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EX-32 - EXHIBIT 32 - FIRST SOUTH BANCORP INC /VA/v472536_ex32.htm
EX-31.2 - EXHIBIT 31.2 - FIRST SOUTH BANCORP INC /VA/v472536_ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - FIRST SOUTH BANCORP INC /VA/v472536_ex31-1.htm

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

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

 

For the quarterly period ended June 30, 2017

 

OR

 

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

For the transition period from          to          .

 

Commission File Number: 0-22219

 

FIRST SOUTH BANCORP, INC.

(Exact name of registrant as specified in its charter)

 

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

 

1311 Carolina Avenue, Washington, North Carolina 27889

(Address of principal executive offices)

(Zip Code)

 

(252) 946-4178

(Registrant's telephone number, including area code)

 

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

Yes x No ¨

 

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

Yes x No ¨

 

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

 

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

 

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

 

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

Yes ¨ No x

 

Number of shares of common stock outstanding as of August 8, 2017: 9,503,691

 

 

 

   

 

 

CONTENTS

 

      PAGE
       
PART I. FINANCIAL INFORMATION    
       
Item 1. Financial Statements    
       
  Consolidated Statements of Financial Condition as of June 30, 2017 (unaudited) and December 31, 2016   1
       
  Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2017 and 2016 (unaudited)   2
       
  Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2017 and 2016 (unaudited)   3
       
  Consolidated Statements of Changes in Stockholders' Equity for the Six Months Ended June 30, 2017 and 2016 (unaudited)   4
       
  Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2017 and 2016 (unaudited)   5
       
  Notes to Consolidated Financial Statements (unaudited)   6
       
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations   33
       
Item 3. Quantitative and Qualitative Disclosures About Market Risk   44
       
Item 4. Controls and Procedures   45
       
PART II. OTHER INFORMATION    
       
Item 1. Legal Proceedings   45
       
Item 1A. Risk Factors   45
       
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds   48
       
Item 3. Defaults Upon Senior Securities   48
       
Item 4. Mine Safety Disclosures   48
       
Item 5. Other Information   48
       
Item 6. Exhibits   48
       
Signatures     49
       
Exhibits      

 

 

 

 

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Financial Condition

 

   June 30,   December 31, 
   2017   2016 
   (Unaudited)     
Assets          
Cash and due from banks  $23,049,153   $22,854,712 
Interest-bearing deposits with banks   17,022,773    23,320,968 
Investment securities available for sale, at fair value   195,401,445    192,606,119 
Investment securities held to maturity   506,553    509,617 
Mortgage loans held for sale   6,380,856    5,098,518 
           
Loans and leases held for investment   776,656,251    700,642,291 
Allowance for loan and lease losses   (9,366,564)   (8,673,172)
Net loans and leases held for investment   767,289,687    691,969,119 
           
Premises and equipment, net   11,152,205    11,291,596 
Assets held for sale   185,906    192,720 
Other real estate owned   2,437,946    3,229,423 
Federal Home Loan Bank stock, at cost   1,847,700    1,573,700 
Accrued interest receivable   3,448,043    3,525,684 
Goodwill   4,218,576    4,218,576 
Mortgage servicing rights   2,134,256    2,148,905 
Identifiable intangible assets   1,490,348    1,611,187 
Bank-owned life insurance   18,351,387    18,080,183 
Prepaid expenses and other assets   6,462,221    8,470,887 
           
Total assets  $1,061,379,055   $990,701,914 
           
Liabilities and Stockholders' Equity          
Deposits:          
Non-interest bearing demand  $208,671,921   $196,917,165 
Interest bearing demand   308,799,734    272,098,903 
Savings   149,720,673    145,031,981 
Large denomination certificates of deposit   136,978,726    122,819,510 
Other time   127,363,292    133,732,804 
Total deposits   931,534,346    870,600,363 
           
Borrowed money   22,500,000    17,000,000 
Junior subordinated debentures   10,310,000    10,310,000 
Other liabilities   5,138,320    5,607,832 
Total liabilities   969,482,666    903,518,195 
           
           
Common stock, $.01 par value, 25,000,000 shares authorized; 9,502,520 and 9,494,935 shares outstanding, respectively   95,025    94,949 
Additional paid-in capital   36,072,883    36,018,743 
Retained earnings   52,822,834    49,560,595 
Accumulated other comprehensive income   2,905,647    1,509,432 
Total stockholders' equity   91,896,389    87,183,719 
           
Total liabilities and stockholders' equity  $1,061,379,055   $990,701,914 

 

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

 

 1 

 

 

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Operations

Three and Six Months Ended June 30, 2017 and 2016

(Unaudited)

 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
   2017   2016   2017   2016 
                 
Interest income:                    
Interest and fees on loans  $8,700,534   $7,642,097   $16,913,822   $14,833,692 
Interest on investments and deposits   1,392,349    1,356,030    2,783,029    2,836,282 
Total interest income   10,092,883    8,998,127    19,696,851    17,669,974 
                     
Interest expense:                    
Interest on deposits   830,192    697,426    1,584,181    1,366,702 
Interest on borrowings   60,469    58,711    122,429    131,797 
Interest on junior subordinated notes   127,011    141,578    251,261    281,617 
Total interest expense   1,017,672    897,715    1,957,871    1,780,116 
                     
Net interest income   9,075,211    8,100,412    17,738,980    15,889,858 
Provision for credit losses   485,000    325,000    750,000    550,000 
Net interest income after provision for credit losses   8,590,211    7,775,412    16,988,980    15,339,858 
                     
Non-interest income:                    
Deposit fees and service charges   1,964,665    1,931,050    3,820,885    3,838,457 
Loan fees and charges   92,723    138,649    178,767    195,634 
Mortgage loan servicing fees   316,988    273,689    638,827    507,689 
Gain on sale and other fees on mortgage loans   654,016    568,403    1,127,578    982,264 
Gain (loss) on sale of other real estate, net   (26,151)   (14,315)   55,500    (26,484)
Gain on sale of investment securities   -    183,955    -    467,470 
Other income   555,678    466,798    1,034,464    1,159,085 
Total non-interest income   3,557,919    3,548,229    6,856,021    7,124,115 
                     
Non-interest expense:                    
Compensation and fringe benefits   5,000,901    4,944,984    10,114,454    9,984,939 
Federal deposit insurance premiums   157,118    160,525    304,492    322,134 
Premises and equipment   1,334,666    1,380,675    2,733,216    2,754,484 
Marketing   119,050    229,434    182,790    417,253 
Data processing   807,722    749,731    1,601,090    1,546,217 
Amortization of intangible assets   151,269    133,571    300,466    265,099 
Other real estate owned expense   105,093    212,883    269,859    306,557 
Other   1,538,363    1,235,090    2,754,365    2,556,137 
Total non-interest expense   9,214,182    9,046,893    18,260,732    18,152,820 
                     
Income before income tax expense   2,933,948    2,276,748    5,584,269    4,311,153 
Income tax expense   879,031    664,734    1,657,155    1,238,345 
                     
NET INCOME  $2,054,917   $1,612,014   $3,927,114   $3,072,808 
                     
Per share data:                    
Basic earnings per share  $0.22   $0.17   $0.41   $0.32 
Diluted earnings per share  $0.22   $0.17   $0.41   $0.32 
Dividends per share  $0.035   $0.030   $0.070   $0.055 
Average basic shares outstanding   9,500,958    9,493,776    9,499,289    9,492,489 
Average diluted shares outstanding   9,554,420    9,519,565    9,548,382    9,517,248 

 

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

 

 2 

 

 

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Comprehensive Income

Three and Six Months Ended June 30, 2017 and 2016

(Unaudited)

 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
   2017   2016   2017   2016 
                 
Net income  $2,054,917   $1,612,014   $3,927,114   $3,072,808 
                     
Other comprehensive income:                    
Unrealized holding gains on securities available-for-sale   1,427,498    3,108,028    2,238,322    4,790,347 
Tax effect   (513,899)   (1,164,857)   (805,796)   (1,776,969)
Unrealized holding gains on securities available-for-sale, net of tax   913,599    1,943,171    1,432,526    3,013,378 
                     
Reclassification adjustment for realized gains included in net income   -    (183,955)   -    (467,470)
Tax effect   -    53,709    -    134,276 
Reclassification adjustment for realized gains, net of tax   -    (130,246)   -    (333,194)
                     
Unrealized gains (losses) on interest rate hedge position   (81,648)   (22,560)   (56,737)   (187,051)
Tax effect   29,393    8,415    20,426    69,770 
Unrealized losses on interest rate hedge position, net of tax   (52,255)   (14,145)   (36,311)   (117,281)
                     
Other comprehensive income, net of tax   861,344    1,798,780    1,396,215    2,562,903 
                     
Comprehensive income  $2,916,261   $3,410,794   $5,323,329   $5,635,711 

 

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

 

 3 

 

  

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Changes in Stockholders' Equity

Six Months Ended June 30, 2017 and 2016

(Unaudited)

 

               Accumulated     
       Additional       Other     
   Common   Paid-in   Retained   Comprehensive     
Six Months Ended June 30, 2017  Stock   Capital   Earnings   Income, Net   Total 
                     
Balance at December 31, 2016  $94,949   $36,018,743   $49,560,595   $1,509,432   $87,183,719 
                          
Net income   -    -    3,927,114    -    3,927,114 
                          
Other comprehensive income, net   -    -    -    1,396,215    1,396,215 
                          
Vesting of restricted stock awards, net   76    16,095    -    -    16,171 
                          
Stock based compensation expense   -    38,045    -    -    38,045 
                          
Dividends   -    -    (664,875)   -    (664,875)
                          
Balance at June 30, 2017  $95,025   $36,072,883   $52,822,834   $2,905,647   $91,896,389 

 

               Accumulated     
       Additional       Other     
   Common   Paid-in   Retained   Comprehensive     
Six Months Ended June 30, 2016  Stock   Capital   Earnings   Income, Net   Total 
                     
Balance at December 31, 2015  $94,892   $35,936,911   $43,691,073   $2,447,898   $82,170,774 
                          
Net income   -    -    3,072,808    -    3,072,808 
                          
Other comprehensive income, net   -    -    -    2,562,903    2,562,903 
                          
Vesting of restricted stock awards, net   35    (35)   -    -    - 
                          
Exercise of stock options   11    (11)   -    -    - 
                          
Stock based compensation expense   -    42,129    -    -    42,129 
                          
Dividends   -    -    (522,045)   -    (522,045)
                          
Balance at June 30, 2016  $94,938   $35,978,994   $46,241,836   $5,010,801   $87,326,569 

 

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

 

 4 

 

  

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Cash Flows

Six Months Ended June 30, 2017 and 2016

(Unaudited)

 

   Six Months Ended 
   June 30, 
   2017   2016 
         
Operating activities:          
Net income  $3,927,114   $3,072,808 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for credit losses   750,000    550,000 
Depreciation   947,338    847,168 
Amortization of intangibles   120,839    122,935 
Amortization of mortgage servicing rights   179,627    142,164 
Accretion of discounts and premiums on securities, net   635,607    768,201 
(Gain) loss on disposal of premises and equipment   (2,000)   1,651 
Loss on sale of assets held for sale   -    87,121 
(Gain) loss on sale of other real estate owned   (55,500)   26,484 
Gain on sale of loans held for sale   (562,938)   (540,097)
Gain on sale of investment securities available for sale   -    (467,470)
Valuation allowance on other real estate owned   176,919    110,170 
Stock based compensation expense   38,045    42,129 
Originations of loans held for sale, net   (19,160,581)   (16,586,508)
Proceeds from sale of loans held for sale   18,441,181    15,818,689 
Other operating activities   724,895    611 
Net cash provided by operating activities   6,160,546    3,996,056 
Investing activities:          
Proceeds from sale of investment securities available for sale   -    40,631,309 
Purchases of investment securities available for sale   (10,360,239)   - 
Purchases of investment securities held to maturity   (506,750)   - 
Proceeds from principal repayments of mortgage-backed securities available for sale   9,167,442    11,829,622 
Proceeds from maturity of investment securities held to maturity   510,000    - 
Proceeds from sale of assets held for sale   -    803,479 
Mortgage servicing rights from loans sold with servicing retained   (164,978)   (130,298)
Originations of loans held for investment, net of principal repayments   (76,279,261)   (62,371,462)
Proceeds from disposal of other real estate owned   935,358    912,253 
Proceeds from disposal of premises and equipment   946,039    297,727 
Purchase of bank-owned life insurance   (271,204)   (2,160,066)
Proceeds from sale (purchase) of FHLB stock   (274,000)   51,800 
Purchase of premises and equipment   (1,751,986)   (236,095)
Net cash used in investing activities   (78,049,579)   (10,371,731)
Financing activities:          
Net increase in deposit accounts   60,933,983    14,140,167 
Net increase (decrease) in FHLB borrowings   5,500,000    (4,500,000)
Cash paid for dividends   (664,875)   (522,045)
Vesting of restricted stock awards, net   16,171    - 
Net cash provided by financing activities   65,785,279    9,118,122 
           
Increase (decrease) in cash and cash equivalents   (6,103,754)   2,742,447 
Cash and cash equivalents, beginning of year   46,175,680    37,991,268 
Cash and cash equivalents, end of year  $40,071,926   $40,733,715 
           
Supplemental disclosures:          
Other real estate acquired in settlement of loans  $265,300   $464,525 
Transfer of premises to assets held for sale  $-   $1,083,320 
Cash paid for interest  $1,575,118   $1,752,134 

 

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

 

 5 

 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

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

 

The accompanying unaudited consolidated financial statements are prepared in pursuant to the instructions for Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements. In the opinion of management, all adjustments necessary for fair presentation of the financial position and results of operations for the periods presented are included, none of which are other than normal recurring accruals. The financial statements of the Company and the Bank are presented on a consolidated basis. The results of operations for the three and six months ended June 30, 2017, are not necessarily indicative of the results of operations that may be expected for the year ended December 31, 2017. The accompanying unaudited consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and related notes appearing in the 2016 Annual Report previously filed on Form 10-K.

 

On June 9, 2017, the Company entered into an Agreement and Plan of Merger and Reorganization (the “Merger Agreement”) with Carolina Financial Corporation (“CARO”). The Merger Agreement provides that, upon the terms and conditions set forth therein, the Company will merge with and into CARO (the “Merger”), with CARO continuing as the surviving corporation. As soon as practicable following consummation of the Merger, the Bank will merge with and into CARO’s wholly owned subsidiary, CresCom Bank ("CresCom"), with CresCom continuing as the surviving entity (the “Bank Merger”). Subject to the terms and conditions of the Merger Agreement, at the effective time of the Merger, the Company’s stockholders will have the right to receive 0.52 shares of CARO common stock for each share of the Company’s common stock. Cash will be paid in lieu of fractional shares. The transaction is expected to close in the fourth quarter of 2017, subject to shareholder and regulatory approval and other customary closing conditions.

 

2. Earnings Per Share. Basic and diluted earnings per share for the three and six months ended June 30, 2017 and 2016 are based on weighted average shares of common stock outstanding. Diluted earnings per share include the potentially dilutive effect of stock-based compensation plans. For both the three and six months ended June 30, 2017 there were 29,250 stock options, respectively, compared to 87,000 stock options, respectively, for both the three and six months ended June 30, 2016, that were anti-dilutive, because the exercise and grant prices exceeded the average market price of the Company’s common stock. The anti-dilutive shares are excluded from the diluted earnings per share calculation for the three and six months ended June 30, 2017 and 2016.

 

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

 

   Unrealized Holding Gains
on Investment Securities
Available-For-Sale
   Unrealized Holding
Gain (Loss) on Cash
Flow Hedging Activities
   Total Accumulated
Other Comprehensive
Income
 
   (In thousands) 
Six Months Ended June 30, 2017               
Balance at December 31, 2016  $1,433   $77   $1,510 
Other comprehensive income before reclassifications   1,432    (36)   1,396 
Amounts reclassified from AOCI   -    -    - 
Net current period other comprehensive income   1,432    (36)   1,396 
Balance at June 30, 2017  $2,865   $41   $2,906 
Six Months Ended June 30, 2016               
Balance at December 31, 2015  $2,695   $(247)  $2,448 
Other comprehensive income (loss) before reclassifications   3,013    (117)   2,896 
Amounts reclassified from AOCI   (333)   -    (333)
Net current period other comprehensive income (loss)   2,680    (117)   2,563 
Balance at June 30, 2016  $5,375   $(364)  $5,011 

 

 6 

 

 

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

 

   Amortized   Gross   Gross   Fair 
   Cost   Unrealized Gains   Unrealized Losses   Value 
  (In thousands) 
Securities available-for-sale:    
June 30, 2017    
Government agencies  $23,470   $411   $24   $23,857 
Mortgage-backed securities   85,037    2,467    21    87,483 
Municipal securities   55,502    1,681    26    57,157 
Corporate bonds   26,917    131    144    26,904 
Total  $190,926   $4,690   $215   $195,401 
December 31, 2016                    
Government agencies  $16,797   $245   $47   $16,995 
Mortgage-backed securities   93,124    2,155    163    95,116 
Municipal securities   53,465    536    319    53,682 
Corporate bonds   26,983    60    230    26,813 
Total  $190,369   $2,996   $759   $192,606 
                     
   Amortized   Gross   Gross   Fair 
  Cost   Unrealized Gains   Unrealized Losses   Value 
   (In thousands) 
Securities held-to-maturity:                    
                     
June 30, 2017                    
Government agencies  $506   $1   $-   $507 
Total  $506   $1   $-   $507 
                     
December 31, 2016                    
Government agencies  $510   $1   $-   $511 
Total  $510   $1   $-   $511 

 

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

 

   Three Months Ended June 30,   Six Months Ended June 30, 
   2017   2016   2017   2016 
   (In thousands) 
Proceeds from Sale  $-   $9,940   $-   $40,631 
                     
Gross realized gains on sales   -    185    -    594 
Gross realized losses on sales   -    (1)   -    (127)
Total realized gains, net  $-   $184   $-   $467 

 

 7 

 

 

4. Investment Securities (Continued)

 

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

 

   Less Than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Losses   Value   Losses   Value   Losses 
  (In thousands) 
June 30, 2017     
Government agencies  $6,727   $24   $-   $-   $6,727   $24 
Mortgage-backed securities   13,240    21    -    -    13,240    21 
Municipal securities   1,126    26    -    -    1,126    26 
Corporate bonds   3,994    4    7,859    140    11,853    144 
Total  $25,087   $75   $7,859   $140   $32,946   $215 
December 31, 2016                              
Government agencies  $6,766   $47   $-   $-   $6,766   $47 
Mortgage-backed securities   27,586    163    -    -    27,586    163 
Municipal securities   24,156    319    -    -    24,156    319 
Corporate bonds   13,751    26    7,795    204    21,546    230 
Total  $72,259   $555   $7,795   $204   $80,054   $759 

 

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

 

   Less Than   One to   Five to   Over 
   One Year   Five Years   Ten Years   Ten Years 
   (In thousands) 
Securities available-for-sale:                    
Government agencies                    
Amortized cost  $-   $23,470   $-   $- 
Fair value   -    23,857    -    - 
Mortgage-backed securities                    
Amortized cost   2,106    64,736    3,165    15,030 
Fair value   2,131    66,076    3,282    15,994 
Municipal securities                    
Amortized cost   4,844    13,686    35,542    1,430 
Fair value   4,886    14,025    36,788    1,458 
Corporate bonds                    
Amortized cost   7,014    11,903    8,000    - 
Fair value   7,015    11,973    7,916    - 
Total Amortized cost  $13,964   $113,795   $46,707   $16,460 
Total Fair value  $14,032   $115,931   $47,986   $17,452 
                     
Securities held-to-maturity:                    
Government agencies                    
Amortized cost  $-   $506   $-   $- 
Fair value   -    507    -    - 
Total Amortized cost  $-   $506   $-   $- 
Total Fair value  $-   $507   $-   $- 

 

United States government agency and mortgage-backed securities with an amortized cost of $60.5 million were pledged as collateral for public deposits at June 30, 2017, compared to $32.6 million at December 31, 2016. In addition, a government agency bond with an amortized cost of $506,000 and $510,000 was pledged as collateral on an interest rate swap transaction at June 30, 2017 and December 31, 2016, respectively.

 

 8 

 

 

4. Investment Securities (Continued)

 

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

 

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

 

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

 

   June 30, 2017 
   Amortized Cost   Fair Value 
   (In thousands) 
Obligations of state and political subdivisions:          
General obligation bonds:          
California  $5,144   $5,341 
Washington   3,361    3,424 
Pennsylvania   2,771    2,785 
Indiana   2,384    2,418 
Texas   2,266    2,260 
Florida   2,223    2,292 
Alabama   1,813    1,844 
Utah   1,781    1,807 
Nevada   1,322    1,354 
Missouri   1,301    1,429 
Other (11 states)   8,676    8,947 
Total general obligation bonds   33,042    33,901 
           
Revenue bonds:          
New York   7,147    7,445 
North Carolina   4,198    4,309 
Mississippi   2,304    2,394 
Oklahoma   2,239    2,340 
Pennsylvania   1,939    1,970 
Other (4 states)   4,633    4,798 
Total revenue bonds   22,460    23,256 
Total obligations of state and political subdivisions  $55,502   $57,157 

 

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

 

 9 

 

 

4. Investment Securities (Continued)

 

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

 

   June 30, 2017 
   Amortized Cost   Fair Value 
   (In thousands) 
Revenue bonds by revenue source:          
University and college  $8,534   $8,916 
Public improvements   6,079    6,294 
Pension funding   1,939    1,970 
Refunding bonds   1,621    1,649 
Other   4,287    4,427 
Total revenue bonds  $22,460   $23,256 

 

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

 

5. Loans Held for Sale. The Bank originates residential mortgage loans for sale in the secondary market. Pursuant to Accounting Standards Codification (“ASC”) 825, Financial Instruments, at June 30, 2017 and December 31, 2016, the Bank marked these mortgage loans to market. Mortgage loans held for sale at June 30, 2017 and December 31, 2016, had estimated fair market values of $6.4 million and $5.1 million, respectively. The Bank originates mortgage loans for sale that are approved by secondary investors. Their terms are set by secondary investors, and they are transferred within 120 days after the Bank funds the loans. The Bank issues rate lock commitments to borrowers, and depending on market conditions, may enter into forward contracts with secondary market investors to minimize interest rate risk related to mortgage loan forward sales commitments. The Bank uses forward contracts to minimize interest rate risk related to mortgage loan forward sales commitments to economically hedge a percentage of the locked-in pipeline. The Bank receives origination fees from borrowers and servicing release premiums from investors that are recognized in income when loans are sold. The following table summarizes forward contract positions of the Bank at June 30, 2017 and December 31, 2016:

 

Forward Contracts  June 30, 2017   December 31, 2016 
   Fair   Notional   Fair   Notional 
   Value   Value   Value   Value 
   (In thousands) 
Mortgage Loan Forward Sales Commitments  $81   $8,949   $65   $6,036 

 

 10 

 

 

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

 

   June 30, 2017   December 31, 2016 
   Amount   Percent of
Total
   Amount   Percent of
Total
 
   (Dollars in thousands) 
Loans Held for Investment                    
Mortgage loans:                    
Residential real estate  $69,649    9.0%  $67,264    9.6%
Residential construction   6,830    0.9    7,875    1.1 
Residential lots and raw land   137    0.0    154    0.0 
Total mortgage loans   76,616    9.9    75,293    10.7 
                     
Commercial loans and leases:                    
Commercial real estate   421,302    54.2    378,173    53.9 
Commercial construction   51,506    6.6    56,118    8.0 
Commercial lots and raw land   31,195    4.0    33,434    4.8 
Commercial and Industrial   90,375    11.6    67,980    9.7 
Lease receivables   22,945    3.0    21,236    3.0 
Total commercial loans and leases   617,323    79.4    556,941    79.4 
                     
Consumer loans:                    
Consumer real estate   20,419    2.6    16,967    2.4 
Consumer construction   419    0.1    105    0.0 
Consumer lots and raw land   8,867    1.1    8,975    1.3 
Home equity lines of credit   39,738    5.1    36,815    5.3 
Consumer other   13,992    1.8    6,347    0.9 
Total consumer loans   83,435    10.7    69,209    9.9 
                     
Gross loans held for investment   777,374    100.0%   701,443    100.0%
                     
Less deferred loan origination fees, net   717         801      
Less allowance for loan and lease losses   9,367         8,673      
                     
Net loans held for investment  $767,290        $691,969      

 

The Bank has pledged eligible loans as collateral for actual or potential borrowings from the Federal Home Loan Bank (“FHLB”) and the Federal Reserve Bank of Richmond (“FRB”). At June 30, 2017, the Bank pledged $283.8 million and $149.5 million of loans to the FHLB and FRB, respectively. See Note 13. Borrowed Money below, for additional information.

 

 11 

 

 

6. Loans Held for Investment (Continued)

 

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

 

   June 30, 2017   December 31, 2016 
   (Dollars in thousands) 
Non-accrual loans held for investment:          
Non-TDR loans accounted for on a non-accrual status:          
Residential real estate  $821   $773 
Residential lots and raw land   -    - 
Commercial real estate   915    482 
Commercial construction   -    - 
Commercial lots and raw land   -    - 
Commercial and industrial   -    72 
Lease receivables   -    - 
Consumer real estate   95    94 
Consumer lots and raw land   25    80 
Home equity lines of credit   128    166 
Consumer other   -    - 
Total non-TDR loans accounted for on a nonaccrual status   1,984    1,667 
           
TDR loans accounted for on a nonaccrual status:          
Past Due TDRs:          
Residential real estate   -    161 
Commercial real estate   -    652 
Commercial construction   -    - 
Commercial lots and raw land   -    - 
Commercial and industrial   -    - 
Consumer real estate   -    149 
Total Past Due TDRs   -    962 
           
Current TDRs:          
Residential real estate   155    163 
Commercial real estate   -    - 
Commercial construction   -    - 
Commercial lots and raw land   -    - 
Commercial and industrial   170    170 
Consumer real estate   139    - 
Consumer lots and raw land   85    89 
Total Current TDRs   549    422 
           
Total TDR loans accounted for on a nonaccrual status   549    1,384 
Total non-performing loans  $2,533    3,051 
Percentage of total loans held for investment, net   0.3%   0.4%
Loans over 90 days past due, still accruing  $-   $- 
Other real estate owned   2,438    3,229 
Total non-performing assets  $4,971   $6,280 

 

Cumulative interest income not recorded on loans accounted for on a nonaccrual status was $114,100 and $115,318 at June 30, 2017 and December 31, 2016, respectively.

 

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

 

 12 

 


6. Loans Held for Investment (Continued)

 

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

 

   30-59   60-89   90 Days   Total       Total   90 Days or 
   Days   Days   or More   Past       Financing   More and 
Past due loans held for investment:   Past Due   Past Due   Past Due   Due   Current   Receivables   Accruing 
   (In thousands) 
June 30, 2017                                   
Residential real estate  $-   $120   $509   $629   $69,020   $69,649   $- 
Residential construction   -    -    -    -    6,830    6,830    - 
Residential lots and raw land   -    -    -    -    137    137    - 
Commercial real estate   98    -    768    866    420,436    421,302    - 
Commercial construction   -    -    -    -    51,506    51,506    - 
Commercial lots and raw land   227    -    -    227    30,968    31,195    - 
Commercial and industrial   30    -    -    30    90,345    90,375    - 
Lease receivables   -    -    -    -    22,945    22,945    - 
Consumer real estate   343    -    61    404    20,015    20,419    - 
Consumer construction   -    -    -    -    419    419    - 
Consumer lots and raw land   -    33    -    33    8,834    8,867    - 
Home equity lines of credit   226    46    44    316    39,422    39,738    - 
Consumer other   14    27    -    41    13,951    13,992    - 
Total  $938   $226   $1,382   $2,546   $774,828   $777,374   $- 
                                    
   30-59   60-89   90 Days   Total       Total   90 Days or 
   Days   Days   or More   Past       Financing   More and 
Past due loans held for investment:  Past Due   Past Due   Past Due   Due   Current   Receivables   Accruing 
  (In thousands) 
December 31, 2016                                   
Residential real estate  $1,048   $176   $565   $1,789   $65,475   $67,264   $- 
Residential construction   -    -    -    -    7,875    7,875    - 
Residential lots and raw land   -    -    -    -    154    154    - 
Commercial real estate   726    4    1,022    1,752    376,421    378,173    - 
Commercial construction   -    -    -    -    56,118    56,118    - 
Commercial lots and raw land   -    -    -    -    33,434    33,434    - 
Commercial and industrial   -    -    72    72    67,908    67,980    - 
Lease receivables   -    -    -    -    21,236    21,236    - 
Consumer real estate   -    42    206    248    16,719    16,967    - 
Consumer construction   -    -    -    -    105    105    - 
Consumer lots and raw land   -    8    81    89    8,886    8,975    - 
Home equity lines of credit   121    33    98    252    36,563    36,815    - 
Consumer other   7    2    -    9    6,338    6,347    - 
Total  $1,902   $265   $2,044   $4,211   $697,232   $701,443   $- 

  

 13 

 

 

 

6. Loans Held for Investment (Continued)

 

The following table presents information on loans that were considered impaired as of June 30, 2017 and December 31, 2016. Impaired loans include loans modified as a TDR, whether on accrual or non-accrual status. At June 30, 2017, impaired loans included $1.2 million of TDRs, compared to $1.9 million at December 31, 2016.

 

       Contractual       YTD Average   Interest Income 
   Recorded   Unpaid Principal   Related   Recorded   Recognized on 
Impaired Loans June 30, 2017  Investment   Balance   Allowance   Investment   Impaired Loans 
           (in thousands)         
With no related allowance recorded:                         
Residential real estate  $425   $511   $-   $538   $13 
Commercial real estate   5,904    5,947    -    6,078    159 
Commercial lots and raw land   1,042    1,042    -    1,611    27 
Commercial and industrial   92    92    -    97    2 
Consumer real estate   208    224    -    202    8 
Consumer lots and raw land   86    92    -    113    2 
Home equity lines of credit   27    30    -    42    1 
Consumer other   36    36    -    37    1 
Subtotal:   7,820    7,974    -    8,718    213 
With an allowance recorded:                         
Commercial real estate   278    278    -    282    7 
Commercial and industrial   170    174    170    218    6 
Consumer lots and raw land   589    589    103    609    12 
Home equity lines of credit   55    58    36    45    2 
Subtotal   1,092    1,099    309    1,154    27 
Totals:                         
Residential   425    511    -    538    13 
Commercial   7,486    7,533    170    8,286    201 
Consumer   1,001    1,029    139    1,048    26 
Grand Total  $8,912   $9,073   $309   $9,872   $240 

 

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

 

 14 

 

  

6. Loans Held for Investment (Continued)

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 15 

 

  

6. Loans Held for Investment (Continued)

 

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

 

June 30, 2017
Commercial Credit Exposure by Assigned Risk Grade  Commercial
Real Estate
   Commercial
Construction
   Commercial Lots
and Raw Land
   Commercial and
Industrial
 
   (In thousands) 
1-Excellent  $-   $-   $-   $9 
2-Above Average   2,678    -    787    286 
3-Average   120,775    10,730    2,745    20,298 
4-Acceptable   269,366    40,173    19,645    61,661 
5-Watch   17,613    603    7,268    5,000 
6-Special Mention   7,238    -    719    1,012 
7-Substandard   3,632    -    31    2,109 
8-Doubtful   -    -    -    - 
9-Loss   -    -    -    - 
Total  $421,302   $51,506   $31,195   $90,375 

 

June 30, 2017
Consumer Credit Exposure by Assigned
Risk Grade
  Consumer
Real Estate
   Consumer
Construction
   Consumer Lots
and Raw Land
   Home Equity
Line of Credit
   Consumer
Other
 
   (In thousands) 
Pass  $20,067   $419   $8,559   $39,499   $13,954 
6-Special Mention   118    -    197    41    1 
7-Substandard   234    -    111    198    37 
8-Doubtful   -    -    -    -    - 
9-Loss   -    -    -    -    - 
Total  $20,419   $419   $8,867   $39,738   $13,992 

  

June 30, 2017
Mortgage and Lease Receivable Credit Exposure by
Assigned Risk Grade
  Residential Real
Estate
   Residential
Construction
   Residential Lots
and Raw Land
   Lease Receivable 
   (In thousands) 
Pass  $67,927   $6,830   $137   $22,848 
6-Special Mention   747    -    -    97 
7-Substandard   975    -    -    - 
8-Doubtful   -    -    -    - 
9-Loss   -    -    -    - 
Total  $69,649   $6,830   $137   $22,945 

 

 16 

 

  

6. Loans Held for Investment (Continued)

 

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

 

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

 

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

 

 17 

 

  

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

 

   June 30, 2017 
   Beginning   Charge-           Ending   Total 
   Balance   Offs   Recoveries   Provisions   Balance   Loans 
   (In thousands) 
Collectively evaluated for impairment:                              
Residential real estate  $695   $(33)  $-   $55   $717   $69,224 
Residential construction   89    -    -    (15)   74    6,830 
Residential lots and raw land   2    -    -    (1)   1    137 
Commercial real estate   4,562    (4)   17    396    4,971    415,120 
Commercial construction   689    -    -    (84)   605    51,506 
Commercial lots and raw land   365    -    -    (28)   337    30,153 
Commercial and industrial   840    (20)   2    259    1,081    90,113 
Lease receivables   226    -    -    11    237    22,945 
Consumer real estate   186    -    1    61    248    20,211 
Consumer construction   1    -    -    3    4    419 
Consumer lots and raw land   134    -    2    (39)   97    8,192 
Home equity lines of credit   414    (5)   22    (5)   426    39,656 
Consumer other   77    (4)   25    162    260    13,956 
Total   8,280    (66)   69    775    9,058    768,462 
Individually evaluated for impairment:                              
Residential real estate   -    -    2    (2)   -    425 
Commercial real estate   -    -    -    -    -    6,182 
Commercial lots and raw land   -    -    14    (14)   -    1,042 
Commercial and industrial   226    (67)   -    11    170    262 
Consumer real estate   -    -    -    -    -    208 
Consumer lots and raw land   144    (26)   15    (30)   103    675 
Home equity lines of credit   23    -    3    10    36    82 
Consumer other   -    -    -    -    -    36 
Total   393    (93)   34    (25)   309    8,912 
Grand Total  $8,673   $(159)  $103   $750   $9,367   $777,374 

 

 18 

 

  

7. Allowance for Loan and Lease Losses (Continued)

 

   June 30, 2016 
   Beginning   Charge-           Ending   Total 
   Balance   Offs   Recoveries   Provisions   Balance   Loans 
   (In thousands) 
Collectively evaluated for impairment:                              
Residential real estate  $730   $-   $-   $(45)  $685   $66,480 
Residential construction   47    -    -    22    69    6,103 
Residential lots and raw land   2    -    -    -    2    165 
Commercial real estate   4,065    -    16    217    4,298    355,006 
Commercial construction   518    -    70    96    684    56,513 
Commercial lots and raw land   303    -    -    73    376    32,721 
Commercial and industrial   641    (2)   3    88    730    57,021 
Lease receivables   196    -    -    8    204    18,927 
Consumer real estate   198    -    7    (17)   188    16,567 
Consumer construction   2    -    -    2    4    417 
Consumer lots and raw land   125    (4)   -    -    121    8,568 
Home equity lines of credit   351    -    1    21    373    32,791 
Consumer other   71    (34)   13    23    73    6,331 
Total   7,249    (40)   110    488    7,807    657,610 
Individually evaluated for impairment:                              
Residential real estate   -    (2)   1    1    -    779 
Commercial real estate   -    (68)   1    414    347    7,221 
Commercial construction   -    -    -    -    -    405 
Commercial lots and raw land   365    -    -    (365)   -    2,357 
Commercial and industrial   14    -    -    (9)   5    40 
Consumer real estate   30    (36)   -    6    -    371 
Consumer lots and raw land   209    (50)   2    (5)   156    765 
Home equity lines of credit   -    -    3    20    23    76 
Consumer other   -    -    -    -    -    40 
Total   618    (156)   7    62    531    12,054 
Grand Total  $7,867   $(196)  $117   $550   $8,338   $669,664 

 

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

 

   June 30, 2017   December 31, 2016 
   (Dollars in thousands) 
Performing TDRs accounted for on accrual status:          
Residential real estate  $-   $- 
Commercial real estate   609    461 
Consumer real estate   35    - 
Consumer lots and raw land   54    95 
Total  $698   $556 
Percentage of total loans, net   0.0%   0.1%

 

 19 

 

  

8. Troubled Debt Restructurings (Continued)

 

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

 

Performing TDRs  Beginning
Balance
   Additions (1)   Charge-offs (2)   Other (3)   Ending Balance 
   (In thousands) 
June 30, 2017                         
Residential mortgage  $-   $-   $-   $-   $- 
Commercial   461    252    -    (104)   609 
Consumer   95    -    -    (6)   89 
Total  $556   $252   $-   $(110)  $698 
                          
June 30, 2016                         
Residential mortgage  $-   $-   $-   $-   $- 
Commercial   770    -    -    (385)   385 
Consumer   107    -    -    (6)   101 
Total  $877   $-   $-   $(391)  $486 

 

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

 

Non-Performing TDRs  Beginning
Balance
   Additions (1)   Charge-offs (2)   Other (4)   Ending Balance 
   (In thousands) 
June 30, 2017                         
Residential mortgage  $324   $-   $-   $(169)  $155 
Commercial   822    -    -    (652)   170 
Consumer   238    -    -    (14)   224 
Total  $1,384   $-   $-   $(835)  $549 
                          
June 30, 2016                         
Residential mortgage  $809   $-   $(2)  $(303)  $504 
Commercial   534    -    -    (234)   300 
Consumer   159    -    -    (7)   152 
Total  $1,502   $-   $(2)  $(544)  $956 

 

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

 

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

 

   June 30, 2017   June 30, 2016 
   (In thousands) 
Note A Structure          
Commercial real estate (1)  $338   $263 
Note B Structure          
Commercial real estate (2)  $206   $174 
Reduction of interest income (3)  $5   $5 

 

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

 

 20 

 

  

8. Troubled Debt Restructurings (Continued)

 

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

 

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

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

 

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

 

   Beginning           Fair Value   Ending 
Six Months Ended:  Balance   Additions   Sales, net   Adjustments   Balance 
   (In thousands) 
June 30, 2017  $3,229   $266   $(880)  $(177)  $2,438 
                          
June 30, 2016  $6,125   $464   $(938)  $(110)  $5,541 

 

 

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

 

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

 

   June 30, 2017   December 31, 2016 
Land  $2,807,558   $2,817,308 
Office buildings and improvements   10,195,264    9,667,612 
Furniture, fixtures and equipment   9,901,636    9,877,872 
Vehicles   623,038    621,238 
Projects/work in process   510,760    571,784 
    24,038,256    23,555,814 
Less accumulated depreciation   12,886,051    12,264,218 
Total  $11,152,205   $11,291,596 

 

The Bank leases certain branch facilities and equipment under separate agreements that expire at various dates through October 30, 2027. Rental expense of $333,082 and $665,416 during the three and six months ended June 30, 2017, and $339,099 and $687,959 during the three and six months ended June 30, 2016, respectively, is included in premises and equipment expense on the accompanying consolidated statements of operations.

 

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

 

2017  $661,076 
2018   1,114,684 
2019   854,960 
2020   637,077 
2021   541,209 
Thereafter   1,553,207 
Total  $5,362,213 

 

 21 

 

  

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

  

Six Months Ended June 30, 2017:  Goodwill   Identifiable Intangibles   Total 
Balance at December 31, 2016  $4,218,576   $1,611,187   $5,829,763 
Amortization   -    (120,839)   (120,839)
Balance at June 30, 2017  $4,218,576   $1,490,348   $5,708,924 
                
Six Months Ended June 30, 2016               
Balance at December 31, 2015  $4,218,576   $1,895,514   $6,114,090 
Amortization   -    (142,164)   (142,164)
Balance at June 30, 2016  $4,218,576   $1,753,350   $5,971,926 

 

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

 

   Identifiable Intangibles 
Net book value at December 31, 2015  $1,895,514 
Accumulated amortization   (284,327)
Net book value at December 31, 2016   1,611,187 
Accumulated amortization   (120,839)
Net book value at June 30, 2017  $1,490,348 

 

The following table presents estimated future amortization expense of the CDI. At June 30, 2017, the remaining life of the CDI was 7.50 years.

 

2017  $120,839 
2018   223,002 
2019   223,002 
2020   223,002 
2021   223,002 
Thereafter   477,501 
Total  $1,490,348 

 

 

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

 

   June 30, 2017   December 31, 2016 
  (In thousands) 
Demand accounts:    
Non-interest bearing checking  $208,672   $196,917 
Interest bearing checking   222,266    189,401 
Money market   86,533    82,698 
Savings accounts   149,721    145,032 
Certificate accounts   264,342    256,552 
Total deposits  $931,534   $870,600 

 

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

 

   $250,000 or
Less
   More than
$250,000
   Total 
   (In thousands) 
Three months or less  $33,113   $3,706   $36,819 
Over three months through one year   107,926    14,323    122,249 
Over one year through three years   53,263    25,636    78,899 
Over three years   18,788    7,587    26,375 
Total time deposits  $213,090   $51,252   $264,342 

 

The aggregate amount of time deposits with balances of $250,000 or more was $51.3 million and $39.2 million at June 30, 2017 and December 31, 2016, respectively.

 

 22 

 

  

13. Borrowed Money. The Bank had $22.5 million of FHLB borrowings outstanding at June 30, 2017, compared to $17.0 million at December 31, 2016. The Bank pledges its stock in the FHLB and certain loans as collateral for actual or potential FHLB advances. At June 30, 2017 and December 31, 2016, the Bank had $259.6 million and $246.2 million, respectively, of credit available with the FHLB. At June 30, 2017, the Bank had lendable collateral value with the FHLB totaling $220.4 million. Additional collateral would be required in order to access total borrowings up to the credit availability limit.

 

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

 

Maturity Date  Interest Rate   Amount 
       (Dollars in thousands) 
May 25, 2018   1.320%  $6,000 
June 22, 2018   1.330%   1,000 
June 25, 2018   0.870%   1,000 
June 25, 2018   1.360%   2,000 
June 29, 2018   1.340%   1,000 
December 21, 2018   1.470%   2,500 
June 24, 2019   1.048%   1,000 
July 8, 2019   1.620%   2,000 
June 22, 2020   1.720%   3,000 
June 29, 2020   1.980%   2,000 
July 6, 2020   1.890%   1,000 
        $22,500 

 

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

 

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

 

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

 

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

 

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

 

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

 

 23 

 

 

 

15. Regulatory Capital (Continued)

 

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

 

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

 

Regulatory Capital Amounts and Ratios  6/30/2017   12/31/2016 
   Amount   Ratio (1)   Amount   Ratio (2) 
   (Dollars in thousands) 
Total risk-based capital (1)  $101,095    12.571%  $96,502    13.009%
Tier 1 risk-based capital (1)   91,444    11.371%   87,517    11.798%
Common equity Tier 1 risk-based capital (1)   91,444    11.371%   87,517    11.798%
Tier 1 leverage capital   91,444    8.838%   87,517    8.894%

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

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

 

16. Stock-Based Compensation. The Company had two stock-based compensation plans at June 30, 2017. The shares outstanding are for grants under the Company’s 1997 Stock Option Plan (the “1997 Plan”) and the 2008 Equity Incentive Plan (the “2008 Plan”). The 1997 Plan matured on April 8, 2008 and no additional options may be granted under the 1997 Plan. At June 30, 2017, the 1997 Plan had 18,250 granted unexercised stock option shares. At June 30, 2017, the 2008 Plan included 124,700 granted unexercised stock option shares, 7,165 granted nonvested restricted stock award shares and 804,150 shares available to be granted.

 

Stock Option Grants. Options granted under the 2008 Plan are granted at the closing price of the Company’s common stock on the NASDAQ Stock Market on the date of grant. Stock options expire ten years from the date of grant and vest over service periods ranging from one year to five years. The Company settles stock option exercises with authorized unissued shares. The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model. The risk-free interest rate is based on the U.S. Treasury rate for the expected life at the time of grant. Volatility is based on the average volatility of the Company based upon previous trading history. The expected life and forfeiture assumptions are based on historical data. Dividend yield is based on the yield at the time of the option grant. A summary of option activity under the Plans during the six month periods ended June 30, 2017 and 2016 is presented below:

 

   Options
Outstanding
   Price   Aggregate
Intrinsic Value
 
Period Ended June 30, 2017:               
Outstanding at December 31, 2016   147,750   $9.91      
Granted   -    -      
Forfeited   (800)   8.13      
Expired   -    -      
Exercised   (4,000)   7.57      
Outstanding at June 30, 2017   142,950    9.98   $1,057,875 
Vested and Exercisable at June 30, 2017   124,750   $10.33   $894,894 
Period Ended June 30, 2016:               
Outstanding at December 31, 2015   165,750   $10.76      
Granted   -    -      
Forfeited   (3,000)   27.87      
Expired   (5,750)   27.71      
Exercised   (3,000)   5.40      
Outstanding at June 30, 2016   154,000    9.90   $306,560 
Vested and Exercisable at June 30, 2016   116,850   $10.84   $217,940 

 

 24 

 

  

16. Stock-Based Compensation (Continued)

 

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

 

   Outstanding   Exercisable 
Range of Exercise Price  Shares   Life   Price   Shares   Price 
$4.00 – 10.00   86,700    5.41   $6.06    68,500   $5.66 
$10.01 – 17.00   27,000    2.20    11.01    27,000    11.01 
$17.01 – 30.00   29,250    0.76    20.65    29,250    20.65 
    142,950    3.85   $9.98    124,750   $10.33 

 

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

 

Period Ended:  June 30, 2017   June 30, 2016 
   Shares   Price   Shares   Price 
Nonvested at beginning of period   32,150   $7.09    53,300   $6.67 
Granted   -    -    -    - 
Forfeited   (800)   8.13    -    - 
Vested   (13,150)   6.34    (16,150)   6.03 
Nonvested at end of period   18,200   $7.59    37,150   $6.95 

 

Total compensation expense charged to income for stock options was $7,952 and $18,997, respectively, for the three and six months ended June 30, 2017, compared to compensation expense of $11,783 and $23,563, respectively, for the three and six months ended June 30, 2016. As of June 30, 2017, total unrecognized compensation cost on granted unexercised shares was $67,249, and is expected to be recognized during the next 2.75 years.

 

Restricted Stock Awards. The Company measures the fair value of restricted shares based on the price of its common stock on the grant date and compensation expense is recorded over the vesting period. There were no restricted stock awards granted during the six months ended June 30, 2017. During the six months ended June 30, 2016, 3,000 restricted stock awards were granted with a four year vesting period, and 2,200 restricted stock awards were granted with a five year vesting period. Total compensation expense recognized for restricted stock awards for the three and six months ended June 30, 2017 was $9,524 and $19,048, respectively, compared to $9,687 and $18,566, respectively, for the three and six months ended June 30, 2016. As of June 30, 2017, there was $43,251 of total unrecognized compensation cost related to nonvested restricted stock granted under the 2008 Plan, which will be recognized over a remaining period of 3.75 years. A summary of nonvested restricted stock awards and vesting changes during the six months ended June 30, 2017 and 2016 is presented below:

 

Period Ended:  June 30, 2017   June 30, 2016 
   Shares   Price   Shares   Price 
Nonvested at beginning of period   11,750   $8.27    10,425   $8.36 
Granted   -    -    5,200    8.15 
Forfeited   -    -    -    - 
Vested   (4,585)   8.31    (3,475)   8.36 
Nonvested at end of period   7,165   $8.25    12,150   $8.27 

 

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

 

   Three Months
Ended
6/30/17
   Three Months
Ended
6/30/16
   Six Months
Ended
6/30/17
   Six Months
Ended
6/30/16
 
Decrease in net income before income taxes  $17,476   $21,470   $38,045   $42,129 
Decrease in net income  $17,476   $21,470   $38,045   $42,129 
Decrease in basic earnings per share  $0.00   $0.00   $0.01   $0.01 
Decrease in diluted earnings per share  $0.00   $0.00   $0.01   $0.01 

 

 25 

 

 

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

 

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

 

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

 

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

 

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

 

 26 

 

 

17. Fair Value Measurement (Continued)

 

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

 

   Fair Value   Quoted Prices In
Active Markets for
Identical Assets
   Significant
Observable Inputs-
Outputs
   Significant
Unobservable
Inputs
 
   (In thousands) 
Description  June 30, 2017   Level 1   Level 2   Level 3 
Securities available-for-sale:                    
Government agencies  $23,857   $23,857   $-   $- 
Mortgage-backed securities   87,483    -    87,483    - 
Municipal securities   57,157    -    57,157    - 
Corporate bonds   26,904    -    26,904    - 
Mortgage loans held for sale   6,381    -    6,381    - 
Bank-owned life insurance   18,351    -    18,351    - 
Interest rate swap   64    -    64    - 
Total June 30, 2016  $220,197   $23,857   $196,340   $- 
                     
Description  December 31, 2016   Level 1   Level 2   Level 3 
Securities available-for-sale:                    
Government agencies  $16,995   $16,995   $-   $- 
Mortgage-backed securities   95,116    -    95,116    - 
Municipal securities   53,682    -    53,682    - 
Corporate bonds   26,813    -    26,813    - 
Mortgage loans held for sale   5,099    -    5,099    - 
Bank-owned life insurance   18,080    -    18,080    - 
Interest rate swap   121    -    121    - 
Total December 31, 2015  $215,906   $16,995   $198,911   $- 

 

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

 

   Fair Value   Quoted Prices In
Active Markets for
Identical Assets
   Significant
Observable Inputs-
Outputs
   Significant
Unobservable
Inputs
 
   (In thousands) 
Description  June 30, 2017   Level 1   Level 2   Level 3 
Impaired loans, net  $8,603   $-   $-   $8,603 
Other real estate owned   2,438    -    -    2,438 
Total June 30, 2016  $11,041   $-   $-   $11,041 
                     
Description  December 31, 2016   Level 1   Level 2   Level 3 
Impaired loans, net  $10,730   $-   $-   $10,730 
Other real estate owned   3,229    -    -    3,229 
Total December 31, 2015  $13,959   $-   $-   $13,959 

 

Impaired loans at June 30, 2017 and December 31, 2016 include $7.8 million and $9.9 million, respectively, of loans identified as impaired, even though an impairment analysis calculated pursuant to ASC 310-10-35 resulted in no allowance.

 

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

 

 27 

 

 

17. Fair Value Measurement (Continued)

 

OREO is recorded at fair value upon transfer of a loan to foreclosed assets, based on the appraised market value of the property. OREO is reviewed quarterly and values are adjusted as determined appropriate. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When an appraised value is not available or management determines the fair value of the collateral is impaired below the appraised value and there is no observable market price, the Bank classifies the foreclosed asset as non-recurring Level 3. Fair value adjustments of $57,624 and $176,919, respectively, were made to OREO during the three and six months ended June 30, 2017, compared to $102,880 and $110,170, respectively, made during the three and six months ended June 30, 2016.

 

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

 

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

 

   Level in  June 30, 2017   December 31, 2016 
   Fair Value  Estimated   Carrying   Estimated   Carrying 
   Hierarchy  Fair Value   Amount   Fair Value   Amount 
     (In thousands) 
Financial assets:       
Cash and due from banks  Level 1  $23,049   $23,049   $22,855   $22,855 
Interest-bearing deposits in other banks  Level 1   17,023    17,023    23,321    23,321 
Securities available for sale  Level 1   23,857    23,857    16,995    16,995 
Securities available for sale  Level 2   171,544    171,544    175,611    175,611 
Securities held to maturity  Level 2   507    506    511    510 
Loans held for sale  Level 2   6,381    6,381    5,099    5,099 
Loans and leases HFI, net, less impaired loans  Level 2   758,880    758,687    678,911    681,239 
Stock in FHLB of Atlanta  Level 2   1,848    1,848    1,574    1,574 
Accrued interest receivable  Level 2   3,448    3,448    3,526    3,526 
Interest rate swap  Level 2   64    64    121    121 
Bank-owned life insurance  Level 2   18,351    18,351    18,080    18,080 
Impaired loans HFI, net of related allowance  Level 3   8,603    8,603    10,730    10,730 
Mortgage servicing rights  Level 3   2,918    2,134    3,128    2,149 
Financial liabilities:                       
Deposits  Level 2  $930,387   $931,534   $869,591   $870,600 
Junior subordinated debentures  Level 2   10,310    10,310    10,310    10,310 

 

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

 

Financial assets:

 

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

 

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

 

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

 

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

 

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

 

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

 

 28 

 

  

18. Fair Value of Financial Instruments (Continued)

 

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

 

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

 

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

 

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

 

Financial liabilities:

 

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

 

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

 

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

 

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

 

21. Subsequent Events. We have evaluated subsequent events after June 30, 2017, and concluded that no material transactions occurred that provided additional evidence about conditions that existed at or after June 30, 2017, that required adjustments to or disclosure in the Consolidated Financial Statements.

 

22. Recent Accounting Pronouncements. The following are Accounting Standards Updates (“ASU”) recently issued by the Financial Accounting Standards Board (the “FASB”) and their expected impact on the Company. Other accounting standards issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s consolidated financial statements.

 

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers. This ASU was developed as a joint project with the International Accounting Standards Board to remove inconsistencies in revenue requirements and provide a more robust framework for addressing revenue issues. The ASU’s core principle is that an entity should recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods or services. ASU 2015-14, issued in August 2015, amended the effective date of this ASU to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Liabilities. The amendments in this ASU 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 ASU 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 ASU 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 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. For public entities, the amendments in this ASU are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

 29 

 

 

22. Recent Accounting Pronouncements (Continued)

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The amendments in this ASU create Topic 842, Leases, and supersede the leases requirements in Topic 840, Leases. Topic 842 specifies the accounting for leases. The objective of Topic 842 is to establish the principles that lessees and lessors shall apply to report useful information to users of financial statements about the amount, timing, and uncertainty of cash flows arising from a lease. Under the new guidance, a lessee will be required to recognize assets and liabilities for leases with lease terms of more than 12 months. The recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee will depend on its classification as finance or operating lease. This ASU will require both types of leases to be recognized on the balance sheet. For public entities, the amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In March 2016, the FASB issued ASU 2016-08, Principal versus Agent Considerations (Reporting Revenue Gross versus Net). The amendments in this ASU affect entities with transactions included within the scope of Topic 606 (Revenue from Contracts with Customers). The scope of Topic 606 includes entities that enter into contracts with customers to transfer goods or services (that are an output of the entity’s ordinary activities) in exchange for consideration. The amendments in this ASU clarify the implementation guidance on principal versus agent considerations. The effective date and transition requirements for this ASU are the same as the effective date of ASU 2014-09 above. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In April 2016, the FASB issued ASU 2016-10, Identifying Performance Obligations and Licensing. The amendments in this ASU affect entities with transactions included within the scope of Topic 606. This ASU clarifies guidance related to identifying performance obligations and licensing implementation guidance contained in the new revenue recognition standard. The ASU seeks to address areas in which diversity in practice potentially could arise, as well as to reduce the cost and complexity of applying certain aspects of the guidance both at implementation and on an ongoing basis. The effective date for this ASU is the same as the effective date and transition requirements in Topic 606 (and any other Topic amended by ASU 2014-09 above). The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In May 2016, the FASB issued ASU 2016-12, Narrow-Scope Improvements and Practical Expedients. The amendments in this ASU address narrow-scope improvements to the guidance on collectibility, noncash consideration, and completed contracts at transition. Additionally, the amendments in this ASU provide a practical expedient for contract modifications at transition and an accounting policy election related to the presentation of sales taxes and other similar taxes collected from customers. The effective date and transition requirements for the amendments in this ASU are the same as requirements of ASU 2014-09. ASU 2015-14, issued in August 2015, amended the effective date of ASU 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In June 2016, the FASB issued ASU 2016-13, Measurement of Credit Losses on Financial Instruments. The main objective of this ASU is to provide financial statement users with more decision-useful information about expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this ASU replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. For public entities that are SEC filers, the amendments in this ASU are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In August 2016, the FASB issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments. Current GAAP is either unclear or does not include guidance on certain cash flow issues included in the amendments in this ASU. The amendments are an improvement in GAAP because they provide guidance for each of the noted issues, thereby reducing the current and potential future diversity in accounting practice. This ASU addresses the following specific cash flow issues: debt prepayment or debt extinguishment costs; settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing; contingent consideration payments made after a business combination; proceeds from the settlement of insurance claims; proceeds from the settlement of corporate-owned life insurance policies (COLIs) (including bank-owned life insurance policies (BOLIs)); distributions received from equity method investees; beneficial interests in securitization transactions; and separately identifiable cash flows and application of the predominance principle. For public business entities, the amendments in this ASU are effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

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22. Recent Accounting Pronouncements (Continued)

 

In October 2016, the FASB issued ASU 2016-16, Intra-Entity Transfers of Assets Other Than Inventory. Topic 740, Income Taxes, prohibits the recognition of current and deferred income taxes for an intra-entity asset transfer until the asset has been sold to an outside party. In addition, interpretations of this guidance have developed in practice for transfers of certain intangible and tangible assets. This prohibition on recognition is an exception to the principle of comprehensive recognition of current and deferred income taxes in GAAP. To more faithfully represent the economics of intra-entity asset transfers, the amendments in this ASU require that entities recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. The amendments in this ASU do not change GAAP for the pre-tax effects of an intra-entity asset transfer under Topic 810, Consolidation, or for an intra-entity transfer of inventory. For public business entities, the amendments in this ASU are effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In November 2016, the FASB issued ASU 2016-18, Restricted Cash. Stakeholders indicated that diversity exists in the classification and presentation of changes in restricted cash on the statement of cash flows under Topic 230, Statement of Cash Flows. This ASU addresses that diversity and its amendments require that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The amendments in this ASU apply to all entities that have restricted cash or restricted cash equivalents and are required to present a statement of cash flows. For public business entities, the amendments in this ASU are effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In January 2017, the FASB issued ASU 2017-01, Clarifying the Definition of a Business. The amendments in this ASU clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of businesses. The amendments in this ASU provide a screen to determine when a set is not a business.  If the screen is not met, it (1) requires that to be considered a business, a set must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create output and (2) removes the evaluation of whether a market participant could replace the missing elements. For public business entities, the amendments in this ASU are effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In January 2017, the FASB issued ASU 2017-03, Accounting Changes and Error Corrections (Topic 250) and Investments-Equity Method and Joint Ventures (Topic 323). This ASU adds and amends SEC paragraphs pursuant to SEC Staff Announcements at the September 2016 and November 2016 Emerging Issues Task Force (EITF) meetings. The September announcement is about Disclosure of the Impact That Recently Issued Accounting Standards Will Have on the Financial Statements of a Registrant When Such Standards are Adopted in a Future Period. The November announcement made amendments to conform the SEC Observer Comment on Accounting for Tax Benefits Resulting from Investments in Qualified Affordable Housing Projects to the guidance issued in ASU 2014-01. For public business entities, amendments to the Topics covered by this ASU are effective for various fiscal years beginning after December 15, 2017, 2018 and 2019, respectively, and interim periods within those fiscal years. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In January 2017, the FASB issued ASU 2017-04, Simplifying the Test for Goodwill Impairment. Topic 350, Intangibles-Goodwill and Other, currently requires an entity to perform a two-step test to determine the amount, if any, of goodwill impairment. In Step 1, an entity compares the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of the reporting unit exceeds its fair value, the entity performs Step 2 and compares the implied fair value of goodwill with the carrying amount of that goodwill for that reporting unit. An impairment charge equal to the amount by which the carrying amount of goodwill for the reporting unit exceeds the implied fair value of that goodwill is recorded, limited to the amount of goodwill allocated to that reporting unit. To address concerns over the cost and complexity of the two-step goodwill impairment test, the amendments in this ASU remove the second step of the test. An entity will apply a one-step quantitative test and record the amount of goodwill impairment as the excess of a reporting unit's carrying amount over its fair value, not to exceed the total amount of goodwill allocated to the reporting unit. The new guidance does not amend the optional qualitative assessment of goodwill impairment. For public entities, the amendments in this ASU are effective for annual goodwill impairment tests in fiscal years beginning after December 15, 2019. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

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22. Recent Accounting Pronouncements (Continued)

 

In February 2017, the FASB issued ASU 2017-05, Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets. The amendments in this ASU clarify the scope of the nonfinancial asset guidance in Subtopic 610-20. This ASU also clarifies that derecognition of all businesses and nonprofit activities (except those related to conveyances of oil and gas mineral rights or contracts with customers) should be accounted for in accordance with derecognition and deconsolidation guidance in Subtopic 810-10. In addition, this ASU eliminates the exception in the financial asset guidance for transfers of investments (including equity method investments) in real estate entities and supersedes the guidance in the Exchanges of a Nonfinancial Asset for a Noncontrolling Ownership Interest Subsection within Topic 845. This ASU also provides guidance on the accounting for what often are referred to as partial sales of nonfinancial assets within the scope of Subtopic 610-20 and contributions of nonfinancial assets to a joint venture or other noncontrolled investee. The amendments in this ASU are effective at the same time as for ASU 2014-09 above. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In February 2017, the FASB issued ASU 2017-06, Employee Benefit Plan Master Trust Reporting. The FASB is issuing this ASU to improve the usefulness of the information reported to users of employee benefit plan financial statements. This ASU relates primarily to the reporting by an employee benefit plan (a plan) for its interest in a master trust. A master trust is a trust for which a regulated financial institution (bank, trust company, or similar financial institution that is regulated, supervised, and subject to periodic examination by a state or federal agency) serves as a trustee or custodian and in which assets of more than one plan sponsored by a single employer or by a group of employers under common control are held. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In March 2017, the FASB issued ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. Topic 715, Compensation-Retirement Benefits, requires an entity to present net periodic pension cost and net periodic postretirement benefit cost as a net amount that may be capitalized as part of an asset where appropriate.  Users have communicated that the service cost component generally is analyzed differently from the other components of net periodic pension cost and net periodic postretirement benefit cost. To improve the consistency, transparency, and usefulness of financial information for users, the amendments in this ASU require an employer to report the service cost component in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. It also requires the other components of net periodic pension cost and net periodic postretirement benefit cost to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. Additionally, only the service cost component is eligible for capitalization, when applicable. The amendments in this ASU are effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In March 2017, the FASB issued ASU 2017-08, Premium Amortization on Purchased Callable Debt Securities. This ASU amends guidance on the amortization period of premiums on certain purchased callable debt securities. Specifically, the amendments shorten the amortization period of premiums on certain purchased callable debt securities to the earliest call date. The amendments affect all entities that hold investments in callable debt securities that have an amortized cost basis in excess of the amount that is repayable by the issuer at the earliest call date (that is, at a premium). The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

In May 2017, the FASB issued ASU 2017-09, Compensation-Stock Compensation (Topic 718), Scope of Modification Accounting. This ASU is being issued to provide clarity and reduce both (1) diversity in practice and (2) cost and complexity when applying Topic 718 to a change to the terms and conditions of a share-based payment award. The amendments in this ASU affect any entity that changes the terms and conditions of a share-based payment award. The amendments in this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. The Company will evaluate the impact this ASU may have on its consolidated financial statements.

 

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

First South Bancorp, Inc. (the "Company") was formed for the purpose of issuing common stock and owning 100% of the stock of First South Bank (the "Bank") and operating through the Bank a commercial banking business. The discussion below focuses primarily on the Bank's results of operations. The Bank has one significant operating segment, providing commercial and retail banking services to its markets located in the state of North Carolina. The Company’s common stock is traded on the NASDAQ Global Select Market under the symbol "FSBK".

 

Mergers and Acquisitions.

 

Proposed Merger with Carolina Financial Corporation. On June 9, 2017, the Company entered into an Agreement and Plan of Merger and Reorganization (the “Merger Agreement”) with Carolina Financial Corporation (“CARO”). The Merger Agreement provides that the Company will merge with and into CARO (the “Merger”), with CARO continuing as the surviving corporation. As soon as practicable following consummation of the Merger, the Bank will merge with and into CARO’s wholly-owned subsidiary, CresCom Bank ("CresCom"), with CresCom continuing as the surviving entity (the “Bank Merger”). Subject to the terms and conditions of the Merger Agreement, at the effective time of the Merger, the Company’s stockholders will have the right to receive 0.52 shares of CARO common stock for each share of the Company’s common stock. Cash will be paid in lieu of fractional shares. The transaction is expected to close in the fourth quarter of 2017, subject to shareholder and regulatory approval and other customary closing conditions.

 

Comparison of Financial Condition at June 30, 2017, and December 31, 2016. Total assets increased by $70.7 million, or 7.1% to $1.1 billion at June 30, 2017, from $990.7 million at December 31, 2016. Earning assets increased by $73.8 million, or 8.0% to $996.0 million at June 30, 2017, from $922.2 million at December 31, 2016. The increases are attributable to growth in the loan and lease portfolio (“loans”) and the investment securities portfolio, while being partially offset by a reduction in interest-bearing deposits with banks to help fund the increased level of loans outstanding. The ratio of earning assets to total assets was 93.8% at June 30, 2017, compared to 93.1% at December 31, 2016.

 

Interest-bearing deposits with banks were $17.0 million at June 30, 2017, compared to $23.3 million at December 31, 2016. These funds are available to support securities purchases, loan originations, deposit withdrawals, liquidity management activities and daily operations of the Bank.

 

The investment securities portfolio increased to $195.9 million at June 30, 2017, from $193.1 million at December 31, 2016. The Bank may make changes in the investment securities portfolio mix to manage sensitivity to future interest rate changes. See “Note 4. Investment Securities” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Mortgage loans held for sale totaled $6.4 million at June 30, 2017, compared to $5.1 million at December 31, 2016, reflecting the net effect of current period mortgage lending activity. During the six months ended June 30, 2017, there were $19.2 million of loan sales, $18.4 million of loan originations, net of principal payments, and $563,000 of net realized gains. Proceeds from mortgage loan sales are used to fund the Bank’s liquidity needs, including loan originations, deposit withdrawals and general bank operations. See “Note 5. Loans Held for Sale” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Total loans held for investment grew by $76.0 million during the current six month period, or 10.8% to $776.7 million at June 30, 2017, from $700.6 million at December 31, 2016. During the six months ended June 30, 2017, there were $76.3 million of originations, net of principal payments, and $265,000 of transfers to other real estate owned (“OREO”). The loans-to-deposit ratio increased to 84.1% at June 30, 2017, from 81.1% at December 31, 2016, as loan growth outpaced deposit growth during the six months ended June 30, 2017. See “Note 6. Loans Held for Investment” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Improving asset quality metrics is a key component of the Bank’s short and long-term performance objectives. Loans held for investment on nonaccrual status, including troubled debt restructurings (“TDRs”) on nonaccrual status declined to $2.5 million at June 30, 2017, from $3.1 million at December 31, 2016. Management and the Board of Directors (“Board”) are committed to improving asset quality, as we believe it is a key driver of stock price performance and overall stockholder value. The ratio of loans held for investment on nonaccrual status to total loans held for investment was 0.33% at June 30, 2017, compared to 0.44% at December 31, 2016.

 

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

 

Management has evaluated all nonperforming loans and believes they are either well collateralized or adequately reserved. However, there can be no assurance in the future that regulators, increased volume and risks in the loan portfolio, adverse changes in economic conditions or other factors will not require additional adjustments to the allowance for loan and lease losses (“ALLL”). Aside from the loans identified on nonaccrual status, there were no loans at June 30, 2017 where known information about possible credit problems of borrowers caused management to have serious concerns as to the ability of the borrowers to comply with their current loan repayment terms.

 

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

 

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

 

The ALLL was $9.4 million at June 30, 2017, compared to $8.7 million at December 31, 2016. The ratio of the ALLL to loans held for investment was 1.21% at June 30, 2017, compared to 1.24% at December 31, 2016. During the six months ended June 30, 2017, there were $750,000 of provision for credit losses and $57,000 of net charge-offs. See “Note 7. Allowance for Loan and Lease Losses” of “Notes to Consolidated Financial Statements (Unaudited)”and “Critical Accounting Policies - Loan Impairment and Allowance for Loan and Lease Losses” for additional information.

 

Based on an impairment analysis of loans held for investment, there were $8.9 million of loans classified as impaired, net of $161,000 in write-downs at June 30, 2017, compared to $11.1 million classified as impaired, net of $654,000 in write-downs at December 31, 2016. At June 30, 2017 and December 31, 2016, the ALLL included $309,000 and $393,000 specifically provided for impaired loans, respectively.

 

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

 

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

 

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

 

OREO acquired from foreclosures declined to $2.4 million at June 30, 2017, from $3.2 million at December 31, 2016. During the six months ended June 30, 2017, there were $880,000 of disposals, $177,000 of valuation adjustments and $266,000 of additions. OREO consists of residential and commercial properties, developed lots and raw land. The Bank believes the adjusted carrying values of these properties are representative of their fair market values, although there can be no assurances that ultimate sales will be equal to or greater than the carrying values. See “Note 9. Other Real Estate Owned” and “Note 17. Fair Value Measurement” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Mortgage servicing rights (“MSRs”) were $2.1 million at both June 30, 2017 and December 31, 2016, respectively. Loans serviced for others declined to $363.5 million at June 30, 2017, from $372.0 million at December 31, 2016, as principal repayments exceeded the volume of new loans sold service retained.

 

The Bank’s investment in bank-owned life insurance (“BOLI”) was $18.4 million at June 30, 2017, compared to $18.1 million at December 31, 2016. The investment returns from the BOLI are utilized to offset a portion of the cost of providing benefit plans to certain employees.

 

Goodwill was $4.2 million at both June 30, 2017 and December 31, 2016, respectively, and is tested for impairment annually. The Company’s most recent annual test determined there was no goodwill impairment. Identifiable intangible assets were $1.5 million at June 30, 2017, compared to $1.6 million at December 31, 2016, reflecting the core deposit intangible associated with a prior period branch acquisition transaction, which is being amortized over a ten year period. See “Note 11. Goodwill and Other Intangibles” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Total deposits increased by $60.9 million, or 7.0% to $931.5 million at June 30, 2017, from $870.6 million at December 31, 2016. For the current six month period non-maturity deposits (personal and business checking, savings and money market accounts) grew by $53.1 million, or 8.7% to $667.2 million at June 30, 2017, from $614.0 million at December 31, 2016.

 

Certificates of deposit (“CDs”) grew by $7.8 million, to $264.3 million at June 30, 2017, from $256.6 million at December 31, 2016. CDs represented 28.4% and 29.5% of total deposits at June 30, 2017 and December 31, 2016, respectively. The Bank attempts to manage its cost of deposits through a combination of monitoring the volume and pricing of new and maturing CDs and growth in non-maturity deposits, in relationship to current funding needs and market interest rates. See “Note 12. Deposits” of “Notes to Consolidated Financial Statements (Unaudited)” and “Interest Expense” below for additional information regarding deposits and the cost of funds.

 

Federal Home Loan Bank (“FHLB”) borrowings increased to $22.5 million at June 30, 2017, from $17.0 million at December 31, 2016. The Bank may use FHLB borrowings as a funding source to provide an effective means of managing its overall cost of funds and to manage its exposure to interest rate risk. There were $10.3 million of junior subordinated debentures outstanding at both June 30, 2017 and December 31, 2016, respectively. See “Note 13. Borrowed Money” and “Note 14. Junior Subordinated Debentures” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Stockholders' equity increased by $4.7 million to $91.9 million at June 30, 2017, from $87.2 million at December 31, 2016. This increase primarily reflects the $3.9 million of net income earned for the six months ended June 30, 2017, a $1.4 million increase in accumulated other comprehensive income resulting from the mark-to-market adjustment of the available-for-sale securities portfolio, and is net of $665,000 of dividends declared. There were 9,502,520 common shares outstanding at June 30, 2017, compared to 9,494,935 shares outstanding at December 31, 2016, reflecting the net effect of 4,478 shares issued pursuant to the vesting of restricted stock awards and 3,107 shares issued pursuant to a stock option exercise during the current six month period.

 

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

 

The tangible equity to assets ratio was 8.12% at June 30, 2017, versus 8.21% at December 31, 2016; and the tangible book value per common share increased to $9.07 at June 30, 2017, from $8.57 at December 31, 2016.

 

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

 

Comparison of Operating Results – Three and Six Months Ended June 30, 2017 and 2016.

 

General. Net income for the three months ended June 30, 2017 increased 27.5% to $2.1 million, or $0.22 per diluted common share, from net income of $1.6 million, or $0.17 per diluted common share earned for the comparative three month period ended June 30, 2016. The improvement in net income on a comparative quarter basis is primarily due to a $975,000, or 12.0% increase in net interest income, while maintaining consistent volumes of non-interest income and non-interest expense (excluding merger-related expenses). The improvement in comparative quarterly net income reflects the impact of strong loan growth over the past twelve months.

 

Net income for the six months ended June 30, 2017 increased 27.8% to $3.9 million, or $0.41 per diluted common share, compared to net income of $3.1 million, or $0.32 per diluted common share earned in the six months ended June 30, 2016. Earnings for the current six month period were positively impacted by increases in net interest income and non-interest income, as well as maintaining a consistent volume of non-interest expense (excluding merger-related expenses), while being partially offset by an increase in the provision for credit losses associated with the strong loan portfolio growth.

 

Impact of Merger-Related Transaction Expenses. In connection with the proposed merger transaction, the Company incurred $278,000 of professional fees and services expense that impacted our results of operations for the quarter and six months ended June 30, 2017. Excluding the net effects of these expenses, net income for the 2017 second quarter would have totaled $2.3 million, or $0.24 per diluted common share. Net income for the first six months of 2017 would have been $4.1 million, or $0.43 per diluted common share. The Company anticipates that it will incur additional expenses associated with the merger transaction prior to its expected consummation in the fourth quarter. The following table presents net income and diluted EPS for the respective June 30, 2017 second quarter and six month periods adjusted for the impact of the merger-related transaction expenses:

 

   Quarter Ended
6/30/17
   Six Months Ended
6/30/17
 
   (In thousands, except per share data) 
Reported Net Income (GAAP)  $2,055   $3,927 
Adjustments for Merger Expenses:          
Professional Fees and Services   278    278 
Income Tax Benefit (Qtr-29.96% / YTD-29.68%)   (83)   (82)
Net Income Adjusted for Merger Expenses  $2,250   $4,123 
           
Reported Diluted EPS (GAAP)  $0.22   $0.41 
Impact of Merger Expenses on Diluted EPS  $0.02   $0.02 
Diluted EPS Adjusted for Merger Expenses  $0.24   $0.43 

  

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Interest Income. Interest income increased to $10.1 million and $19.7 million for the three and six months ended June 30, 2017, from $9.0 million and $17.7 million for the comparable 2016 periods. The year-over-year growth in interest income is due to changes in the composition and volume of our earning asset base, coupled with an increase in yields on earning assets. The tax equivalent yield on average earning assets increased to 4.19% and 4.17% for the three and six months ended June 30, 2017, from 4.17% and 4.12% for the three and six months ended June 30, 2016. Average earning assets increased to $975.2 million and $960.9 million for the three and six months ended June 30, 2017, from $875.5 million and $870.5 million for the comparative 2016 three and six month periods.

 

Interest Expense. Interest expense increased to $1.0 million and $2.0 million for the three and six months ended June 30, 2017, from $898,000 and $1.8 million for the comparable 2016 periods. Interest expense was primarily impacted by increased interest paid on deposits between the comparative reporting periods, reflecting the growth in total deposits discussed above. The cost of average interest-bearing liabilities increased to 0.55% and 0.54% for the respective three and six months ended June 30, 2017, from 0.52% for both of the comparable 2016 periods. The Bank’s cost of interest-bearing liabilities has been impacted by the growth of non-maturity deposits and CDs as discussed above, as well as pricing of new and renewed CDs in the current interest rate environment.

 

Average interest-bearing liabilities increased to $743.3 million and $733.9 million for the three and six months ended June 30, 2017, from $685.7 million and $685.4 for the comparable 2016 periods. Average non-interest-bearing demand deposits increased to $201.5 million and $198.3 million for the three and six months ended June 30, 2017, from $170.2 million and $166.8 million for the 2016 three and six months periods.

 

Net Interest Income. Net interest income for the three and six months ended June 30, 2017 increased to $9.1 million and $17.7 million, from $8.1 million and $15.9 million for the comparable 2016 periods. The tax equivalent net interest margin increased to 3.78% and 3.76% for the three and six months ended June 30, 2017, from 3.76% and 3.71% for the comparable 2016 periods. Yields on earning assets have been positively impacted by the strong growth in the Bank’s loan portfolio. This loan growth has resulted in a significant change in the mix of our earning assets over comparative periods. On the liability side of the balance sheet, continued expansion of our non-maturity deposit base, including non-interest bearing demand deposit accounts, has allowed the Company to efficiently fund its loan growth.

 

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

 

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Table 1 – Yield/Cost Analysis  Three Months Ended June 30, 
   2017   2016 
   Average
Balance
   Interest   Average
Yield Cost
   Average
Balance
   Interest   Average
Yield Cost
 
  (Dollars in thousands) 
Interest earning assets:    
Loans receivable  $750,246   $8,701    4.60%  $657,301   $7,642    4.62%
Investments and deposits   224,965    1,392    2.83(1)   218,228    1,356    2.82(1)
Total earning assets   975,211    10,093    4.19(1)   875,529    8,998    4.17(1)
Nonearning assets   66,612              72,232           
Total assets  $1,041,823             $947,761           
Interest bearing liabilities:                              
Deposits  $714,938    830    0.47   $653,904    697    0.43 
Borrowings   18,044    61    4.34    21,531    59    1.10 
Junior subordinated debentures   10,310    127    4.87    10,310    142    5.43 
Total interest bearing liabilities   743,292    1,018    0.55    685,745    898    0.52 
Noninterest bearing demand deposits   201,511    -    -    170,244    -    - 
Total sources of funds   944,803    1,018    0.43    855,989    898    0.42 
Other liabilities   5,568              5,845           
Stockholders’ equity   91,452              85,927           
Total liabilities and equity  $1,041,823             $947,761           
Net interest income       $9,075             $8,100      
Interest rate spread (1)(2)             3.65%             3.64%
Net interest margin (1)(3)             3.78%             3.30%
Ratio of earning assets to interest  bearing liabilities             131.20%             127.68%
                               
   Six Months Ended June 30, 
   2017   2016 
   Average
Balance
   Interest   Average
Yield Cost
   Average
Balance
   Interest   Average
Yield Cost
 
   (Dollars in thousands) 
Interest earning assets:    
Loans receivable  $729,510   $16,914    4.62%  $639,323   $14,834    4.60%
Investments and deposits   231,340    2,783    2.75(1)   231,173    2,836    2.77(1)
Total earning assets   960,850    19,697    4.17(1)   870,496    17,670    4.12(1)
Nonearning assets   67,177              72,736           
Total assets  $1,028,027             $943,232           
Interest bearing liabilities:                              
Deposits  $703,463    1,584    0.45   $647,682    1,367    0.42 
Borrowings   20,105    123    1.22    27,422    132    0.97 
Junior subordinated debentures   10,310    251    4.85    10,310    281    5.40 
Total interest bearing liabilities   733,878    1,958    0.54    685,414    1,780    0.52 
Noninterest bearing demand deposits   198,308    -    -    166,756    -    - 
Total sources of funds   932,186    1,958    0.42    852,170    1,780    0.42 
Other liabilities   5,547              5,966           
Stockholders’ equity   90,294              85,096           
Total liabilities and equity  $1,028,027             $943,232           
Net interest income       $17,739             $15,890      
Interest rate spread (1)(2)             3.63%             3.60%
Net interest margin (1)(3)             3.76%             3.71%
Ratio of earning assets to interest  bearing liabilities             130.93%             127.00%

 

1.Shown as a tax-adjusted yield.
2.Represents the difference between the average yield on earning assets and the average cost of funds.
3.Represents net interest income divided by average earning assets.

 

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Provision for Credit Losses. The Bank's methodology for determining its provision for credit losses includes amounts specifically allocated to credits that are individually determined to be impaired and general provisions allocated to groups of loans that have not been individually assessed for impairment. The Bank recorded $485,000 and $750,000 of provisions for credit losses in the three and six months ended June 30, 2017, compared to $325,000 and $550,000 recorded in the three and six months ended June 30, 2016. The increase in provision for credit losses was primarily to support the $76.0 million net growth in loans held for investment during the current reporting periods. Provision for credit losses is necessary to maintain the ALLL at a level that management believes is adequate to absorb probable future losses in the loan portfolio. See “Note 7. Allowance for Loan and Lease Losses” of “Notes to Consolidated Financial Statements (Unaudited)” and “Allowance for Loan and Lease Losses” and “Critical Accounting Policies - Loan Impairment and Allowance for Loan and Lease Losses” included herein for additional information.

 

Non-interest Income. Total non-interest income totaled $3.6 million and $6.9 million for the three and six months ended June 30, 2017, compared to $3.5 million and $7.1 million for the 2016 three and six month periods. Non-interest income consists of deposit fees and service charges; loan fees and charges; mortgage loan servicing fees; gain on sale and other fees on mortgage loans, net gain on investment securities and OREO sales; and other miscellaneous income. Fees and service charges on deposits, and fees on loans and loan servicing fees earned during each period are influenced by the volume of deposits and loans outstanding, the volume of the various types of deposit and loan account transactions processed, the volume of loans serviced for others and the collection of related fees and service charges.

 

Deposit fees and service charges remained relatively consistent at $2.0 million and $3.8 million for the three and six months ended June 30, 2017, compared to $1.9 million and $3.8 million for the 2016 three and six month periods. Deposit fees and service charges represented 55.2% and 55.7% of total non-interest income for the three and six months ended June 30, 2017, compared to 54.4% and 53.9% for the 2016 three and six month periods. The amount of service charges and fees is generally dependent upon the volume of account transaction activity and the collection of related service charges and fees.

 

Total non-interest income generated from the sale and servicing of mortgage loans and loan fees increased to $971,000 and $1.8 million for the three and six months ended June 30, 2017, from $842,000 and $1.5 million for the 2016 three and six month periods. The Bank may sell or securitize fixed-rate residential mortgage loans to reduce interest rate and credit risk exposure, and to provide a more balanced sensitivity to future interest rate changes, while retaining certain other mortgage loans for future securitization into available-for-sale mortgage-backed securities. Proceeds from mortgage loan sales provide liquidity to support the Bank’s operating, financing and lending activities. We continue to explore various strategies to enhance our non-interest income, including the purchase of mortgage servicing rights.

 

No gains on sales of investment securities available-for-sale were recorded for the three and six months ended June 30, 2017, compared to $184,000 and $467,000 for the 2016 three and six month periods. During the three and six months ended June 30, 2017, the Bank did not sell any investment securities available-for-sale, compared to $9.9 million and $40.6 million sold in the 2016 three and six month periods. Proceeds from investment securities sales in 2016 were primarily used to fund net growth in our loan portfolio.

 

During the three and six months ended June 30, 2017, the Bank recorded net losses of $26,000 and net gains of $56,000, respectively, from the sale of OREO compared to net losses of $14,000 and $26,000 for the respective 2016 three and six month periods, as the Bank continues in its efforts of disposing of these nonperforming assets. See “Note 9. Other Real Estate Owned” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Other non-interest income was $556,000 and $1.0 million for the three and six months ended June 30, 2017, compared to $467,000 and $1.2 million for the 2016 three and six month periods. Other non-interest income includes revenue from BOLI investments. BOLI earnings were $132,000 and $271,000 for the three and six months ended June 30, 2017, compared to $142,000 and $277,000 for the 2016 periods.

 

 39 

 

 

Other non-interest income also includes revenues of $111,000 and $227,000 for the three and six months ended June 30, 2017, from gains and retained servicing fees on Small Business Administration (“SBA”) loans sold , compared to $142,000 and $286,000 for the 2016 three and six month periods. During the first six months of 2016, other non-interest income also included the receipt of a $230,000 non-recurring fee.

 

Non-interest Expense. Total non-interest expense was $9.2 million and $18.3 million for the three and six months ended June 30, 2017, compared to $9.0 million and $18.2 million for the 2016 three and six month periods. The year-over-year variation in non-interest expenses is partially attributable to the $278,000 of merger-related expenses discussed above.

 

Compensation and benefit expenses, the largest component of non-interest expense, was $5.0 million and $10.1 million for the three and six months ended June 30, 2017, compared to $4.9 million and $10.0 million for the 2016 three and six month periods. The six months ended June 30, 2016 included $65,000 of severance costs associated with branch consolidations during the period. The Bank will continue to manage staffing levels to ensure we meet the ongoing needs of our customers and to support our future growth.

 

Federal Deposit Insurance Corporation (the “FDIC”) insurance premiums were $157,000 and $304,000 for the three and six months ended June 30, 2017, compared to $161,000 and $322,000 for the 2016 three and six month periods. The amount of our quarterly FDIC insurance premiums is determined by an FDIC calculation method based on various risk based components, combined with growth in our balance sheet.

 

Premises and equipment expense remained consistent at $1.3 million and $2.7 million for the three and six months ended June 30, 2017, compared to $1.4 million and $2.8 million for the 2016 three and six month periods. During the first quarter of 2017, we consolidated two branch locations with other nearby facilities, compared to three branch locations consolidated into other facilities in the first quarter of 2016. We continue to explore opportunities to gain efficiencies and performance improvements from our branch network.

 

Marketing expense declined to $119,000 and $183,000 for the three and six months ended June 30, 2017, from $229,000 and $417,000 for the 2016 three and six month periods. During the prior fiscal year, we focused marketing efforts on enhancing our brand awareness throughout our footprint and more specifically in new markets.

 

Data processing costs increased to $808,000 and $1.6 million for the three and six months ended June 30, 2017, compared to $750,000 and $1.5 million for the 2016 three and six month periods. Data processing costs fluctuate in conjunction with growth in the volume of loan and deposit accounts, combined with transaction activity volumes.

 

Total amortization of intangible assets, including MSRs and identifiable intangible assets, increased to $151,000 and $300,000 for the three and six months ended June 30, 2017, from $134,000 and $265,000 for the 2016 three and six month periods. Amortization of MSRs was $91,000 and $180,000 for the three and six months ended June 30, 2017, compared to $62,000 and $123,000 for the 2016 three and six month periods. The increase in the amortization of MSRs during the respective 2017 periods is primarily attributable to amortization expense associated with a $778,000 MSR portfolio purchased in the third quarter of 2016. Amortization of the core deposit intangible, which is the only identifiable intangible asset subject to amortization, was $60,000 and $121,000 for the three and six months ended June 30, 2017, compared to $71,000 and $142,000 for the 2016 three and six month periods. See “Note 11. Goodwill and Other Intangibles” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

Total expenses attributable to the ongoing maintenance, property taxes, insurance and valuation adjustments for OREO properties were $105,000 and $270,000 for the three and six months ended June 30, 2017, compared to $213,000 and $307,000 for the 2016 three and six month periods. OREO valuation adjustments included therein were $58,000 and $177,000 for the three and six months ended June 30, 2017, compared to $103,000 and $110,000 for the 2016 three and six month periods. Management continuously analyzes the carrying value of OREO and makes valuation adjustments as necessary. See “Note 9. Other Real Estate Owned” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

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Other non-interest expense increased to $1.5 million and $2.8 million for the three and six months ended June 30, 2017, compared to $1.2 million and $2.6 million for the 2016 three and six month periods. The increase in other non-interest expenses is primarily attributable to the $278,000 in merger-related expenses previously discussed. In addition, during the first quarter of 2017 and the first quarter of 2016, the Bank consolidated two and three existing branches, respectively, into nearby locations. Of the locations that were consolidated, four of the facilities are leased and one was owned. The Bank sold the owned location in first quarter of 2016 and realized an $85,000 pre-tax loss, which is included in other non-interest expense during that reporting period.

 

Income tax expense increased to $879,000 and $1.7 million for the three and six months ended June 30, 2017, from $665,000 and $1.2 million for the 2016 three and six month periods. The effective income tax rates were 29.96% and 29.68% for the three and six months ended June 30, 2017, compared to 29.20% and 28.72 % for the for the 2016 three and six month periods. The Bank’s investment in BOLI and tax-exempt municipal bonds contribute to more favorable effective income tax rates, which has been partially offset by the strong growth in the loan portfolio. See “Critical Accounting Policies” below for additional information.

 

Key Performance Ratios. Three of our key performance ratios are return on average assets (“ROA”), return on average equity (“ROE”) and the efficiency ratio. ROA improved to 0.79% and 0.77% for the three and six months ended June 30, 2017, from 0.68% and 0.66% for the comparable 2016 three and six month periods. ROE improved to 9.01% and 8.77% for the three and six months ended June 30, 2017, from 7.55% and 7.26% for the comparable 2016 three and six month periods. The efficiency ratio improved to 71.65% and 73.23% for the three and six months ended June 30, 2017, from 77.59% and 79.14% for the comparable 2016 three and six month periods. The efficiency ratio measures the proportion of net operating revenues that are absorbed by overhead expenses. We anticipate the efficiency ratio to improve as we continue exploring opportunities to increase operating leverage and gain efficiencies from our branch network.

 

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

 

At June 30, 2017, the Bank had cash, deposits in other banks, investment securities and loans held for sale totaling $242.4 million, compared to $244.4 million at December 31, 2016. The Bank calculates its liquidity position under policy guidelines based on liquid assets in relationship to deposits and short-term borrowings. Based on its calculation guidelines, the Bank’s liquidity ratio was 20.6% at June 30, 2017, compared to 25.0% at December 31, 2016, which management believes is adequate.

 

The Bank believes it can meet future liquidity needs with existing funding sources. The Bank's primary sources of funds are deposits, principal payments on loans and mortgage-backed securities, funds provided from operations, the ability to borrow from the FHLB of Atlanta and other lines of credit, and the availability of loans and investment securities available-for-sale. At June 30, 2017, the Bank had $259.6 million of credit availability with the FHLB, of which there was lendable collateral value totaling $220.4 million. Additional collateral would be required in order to access total borrowings up to the credit availability limit. In addition, at June 30, 2017, the Bank had additional capacity to borrow $107.1 million from the Federal Reserve Bank (“FRB”) Discount Window. At June 30, 2017, the Bank had $70.0 million of pre-approved, but unused lines of credit. See “Note 13. Borrowed Money” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

 

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

 

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

 

Table 2 – Contractual Obligations  Payments Due by Period 
   Total   Less Than 1
Year
   1-3 Years   3-5 Years   More Than 5
Years
 
   (In thousands) 
Borrowed money  (1)  $22,500   $11,000   $10,500   $1,000   $- 
Junior subordinated debentures (2)   10,310    -    -    -    10,310 
Lease obligations (3)   5,362    1,241    1,744    1,078    1,299 
Deposits (4)   931,534    826,260    78,899    26,375    - 
Total contractual obligations  $969,706   $838,501   $91,143   $28,453   $11,609 

 

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

 

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

 

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

 

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

 

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

 

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

 

 42 

 

 

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

 

Table 3 – Off Balance Sheet Arrangements  June 30, 2017   December 31, 2016 
   (In Thousands) 
Commitments to originate loans  $120,165   $112,070 
Undrawn balances on lines of credit and credit reserves   56,865    54,186 
Standby letters of credit   615    487 
Total contractual obligations  $177,645   $166,743 

 

The reserve for unfunded commitments was $283,742 and $311,623 as of June 30, 2017 and December 31, 2016, respectively, which was recorded in other liabilities on the consolidated balance sheets.

 

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

 

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

 

In calculating NII at risk, the Company begins with a base amount of NII that is projected over the next twelve and twenty four months, assuming the balance sheet is static and the yield curve remains unchanged over the period. The current yield curve is then “shocked,” or moved immediately, ±1.0 percent, ±2.0 percent, ±3.0 percent and ±4.0 percent in a parallel fashion, or at all points along the yield curve. New twelve and twenty four month NII projections are developed using the same balance sheet but with the new yield curves and these results are compared to the base scenario. The Company also models other scenarios to evaluate potential NII at risk such as a gradual ramp in interest rates, a flattening yield curve, a steepening yield curve, and others that management deems appropriate.

 

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

 

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

 

Table 4 – NII and EVE Analysis     June 30, 2017  
Immediate change in interest rates:     Estimated Exposure
to NII
    Estimated Exposure to
EVE
 
+4.0%       6.57 %   1.68 %
+3.0%       5.90     4.25  
+2.0%       3.82     5.75  
+1.0%       2.09     4.27  
No change            
-1.0%       (4.79 )   (9.18 )

 

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

 

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

 

PART II. OTHER INFORMATION

 

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

 

Item 1A. Risk Factors: As previously discussed in this report, on June 9, 2017, the Company and Carolina Financial Corporation (“Carolina Financial”) entered into an Agreement and Plan of Merger and Reorganization, pursuant to which the Company will merge with and into Carolina Financial, with Carolina Financial as the surviving entity, subject to the terms and conditions set forth in the merger agreement. The following risk factors relating to the merger are being provided in addition to the risk factors previously disclosed in the Company’s Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 2017.

 

In addition, Carolina Financial’s and the Company’s respective businesses are subject to numerous risks and uncertainties, including the risks and uncertainties described in this section, in Carolina Financial’s Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2016, and in the Company’s Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 2016.

 

First South stockholders will experience a reduction in percentage ownership and voting power of their shares as a result of the merger. First South stockholders will experience a substantial reduction in their percentage ownership interest and effective voting power relative to their percentage ownership interest in First South compared to their ownership interest and voting power prior to the merger. Former First South stockholders will own less than a majority of the outstanding voting stock of the combined company and could, as a result, be outvoted by current Carolina Financial stockholders if such current Carolina Financial stockholders voted together as a group.

 

Because the market price of Carolina Financial common stock will fluctuate, First South stockholders cannot be sure of the exact value of shares of Carolina Financial common stock they will receive. Upon completion of the merger, each outstanding share of First South common stock will be converted into the merger consideration consisting of shares of Carolina Financial common stock, as provided in the merger agreement. The closing price of Carolina Financial common stock on the date that the shareholder actually receives the shares of such stock after the merger is completed and the closing price of Carolina Financial common stock the date on which the effective time of the merger is to occur may vary from each other, as well as from the closing price of Carolina Financial common stock on the date that the Carolina Financial and First South announced the merger, on the date that this proxy statement/prospectus is being mailed to Carolina Financial and First South stockholders, and on the date of the special stockholders’ meetings. Stock price changes may result from a variety of factors, including general market and economic conditions, changes in Carolina Financial’s business, operations and prospects, and regulatory considerations, among other things. Many of these factors are beyond the control of Carolina Financial. Accordingly, at the time of the First South special stockholders’ meeting, because of the above timing differences, First South stockholders will not be able to calculate the exact value of Carolina Financial common stock they may receive upon completion of the merger.

 

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Combining the two companies may be more difficult, costly, or time consuming than Carolina Financial or First South expects. The success of the merger will depend, in part, on Carolina Financial’s ability to realize the anticipated benefits and cost savings from combining the businesses of Carolina Financial and First South. However, to realize these anticipated benefits and cost savings, we must successfully combine the businesses of Carolina Financial and First South. If we are not able to achieve these objectives, the anticipated benefits and cost savings of the merger may not be realized fully or at all or may take longer to realize than expected.

 

Carolina Financial and First South have operated, and, until completion of the merger, will continue to operate, independently. It is possible that the integration process could result in the loss of key employees or disruption of each company’s ongoing business or inconsistencies in standards, controls, procedures, and policies that would adversely affect Carolina Financial’s ability to maintain relationships with clients, depositors, and employees or to achieve the anticipated benefits of the merger. Integration efforts between the two companies will also divert management attention and resources. These integration matters could have an adverse effect on First South during that transition period.

 

Carolina Financial and First South will incur significant transaction and merger-related integration costs in connection with the merger. Carolina Financial and First South expect to incur significant costs associated with completing the merger and integrating the operations of the two companies. Carolina Financial and First South are continuing to assess the impact of these costs. Although Carolina Financial and First South believe that the elimination of duplicate costs, as well as the realization of other efficiencies related to the integration of the businesses, will offset incremental transaction and merger-related costs over time, this net benefit may not be achieved in the near term, or at all.

 

Carolina Financial has not previously operated in First South’s markets in eastern North Carolina. First South’s service area is eastern and central North Carolina. The banking business in these areas is extremely competitive, and the level of competition may increase further. Carolina Financial has not previously participated in these markets, and there may be unexpected challenges and difficulties that could adversely affect Carolina Financial following the merger.

 

Carolina Financial and First South may not receive regulatory approvals or such approvals may take longer than expected or impose conditions Carolina Financial and First South do not presently anticipate. The merger of the two banks must be approved by the FDIC, the South Carolina Board of Financial Institutions, and the North Carolina Commissioner of Banks. These regulatory agencies will consider, among other things, the competitive impact of the bank merger, each of Carolina Financial and First South’s financial and managerial resources, and the convenience and needs of the communities to be served. As part of that consideration, Carolina Financial and First South expect that the FDIC will review the capital position, safety and soundness, and legal and regulatory compliance matters and Community Reinvestment Act matters. There can be no assurance as to whether the necessary regulatory approvals will be received, the timing of such approvals, or whether any conditions will be imposed that might limit the combined company’s ability to do business after the bank merger as presently anticipated. Carolina Financial has filed notice of the merger with the Federal Reserve, rather than seeking the approval of the Federal Reserve to consummate the merger, because the merger qualifies as a “waiver transaction” under the applicable rules and regulations of the Federal Reserve. However, if the Federal Reserve were to subsequently determine that the merger did not qualify as a waiver transaction, then Carolina Financial would be required to submit a formal merger application for approval of the merger by the Federal Reserve.

 

The merger agreement limits First South’s ability to pursue alternatives to the merger. The merger agreement contains provisions that limit First South’s ability to discuss competing third-party proposals to acquire all or a significant part of First South. In addition, First South has agreed to pay Carolina Financial a termination fee of $5,750,000 if the transaction is terminated because First South decides to pursue another acquisition transaction, among other things. These provisions might discourage a potential competing acquirer that might have an interest in acquiring all or a significant part of First South from considering or proposing that acquisition, even if it were prepared to pay consideration with a higher per share price than that proposed in the merger with Carolina Financial, or might result in a potential competing acquirer proposing to pay a lower per share price to acquire First South than it might otherwise have proposed to pay.

 

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First South directors and executive officers have financial interests in the merger that are different from, or in addition to, the interests of First South stockholders. Executive officers of First South negotiated certain terms of the merger agreement with their counterparts at Carolina Financial, and First South’s board of directors adopted the merger agreement and by a unanimous vote of the directors present and voting recommended that First South stockholders vote to approve the merger agreement and the merger on the terms set forth in the merger agreement. In considering these facts, First South stockholders should be aware that First South’s directors and executive officers have financial interests in the merger that are different from, or in addition to, the interests of First South stockholders. For example, two of First South’s directors will be invited to join the Carolina Financial board of directors, the remaining First South directors will be entitled to participate on an advisory board of CresCom Bank following the merger and will receive certain fees for their service, and Bruce W. Elder, president and chief executive officer of First South, will be invited to join the CresCom Bank board of directors. In addition, certain executive officers of First South have entered into agreements with First South and Carolina Financial that provide, among other things, retention, employment, consulting, severance and/or other benefits following the merger. These and some other additional interests of First South directors and executive officers may create potential conflicts of interest and cause some of these persons to view the proposed transaction differently than First South stockholders may view it.

 

If the merger is not completed, First South common stock could be materially adversely affected. The merger is subject to customary conditions to closing, including the approval of the First South stockholders and the Carolina Financial stockholders. In addition, Carolina Financial and First South may terminate the merger agreement under certain circumstances. If Carolina Financial and First South do not complete the merger, the market price of First South common stock may fluctuate to the extent that the current market prices of those shares reflect a market assumption that the merger will be completed. Further, whether or not the merger is completed, First South will also be obligated to pay certain investment banking, legal and accounting fees, and related expenses in connection with the merger, which could negatively impact results of operations when incurred. In addition, neither company would realize any of the expected benefits of having completed the merger. If the merger is not completed, First South cannot assure its stockholders that additional risks will not materialize or not materially adversely affect the business, results of operations and stock price of First South.

 

Carolina Financial may fail to realize the cost savings estimated for the merger. Carolina Financial expects to achieve cost savings from the merger when the two companies have been fully integrated. The cost savings estimates assume the ability to combine the businesses of Carolina Financial and First South in a manner that permits those cost savings to be realized. If the estimates turn out to be incorrect or if Carolina Financial is not able to combine successfully the two companies, the anticipated cost savings may not be fully realized or realized at all, or may take longer to realize than expected.

 

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds: Not applicable

 

Item 3. Defaults Upon Senior Securities: Not applicable

 

Item 4. Mine Safety Disclosures: Not applicable.

 

Item 5. Other Information: Not applicable

 

Item 6. Exhibits: The following exhibits are filed herewith:

 

Number   Title
     
2.1   Agreement and Plan of Merger and Reorganization, dated June 9, 2017, by and between Carolina Financial Corporation and First South Bancorp, Inc. (Incorporated herein by reference from Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on June 15, 2017).
     
31.1   Rule 13a-14(a) Certification of Chief Executive Officer
     
31.2   Rule 13a-14(a) Certification of Chief Financial Officer
     
32   Section 1350 Certification
     
101   Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Statements of Financial Condition as of June 30, 2017 (unaudited) and December 31, 2016; (ii) Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2017 and 2016 (unaudited); (iii) Consolidated Statements of Comprehensive Income (Loss) for the Three and Six Months Ended June 30, 2017 and 2016 (unaudited); (iv) Consolidated Statements of Changes in Stockholders’ Equity for the Six Months Ended June 30, 2017 and 2016 (unaudited); (v) Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2017 and 2016 (unaudited); and (vi) Notes to Consolidated Financial Statements (unaudited) as of June 30, 2017 and December 31, 2016, and for the Three and Six Months Ended June 30, 2017 and 2016.

  

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SIGNATURES

 

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

 

  FIRST SOUTH BANCORP, INC.
     
  By: /s/ Scott C. McLean  
    Scott C. McLean
    Executive Vice President
    Chief Financial Officer
    (Principal Financial and Accounting Officer)
     
    Date: August 8, 2017

 

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