 1 Capital includes Common Equity Tier 1 and Additional Tier 1, which consists of additions for certain items to Common Equity Tier 1. None of these additions apply to the Company or the Bank; therefore, for both entities Common Equity Tier 1 capital equals Tier 1 capital. The Company’s and the Bank’s Tier 2 capital consists of the allowance for loan losses subject to certain limitations and, in the case of the Company, its junior subordinated debt in excess of 25% of its Tier 1 capital. A bank holding company’s qualifying capital base for purposes of its risk-based capital ratio consists of the sum of its Tier 1 and Tier 2 capital. The regulatory minimum requirements are illustrated in the chart below. Effective January 1, 2016, the Minimum Basel III Phase In Requrements disclosed below include the year-one phased in capital conservation buffer of 0.625%. The Company and the Bank are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio. These requirements are set by regulation and are shown in the table below. These requirements are applicable to all but the most highly-rated institutions that are not anticipating or experiencing significant growth and have well-diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity and good earnings. The regulators may require individual bank holding companies and banks to maintain higher levels of capital depending on the regulators’ assessment of the risks faced by the bank holding company or the bank. As of March 31, 2016, the Company and the Bank exceeded each of the capital requirements shown in the following table.

	Capital Ratios
						Minimum Basel III Phase In					Minimum Basel III Fully Phased In					Well Capitalized
	Actual					Requirement					Requirement					Requirement
(Dollars in thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio			Amount		Ratio
The Bank
Total capital (to risk-weighted assets)	$	60,573		17.50	%	$	27,687		8.625	%	$	36,339		10.50	%	$	34,609		10.00	%
Tier 1 capital (to risk-weighted assets)		56,245		16.25	%		20,765		6.625	%		29,418		8.50	%		27,687		8.00	%
Common equity Tier 1 capital (to risk- weighted assets)		56,245		16.25	%		15,574		5.125	%		24,226		7.00	%		22,496		6.50	%
Tier 1 capital (to average assets)		56,245		11.85	%		18,988		4.00	%		18,988		4.00	%		23,735		5.00	%
The Company
Total capital (to risk-weighted assets)	$	68,529		19.46	%	$	28,178		8.625	%	$	36,984		10.50	%		N/A		N/A
Tier 1 capital (to risk-weighted assets)		64,076		18.19	%		21,134		6.625	%		29,939		8.50	%		N/A		N/A
Common equity Tier 1 capital (to risk- weighted assets)		64,076		18.19	%		15,850		5.125	%		24,656		7.00	%		N/A		N/A
Tier 1 capital (to average assets)		64,076		13.05	%		19,637		4.00	%		19,637		4.00	%		N/A		N/A

SOUTHCOAST FINANCIAL CORPORATION

Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - continued

Off Balance Sheet Risk

The Company makes contractual commitments to extend credit and issues standby letters of credit in the ordinary course of its business activities. These commitments are legally binding agreements to lend money to customers at predetermined interest rates for a specified period of time. In addition to commitments to extend credit, the Company also issues standby letters of credit which are assurances to a third party that it will not suffer a loss if the customer fails to meet a contractual obligation to the third party. At March 31, 2016, the Company had issued commitments to extend credit of approximately $25.3 million and letters of credit of approximately $441,000 through various types of commercial lending arrangements. Approximately $17.3 million of these commitments to extend credit had variable rates.

The following table sets forth the length of time until maturity for unused commitments to extend credit and standby letters of credit at March 31, 2016.

(Dollars in thousands)	Within One Month		After One Through Three Months		After Three Through Twelve Months		Within One Year		Greater Than One Year		Total

Unused commitments to extend credit	$	872	$	1,466	$	8,253	$	10,591	$	14,711	$	25,302
Standby letters of credit		132		5		304		441		-		441

Totals	$	1,004	$	1,471	$	8,557	$	11,032	$	14,711	$	25,743

Based on historical experience, many of the commitments and letters of credit will expire unfunded. Accordingly, the amounts shown in the table above do not necessarily reflect the Company’s need for funds in the periods shown. Further, through its various sources of liquidity, the Company believes it will be able to fund these obligations as they arise. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on the Company’s credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate.

Item 3. - Quantitative and Qualitative Disclosures About Market Risk.

Information about the Company’s exposure to market risk was disclosed in its Annual Report on Form 10-K for the year ended December 31, 2015, which was filed with the Securities and Exchange Commission on March 25, 2016. There have been no material quantitative or qualitative changes in market risk exposure since the date of that filing.

Item 4. - Controls and Procedures.

Based on the evaluation required by 17 C.F.R. Sections 240.13a-15(b) or 240.15d-15(b) of the Company’s disclosure controls and procedures (as defined in 17 C.F.R. Section 240.13a-15(e) and 240.15d-15(e), the Company's chief executive officer and chief financial officer concluded that such controls and procedures, as of the end of the period covered by this quarterly report, were effective.

There has been no change in the Company’s internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

SOUTHCOAST FINANCIAL CORPORATION

PART II - OTHER INFORMATION

Item 6. Exhibits

31-1	Rule 13a-14(a) Certifications of CEO

31-2	Rule 13a-14(a) Certifications of CFO

32	Section 1350 Certification

101.INS**

XBRL Instance

101.SCH**

XBRL Taxonomy Extension Schema

101.CAL**

XBRL Taxonomy Extension Calculation

101.DEF**

XBRL Taxonomy Extension Definition

101.LAB**

XBRL Taxonomy Extension Labels

101.PRE**

XBRL Taxonomy Extension Presentation

SIGNATURES

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

Date:May 12, 2016	By:	/s/ L. Wayne Pearson
		L. Wayne Pearson
		Chief Executive Officer

Date:May 12, 2016	By:	/s/ William C. Heslop
		William C. Heslop
		Chief Financial Officer

SOUTHCOAST FINANCIAL CORPORATION

Exhibit Index

31-1	Rule 13a-14(a) Certifications of CEO

31-2	Rule 13a-14(a) Certifications of CFO

32	Section 1350 Certification

101.INS**

XBRL Instance

101.SCH**

XBRL Taxonomy Extension Schema

101.CAL**

XBRL Taxonomy Extension Calculation

101.DEF**

XBRL Taxonomy Extension Definition

101.LAB**

XBRL Taxonomy Extension Labels

101.PRE**

XBRL Taxonomy Extension Presentation

** XBRL information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, as amended, and otherwise is not subject to liability under these sections.

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